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"A lexicon of Risk in Middle East Banking" September 2002 link
by Warren Edwardes, Chief Executive of Delphi Risk Management Limited.
"Key Financial Instruments: understanding and innovating in the world of derivatives" 4 February 2000 Financial Times Prentice Hall ISBN 0273 63300 7 London link
This article is based on Appendix 1 to
Edwardes’ international best-seller "Key Financial Instruments: understanding
innovation in the world of derivatives" Financial Times Prentice
Hall (ISBN 0273 63300 7) and recent speeches to The Bank of England and at Risk
2002, Dubai in May and June 2002 respectively.
Warren was previously on the board of Charterhouse Bank and has worked in the treasury divisions of Barclays Bank, British Gas and Midland Bank. He first researched into what were later to be called "derivatives" in 1975 and was part of the team that executed one of the world's first currency swaps in 1981. Since then he has devised and transacted numerous structures that form part of the history of derivatives. Warren can be contacted via email@example.com
Edwardes is a Board Governor of The Institute of Islamic Banking & Insurance
Edwardes was previously on the board of Charterhouse Bank and has worked in the treasury divisions of Barclays Bank, British Gas and Midland Bank. He first researched into what were later to be called "derivatives" in 1975 and was part of the team that executed one of the world's first currency swaps in 1981. Since then he has devised and transacted numerous structures that form part of the history of derivatives.
Soon after being commissioned to write “Key financial instruments” I happened to be listening to an old Paul Simon song – “50 ways to leave your lover”. With increasing awareness of operational risk concerns in banking and the forthcoming Basle II capital requirements, with operational risk an integral part, I decided to write down a list of “50 ways to lose your money”. There may well be some risks that you feel should be included and some of the risks below may be regarded as trivial. In fact, Basle II has its own selection of risks it defines as “operational risk” which differs from my list. But just because a regulator may not recognise a risk does not mean that such a risk is immaterial. After all Basle II places no stress at all on operational risk. Most of the major banking catastrophes, regulated under the current regime, such as Barings, Allfirst/Allied Irish and Sumitomo have been connected with operational risk.
Does Middle East banking risk really differ from Western banking risk? Not really different but there are a few special cases. Risk is much the same as for a British bank branch in Singapore or an Irish Bank subsidiary in the US.
Consider recent Middle East banking news items to illustrate risk: “Moody’s upgrades Bahrain and Qatar”; “Malaysia to hold bond road show at DIFC on June 17“; “GIB issue $325mn FRN”; “Gulf states and Malaysia buy Lebanese Eurobond”; “Pakistan Muslim Commercial Bank to buy 51pc stake in United Bank Ltd “; “Union Bank Ltd buys Emirates Bank International branch network in Pakistan”; “Legal Perspective: Different warranties in international finance”; “HSBC launches Healthcare protected investment fund”; “Al Ahli launches controlled-risk investment funds”; “Gulf Finance House launches new company to invest in real estate in the UK”; “meFortunes, the investment scheme from Emirates Bank Group gives customers the chance to win up to Dh100,000 every week.”; “Repatriation by Arabs evident”; “Banks in UAE have no exposure to Rastogi Group” “Mashreqbank Bank recovers 20pc of Madhav Patel's dues”; “Banks to implement risk management in phases”; “Banks becoming more conservative on credits”. One could categorise all of these risks by the risk types below.
you really know what you are buying? Enron and World Com shows that accounting
can be highly creative. On the other hand, as the target of acquisitive
companies, are you spending too much management time fending off predators? Can
you marry the different cultures between banks?
Careless Error Risk
Over confidence leads to errors. I
still vividly remember as a raw but confident dealer over twenty years ago,
saying, "buy dollars" when I
meant, "buy pounds". It was
highly embarrassing but it was quickly sorted out. If you have a good
relationship with your counterpart errors can be sorted out. But fix the problem
immediately. Human error should be forgiven but law does not cover this.
off that product too long even if it is going to compete with existing products.
Somebody else will build a better home loan product if you do not. Be innovative
or ready to immediately react to competitors. Unsurprisingly, LIBOR influences
mark-ups in Islamic banking.
Are your customers subject to gold or
other commodity prices? Gold producers have their liabilities linked to the gold
price. If you take delivery under an Islamic contract can the commodity price be
confirmation now! And avoid jargon. Don't talk about strangles and straddles
when you refer to derivatives. Is it Al Wadiah or Musharaka? Define terms
Competence / Understanding
latest guaranteed investor products really understood by the banks’ senior
management? Do you understand your dealers? Don't be afraid of your own
ignorance. Go on a course - or buy a book. And don't be afraid to ask seemingly
Concentration of assets Risk
Exposure Risk is obvious but sometimes governments direct banks to lend to
champion industries. This is a problem for Islamic finance as no tobacco,
banking and alcohol investments can lead to heavy weighting in property and
technology. Non-correlated investments need to be identifies.
Concentration of liabilities Risk
Does your fund depend on one or two
investors? Retail bankers have fewer liquidity problems than wholesale bankers.
Do not place yourself at the mercy of a few lenders.
Concentration of business type Risk
supermarket or nimble niche player are both fine. But can you reinvent yourself
if markets change? But if market appetite or regulations change, can you
reinvent your institution?
currency be converted and delivered into a freely tradable currency? Non
Deliverable Forwards are widely used in Asia in an attempt to neutralise this
lending carried out in local emerging markets really riskier from your banks’
perspective than an investment in the US?
So how much
has the customer borrowed elsewhere? Has your client used off-balance sheet
finance excessively? Will the parent really stand behind that “letter of
comfort”. Do you understand the terms behind Credit derivatives? In Islamic
banking risks are perhaps not loans but equity not loan risk.
are sometimes seen as a basis for negotiation. And there is a difference between
the Middle East and Malaysia in Islamic banking.
