Risk Management Framework of Islamic Banks in Pakistan

This report provides an empirical investigation of the risk management framework of Islamic banks in Pakistan. The literature review covers various aspects of risk management, including credit risk, market risk, liquidity risk, and operational risk. The report also explores the characteristics of risks faced by Islamic banks, differentiating between theoretical formulations and practical practices. It delves into the risk management framework, highlighting key components such as risk identification, measurement, mitigation, reporting, and monitoring. The study further examines the specific challenges faced by Islamic banks, such as credit risk, benchmark risk, liquidity risk, and Shariah risk. The research methodology section outlines the approach taken to analyze and assess the risk management practices within the context of Islamic banking in Pakistan. The report concludes with a discussion on the practical implementation and effectiveness of risk management strategies.

Empirical Investigation of
Risk Management
Framework of Islamic
Banks in Pakistan.

Contents
Literature Review.............................................................................................................................3
ISLAMIC BANKING RISK managerial process:...............................................................27
RESEARCH METHODOLOGY...................................................................................................31
REFERENCES..............................................................................................................................57

Literature Review
The process of identifying, analysing and accepting or mitigating ambiguity in financial
decisions is called as risk management. Basically, risk assessment takes place as a shareholder or
portfolio manager analyses and tries to measure the potential for risks of an investing, including
a systemic risk, and then, considering the investment priorities and risk perception of the
portfolio, takes the necessary action (or inaction). In the world of banking, risk control exists
everywhere (Farook, Hassan and Clinch, 2012). It happens whenever an investor purchases a
U.S. where a mutual fund contracts to hedge his financial risk with currency swaps, because
when a bank conducts a background check through an investor before offering a private credit
facility, government securities over bond funds. Investment bankers use credit default swaps
such as futures contracts, and fund managers use techniques to reduce or efficiently control risk,
such as asset allocation, risk tolerance and role scaling.
In my opinion, risk management is consider the identification, assessment and prioritisation
of risks, accompanied by the adding significant use of assets to minimise, regulate and evaluate
the likelihood of tragic incidents or to maximise the realisation of possibilities. Risk assessment
describes a new form of risk which is 100% likely to exist, but is overlooked by the company
because of a lack of detection capability. These risks lower overall information workers'
efficiency, lower cost-effectiveness, sustainability, operation, output, credibility, market equity,
and output of earnings. Intangible risk assessment helps risk management to generate instant
benefit by recognising and reducing productivity-depleting risks.
The Islamic banking paradigm has grown to one-tier musharaka with various investment
resources. Capital investment reserves take the shape of profit sharing brokerage accounts mostly
on loan portfolio of Islamic banks. Financing accounts may be further defined as regulated and
unregulated, with the latter requiring redemption limits before the settlement date. Current
liabilities in banking institutions or trying to check / debit cards take the shape of qardhasan
(interest-free loans) that are entirely repaid on demand. In the investment property side, banks
should use following sources of financing: murabaha (price-plus or mark-up sale), instalment in
the series sale (medium / long-term murabaha), bai-muajjal (price-deferred sale), istisnaa / salam
(item delayed sale or pre-paid sale) as well as ijara (leasing) but also profit-sharing (musharaka
but also mudaraba). These methods of financing are used asset-side tools, using the concept of
profit-sharing to compensate depositors, are a special characteristic of banking institutions. Such

devices modify the essence of the threats posed by Islamic banks. A few of the critical
challenges confronted by Islamic banks are mentioned below. Credit risk seems to be the
absence of revenue resulting from the default of reimbursement by the counterparty (Tabash,
2018).
As signed and agreed, on moment or in filled. For instance, in murabaha agreements, credit
risk appears in the format of a transaction sovereign default mostly on complete and timely
payment of debts. Non - compliance may be the product of systemic risk (wilful default) or
because of outside organization's objective or company controls triggers. Wilfully default
requires to be identified obviously as Islam doesn't really enable bailout package depending on
compensation payments except perhaps in the scenario of wilfully default. Through the case of
strategies of funding profit-sharing (such as mudaraba and musharaka), the credit risk would be
another non-payment, whenever due, of another bank's portion by the entrepreneur. In such
cases, this difficulty may occur for banks due to the obvious inverted issue of knowledge in
which individuals can not have adequate information mostly on company's expected income.
Market threats, originating from macro channels, may be systemic or unsystematic, being
Assetor specific instruments. Money and equity price threats, for instance, will come under a
coherent method as well as the increase in the markets of goods or securities that the company is
concerned with will come under a particular business risk. The existence of a murabaha seems to
be that, for both the length of the agreement, the mark-up is repaired. Subsequently, the mark-up
values on these mutual fund deals could not be changed if the reference rate increases. Banks are
facing challenges associated from price changes in interest rates as a consequence. In profit-
sharing financial instruments such as mudaraba and musharaka, discount risk may also occur as
the profit-sharing proportion relies, along with other items. In addition, it happens as a result of
borrowing, not the method of trade (Khan, Khan and Tahir, 2017). Unlike mark-up danger, the
dangers of product prices happen as a consequence of the bank's keep, as in Salam, Ijara as well
as mudaraba / musharaka, products or renewable properties. Notice that within a single deal,
both the mark-up threat as well as the uncertainty of the store of value / asset bubble can occur.
In renting, for example, the machinery itself is subjected to the danger of product costs and
mark-up costs are related to deferred or unpaid leases. Liquidity risk emerges either from
problems in raising cash from repayments at acceptable rates (funding liquidity risk) and from
the selling of assets (asset liquidity risk). For Islamic banks, the financial leverage emanating

from both sources is important. Banking institutions are vulnerable to face serious liquidity
threats for a variety of reasons. Second, the securitisations of Islamic banks' current reserves,
which are primarily equity in nature, are subject to a fiqh limit. Second, banking institutions are
still unable to collect funds easily from the investors because of problems of financial products.
This question is getting more serious this is because there are zero cross-Islamic financial
markets for banks. Third, the last-resort borrower (LLR) offers customers with immediate
liquidity facilities if necessary. Existing LLR centres are premised on interest, and Islamic banks
were also thus unable to advantage from them (Rehman, Benamraoui and Dad, 2018). The risk
of directly or indirectly failure arising from insufficient or failed organisational procedures,
entities, and technologies or from external incidents is an operating risk. Risk management in
terms of political risk may be severe in such institutions, considering the novelty of Islamic
banks. In this respect, operational risk particularly emerges as banks do not have adequate
trained professionals (capacity and ability) to undertake Islamic business transaction. The
computer programme present on the marketplace for traditional banks might not be ideal for
Islamic banks, explaining the various nature of industry. This relates to technology threats in the
production and application of information systems in the technology. The major activity of
Islamic banks is now in dealing (murabaha) and investment in equity funds (musharaka and
mudaraba), new banking legislation and regulations banning commercial banks from conducting
such practises in most jurisdictions.
RISK MANAGEMENT FRAMEWORK IN ISLAMIC BANKING IN PAKISTAN
To start with what is risk management in banks? Some companies will have a particular risk
management framework in place to figure out the existing and the potential risks and to access
how to deal with them if they arises. The identification of risk, its measurement, mitigation,
reporting and monitoring are the six major key features of an effective framework. Islamic banks
is an alternative to conventional banks. This system was established in early 1970s with the aim
of provision of shariah and financial services such as investments, financing and trade prospect.
In such a short period of time it has gained a good amount of growth. These days some of the
financial institutes are doing their activities in a very risky environment (Ariffin, 2012).
The risks faced by these banks can be financial and non-financial risks. Financial risks can be
referred to as the risks in which the obligations and the liabilities cannot meet to the available
assets. It can be further distributed into market risk and credit risk on the other hand the non-

financial risks are faced by the banks itself which includes the legal, regulatory and the
operational risks. The risks which arises as an instrument or asset in the market is called market
risk and it is further classified as systematic market risk and unsystematic market risk.
Operational risks arises due to technical errors or human error or error in day to day operation of
the bank. Human risks are due to fraud and inefficiency, and technological risk is due to
telecommunication system and program failure. Legal risk is in a financial contract. It is
basically linked to the statues, legislation and regulations which have direct effect on the
requirements of transactions and contract (Abdullah and Khan, 2012).
CHARACTERISTICS OF RISK FACED BY ISLAMIC BANKS: There is a difference between
practical practices and theoretical formulations of Islamic banking. Theoretically, Islamic
banking works according to the Islamic economist that is the liability of the banks should be
limited to the investment. While on the assets side of the bank the funds must be used in the
profit and loss sharing agreements. Therefore if there is any shock on the assets side will be
neglected by the nature of risk sharing agreement of the investment. In this way the Islamic
banks are more stable and systematic as compared to the conventional banking system. The risks
which are related with the business of banks are shared with the account holders. Islamic banks
face some other kinds of risks which are due to the different characteristics of Islamic banks. The
risks which are faced by the Islamic banks includes the credit risks, bench mark risks, liquidity
risks, operational risk, legal risk, withdrawal risk and fiduciary and shariah risk.
Islamic banking system should elevate the capital adequacy, and also elevate the company’s
assets through the bond, should increase the number of shares or other forms of financing with
these aspects of control it is expected to reduce the credit risk of Islamic banking.
RISK MANAGEMENT FRAMEWORK: There are five major components which should be
under consideration while creating the risk management framework. These components includes
risk identification, risk measurements and assessment, risk mitigation, risk reporting and
monitoring and risk governance. The main essential elements in risk management are its
identification, measurement, monitor and the management of various kinds of risks. This can be
effectively implemented through a wider process (Khalid and Amjad, 2012). For an individual
financial institution the risk management is dependent upon the size of the institution and nature
of business. According to basel 2, the credit risk is managed by standardized approach and

internal rating based approach. IRB banks can access the usage of internal estimation of credit
worthiness to figure out the losses in future.
Risk identification: The step in identification of risk a company faces is to define the risk
universe which is list of all possible risks (Zarrouk, Jedidia and Moualhi, 2016). For example IT
risk, operational risk, regulatory risk, legal risk, political risk, strategic risk, credit risk. There are
various kinds of risks faced by the banks or financial institutions. Risk can be defined as the
exposure where the outcome is uncertain. Among the important risks that the banks faced is the
credit risk and it is due to borrower’s inability to meet the predetermined debt. The development
of a sound credit portfolio is only possible if useful precautionary measures are taken to mitigate
credit risk. Risk management in banking can be defined as the way banks deals with the risks and
the related playoffs, including its identification, classification and the methods used to measure,
mitigate, monitor and control risks. Effective and efficient management of risk has become a key
phenomenon for the success of banking business.
Risk measurement: This provides information on either a specific risk exposure or an aggregate
risk exposure, and the average of loss experienced due to those exposures. In measuring specific
risk exposure it is important to consider the consequence of that risk an overall profile of the
organization. Some risks might provide benefits while some may not. Another important point to
be noted is the ability to measure an exposure. Some risks are easier to measure while some are
not. For example market risks can be measured by observing market prices; nut to measure an
operational risk is not an easy task. Common aggregate risk measures includes value at risk,
earning at risk and economic capital.
Risk mitigation: After measuring and analysing risk now the company needs to decide on which
the risks to be eliminated or to be reduced. Risk mitigation can come into consideration through
an outright sale of assets or liabilities, buying insurance, hedging with derivatives or
diversification (Bilal, Talib and Khan, 2013).
Risk reporting and monitoring: It is necessary to regularly have a report on specific and
aggregate risk measure to maintain that the risk levels are at optimal levels. Financial institutions
provide regular risk reports. Other instituyions require less reporting. These risk reports are then
sent to the risk personnel having the authority to adjust risk exposures.
Risk governance: It is a process that ensures that all the company employees are performing their
works in accordance with risk management framework. Risk governance basically involves

defining the roles of all the employees, segregating duties and assigning authority to individuals,
and the board for approval of core risks, risk limits, exceptions to limits and risk reports and the
general overview.
PAKISTAN RISK MANAGEMENT GUIDELINES FOR ISLAMIC BANKS
These guidelines are issued by the SBP for the Islamic banking which are:
The Islamic banks should have a comprehensive procedure of risk reporting and managing,
which requires a proper and senior management over department for identification,
measurement, it’s monitoring, for its reporting and controlling (Daly and Frikha 2016.).
They need to establish financing strategies which are compatible to teaching of shariah.
Islamic banks should establish suitable methodologies for assessment of credit risk which is
related with every instrument of Islamic financing.
Islamic banking system should have suitable policy for investment activities like musharakh and
mudarabh.
Islamic banks should adopt methodologies which are suitable for the assessment of potential and
impact on the calculation of profit. Both mudarib and musharakh partners and should mutually
agree on the methods used.
Islamic banks should have market risk management framework for its assets.
They should have appropriate policies for the liquidity management.
They are required to have framework for management of displaced commercial risk, wherever
required.
The Islamic banking system are required to keep the interest safeguard of all its depositors. They
also should ensure the bases for assets, revenue expense and profit allocation.
The Islamic financial industry is basically consists of commercial and investment Islamic banks,
the Islamic companies provide shariah compatible finance services, mutual funds and index
funds. During the short period of time that is from the early 1970s the Islamic banking have
leaded to a tremendous growth in banking industry. But then these banking are exposed to risks
as compared to conventional banking (Rashid, Yousaf and Khaleequzzaman, 2017).
So to ensure the presence of efficient risk management framework these guidelines are provided
by state bank of Pakistan in 2008. Over the last few years the Islamic banking is expanding in
Pakistan and creating more challenge to other banks to seek the potential operational risk
exposures. The final system dynamic models evaluates that Islamic banking system has found a

comprehensive method of action for identifying, assessing, understanding, analysing and
monitoring and controlling the operational risk exposures just to neglect any potential loss which
arises. This model also illustrates that the IBI banks in Pakistan came up with the efficient
mechanism to counter or to figure out various risks under the guidelines which are provided by
the regulatory authority (Said, 2013). This model is also helpful for managers, scholars,
shareholders, policy makers and regulators as they provide a useful and helpful in sights to them
which is to make them understand the operational risk management behaviour of Islamic
banking in Pakistan. Moreover this model also provides support to board and senior management
for not only the banks in Pakistan , but to all the Islamic banks around the world for establishing
a comprehensive, effective and efficient operational risk management framework by overcoming
any kind of deficiency in their existing system. This could be concluded by the fact that while
managing operational risk, the Islamic banking system in Pakistan are not throwing caution in
anyway but instead they are playing safe.
Third, the non-standardization of agreements makes it more complicated and expensive for the
whole position to negotiate multiple facets of an agreement. Financial firms are not covered from
threats that could or might not be actionable or that they should not foresee. After the deal is
executed, through use of structured contracts will also make agreements easy to manage and
track. Finally, the absence of Muslim courts capable of administering Islamic contracts raises the
legal consequences of these agreements being used in Islamic banks. Uncertainty over the true
market value of securities is generated by an adjustable interest rate on saving / affects the
results. In order to minimize the risk of failure leading to a smaller rate of return, wealth
retention can be an important consideration in the redemption decision of banks. This presents a
'withdrawal risk' from its standpoint of the banker that is related to the higher return on
investment compared to financial firms (Majeed and Zanib, 2016). Fiduciary risk may be
triggered by the Muslim Bank's violation of contract. For instance, the bank cannot really be able
to totally abide by the terms of individual schedules for sharia. Ability to effectively conform
with Muslim sharia either wittingly or unwittingly refers to a loss of trust among borrowers and
thus causes reserves to be withdrawn. Similarly, where depositor holders view a low rate of
return as breaking an investment contract or lack of funding by the company, a better rate of
interest than the marketplace can often add fiduciary danger. The objective of this essay is to

calculate the extent about which risk management practises (RMPs) and strategies are used by
Islamic banks in Pakistan in struggling with key risks. Design / research methods / method-A
structured questionnaire has been used covering six components: risk management (URM)
comprehension, risk appraisal and interpretation (RAA), risk recognition (RI), risk reporting
(RM), collateral risk assessment (CRA) and RMPs. This analysis finds that banking institutions
are very fairly effective in risk management, in which the most influential factors in RMP, URM,
RM and CRM. The findings of the paper are limited to Islamic banks' RMPs in Pakistan. This
text discusses the Islamic banks' RMPs in Pakistan. The findings can be seen as useful guidance
for developing RMPs in selected Islamic banks but would be of benefit to individuals involved in
the Islamic financial system (Ergeç and Arslan, 2013).
Islamic banking is among the largest rising assets of the global market, with unprecedented
growth in wealth and major bank numbers. The Islamic financial firms' overall assets crossed
US$ 1.8 trillion, with 375 Islamic finance operating worldwide. Throughout the last 4 years,
around 2009 and 2013, the annual growth rate of that same Islamic banking sector was 17.6
percent. Overall, it has been rising faster that banking reserves. Banks are increasingly facing
different forms of threats that can theoretically be harmful the effect on their company. Risk
management’s mission is to mitigate the detrimental impact that uncertainties has on a bank’s
profitability and resources. The relevance of the thesis derives with the need to analyse, from
moment to time, credit risk management throughout the financial sector, as risk management
practises are continuously changing due to the incorporation of diverse marketing strategies.
Increased risk reduction and additional legal standards have been implemented. The research
aims to examine the influence of risk mitigation mechanism components on commercial banks
activities (Ghenimi and OMRI, 2016).
Banks serve as a financial broker (i.e., borrower and debtor) for involved individuals. There have
been two significant explanations for the development of banking, i.e. because they provide
consumers with capital and investment banking. Banks receive consumers' investments and
spend money in lending to anyone in need of capital, while at the same time offering collateral
for the removal of funds. Banks are also responsible for the transformation of short-term
deposits. Any part of it is provided to the borrower on their invested balance of long-term loans
when offering an interest rate. For good banking practise, risk control is fundamental. Without a
mistake, all commercial banks face a huge range of threats today, like market risk, capital

adequacy, exchange rate threat, price risk and liquidity risk that could result in a financial system
collapse. Thus the and for success and stability of banks, effective risk control is utterly
mandatory. Iqbal and Mirakhor (2011) said that impact on bank faced credit and consumer risk
3 decades ago, and yet the financial sector has evolved with period and is already subject to
multiple uncertainties due to entire new which are not historically present (Majeed and Zainab,
2017). Two reasons and developments in the industry, the need for risk control are regarded:
First, following the collapse of the Bretton Woods international exchange rate regime,
heightened financial uncertainty culminated throughout the stability of that same currency
exchange rates as well as the interest payment. Secondly, something like a risk management
mechanism in financial markets to control risks associated with emerging products has been
posed by the accelerated launch of new products throughout the derivatives industry. Thirdly, the
financial system is evolving from a conservative model of financing to a conventional model of
lending activities for fee-earning.
After the international economic meltdown, risk approach has gained intensified interest,
although risk management strategies, procedures and approaches that used traditional and
Islamic banking are definitely becoming a significant topic for debate (Al-Wesabi, 2012). The
global volatility has raised the need to re-evaluate developing and developing nations' financial
structures. In addition, identifying the factors that have resulted in economic crisis is important.
Since the economic meltdown, it was assumed that the collapse of certain financial firms was
attributed to poor risk control procedures, risk assessment limitations, evaluation and reduction
strategies. Moreover, corruption and lack of morals have become the foundation of the entire
banking markets. After the financial crisis, which stresses the Shariah concepts relating to debt,
equity or risk, financial sector is seen as an option. Risk is a condition that, in the context of
business operations, is related to and triggers unlikely, unknown and repeated operations. For
any of this, equity is held within banking as a safeguard that protects the money of the
borrowers. There are many interconnected threats that may have consequences for all other
forms of threats. The weakness of the Basel I and II rules has been figured out by the separate
economic collapse. In addition, the demands and importance of many changes in the financial
risk management activities have been initiated by these emergencies. A really have to establish a
complex risk management system within institutions has been generated by this reconsidering
(Ashraf, Rizwan and L’Huillier, 2016).

An up-to - date analysis of risk management plan, problems and developments in Islamic and
traditional banking industry of Pakistan is given in the present research report. It also reflects on
realistic execution and, from the viewpoint of various risk analysts and professionals, discusses
the diverse risk and risk control activities of banks. This research also shows the shortcomings of
banks working in Pakistan in their risk management activities and procedures. There is a
concurrent banking structure in Pakistan, where traditional and Islamic business operates next to
each other. It really would be important to assess both financial structures' risk management
practises (Ahmed, 2013).
In plain terms, risk is volatility that occurs due to unfavourable benefit and loss fluctuations.
Credit danger, liquidity risk, business risk, equity risk, interest rate risk, exchange rate risk and
discrepancy risk are among the key threats facing banking system. Some of these are discussed
underneath
Transactional Risks: These risks present obstacles for businesses and individuals in working
with complex financial assets, as currency values can adjust over a short amount of time.
Through using financial derivatives as well as other related securities, such impact could be
minimised. It includes some sub parts that are discussed underneath:
Credit risk: The most influential vulnerability throughout the banking sector is credit risk. Credit
losses in financial institutions accounted for 60% of overall risks, according to Drzik et al.,
(2018). Credit danger seems to be the most apparent of the threats, maybe (Al Ali and Naysary,
2014). To assess the possibility that a consumer can start paying what's been borrowed to them,
bankers have to do their utmost. The new bank looks more strongly at systemic risk than at loans
to customers in the view of the new credit crisis. The financial institution would have to decide
how often default risk they are ready to take on a single client. For the particular case, this is
really a query users will have to tackle. Through bank can have clear terms of service under
which it is prepared to work, so they will need to decide what they are, but instead adhere to
them as credit cards consumers are brought in. Credit risk relates to the creditor loan defaults on
debtor or fulfilment of contractual obligations. This is an important component of investing in
limited income, and this is why ratings agencies assess the default risk of develop active and
businesses. The following portion of systemic risk is split through credit risk:
i. Default risk: if a creditor fails to pay forward the single or multiple mortgage sums ( Masood
and Ashraf, 2012). There are some default cases, like delay throughout the settlement of the loan,