Currency Economic Risk
Japanese producers faced competition from
Korean producers post the devaluation of the Korean Won giving them Economic
exposure with respect to the Won. GCC currencies are USD based. Will they become
EUR linked with an increase in politically driven trade? Economic exposure is
Currency Transaction Risk
This is the
risk that future foreign currency receivables will change in home currency
terms. If derivatives not permitted an Islamic institution cannot hedge the
exchange rate. However, a number of institutions including Delphi are developing
derivatives substitutes for Islamic institutions.
Currency Translation Risk
is the risk of revaluation of foreign assets or liabilities as a result of a
movement in currency value. No cash flow here. If GCC currencies de-link from
the US dollar, the balance sheet value of dollar assets or liabilities will
fluctuate in home currency terms.
Customer Satisfaction Risk
customers like doing business with you? Will they come back for more of the
same? Do they call you for other products? If you are running an Islamic Banking
Profit and Loss product and you make a loss will you pass that on to your
Disaster Recovery Risk
prepared? Think of September 11th. Remember Iraq / Kuwait. Be sure to
carefully watch traders who are making substantial profits. If the profits are
speculation generated, they will probably turn into losses! Recall Barings and
Economic Activity Risk
in economic activity will affect your business. Dubai is in close proximity to
two of the US’s “axis of evil” countries. Tourists will stay away if there
Energy Price Risk
had the interest rate on its liabilities linked to the price of oil. Most
Islamic countries’ economies are linked to the oil price. Your oil-producing
clients could provide a hedge to airlines?
If you lend
to polluters, you may be faced with competition from a bank such as
the Co-operative Bank of the UK that does not. Are environment unfriendly
policies Haram? Does a conventional bank have to look at the Hallalness of its
Equity Market Risk
banking is ideally profit and loss sharing. This is venture capital or equity
investment. If the funds are own account then beware as equity investments have
a higher capital requirement than loans.
Fraud (banker) Risk
you tape all conversations. Transparency is required. Avoid the risk of
Fraud (customer) Risk
client say that he did not understand that complex structure? All will be fine
if the client is winning. He will only cry "foul" if he loses. I am
regular “expert witness” in cases and there are only complaints when deals
Fraud (staff) Risk
follows a covered-up disaster. And watch staff who don't take holidays. Many an
irregularity has surfaced when a banker who never took a holiday fell ill and
his position was taken over by a colleague. Reward whistle-blowers.
Image / PR Risk
from bad publicity is extremely difficult. Keep the media, rating agencies and
your Counterparties fully informed of any potential difficulties. No fund
manager or treasurer wants to hold an asset or do business with a bank that
suffers from adverse reporting in the media. There was an initial global
reaction against all Gulf banks in the aftermath of September 11. There should
have been proactive PR.
Even a small
piece of information may be somebody else's missing link. And beware of the
boastful. In my experience the most leaky are the most senior.
real assets as security in an asset-backed Islamic transaction may lead to over-
Interest rate Risk
linked to interest rates. Islamic finance is not a closed economy. If interest
rates rise sharply in relation to mark-up rates, deposits will flow out of
Islamic banks and into conventional banks (and vice versa).
currencies really fixed to the US Dollar? Could Gulf countries become linked to
or English word can have different meanings in the other language.
Derivatives insurance contracts and therefore prohibited to banks in many
much less about holding liquid assets than about managing and diversifying
liabilities. Remember Continental Illinois! Events like Sep 11 can lead to a
freeze on lending. This is a major problem for Islamic banking is the absence of
a developed Islamic money market.
staff sickly? Don't be too reliant on any one person. Or is someone likely to
impact on others' performance through racist or sexist remarks? Make sure you
can cope if your staff fall ill during world cup matches.
separate flights on trips. And don't even think about buying key-man insurance.
A sure sign of a badly run firm or team is when such insurance is even
considered. It may be good for the ego of the person in question, but the
solution is not the purchase of insurance but internal hedging; just make sure
that at least two people can do the job.
everything other than market or credit risks.
Performance Measurement Risk
worth hiring can manage his management accounts and can show book profits at the
expense of real losses. Just make sure you check the character of the person you
are hiring. Most measures of performance are crude and slavish adherence to
rules can lead to poor real performance.
and events in Palestine have made an impact on Middle East Banking. What will be
the impact of a US attack on Iraq?
Property (Real Estate) Risk
property asset-backed loans have sufficient cover? Is the property liquid?
Rating Agency Risk
downgrading or even credit watch can impact on liquidity and the entire
business. Investment grade bonds do not default. They become Junk and then
default. On the other hand an upgrading, as has been seen for Bahrain and Qatar,
can have an impact on appetite for other regional debt.
operate in several countries you may face different rules.
product may later be deemed Haram. Zero coupon bonds were Hallal. Non Islamic
banks may have to become Islamic.
star team move to a competitor after you buy the bank? This has happened on
several occasions in The Gulf.
This is the
risk that you meet your part of the bargain and your Counterparty does not.
Escrow accounts could have averted the only Murabaha default case to have gone
financial systems are closely inter-linked.
banking has a tax impact. Do the sale and repurchase transactions face purchase
tax? Are economically identical products treated differently in an Islamic and
Conventional bank in the same country?
systems manage in a disaster or war? Can you cope with system failure? Are your
fax confirmations going to your customer or a competitor? Email can take a long
time – perhaps days.
A US attack
on Iraq will paralyse air transport in the Middle East.
Kuwait’s burning oil fields probably
had an adverse impact on employees’ health and tourists. Weather derivatives
are being traded but are Haram. Weather Takaful?
final risk is the most insidious and dangerous risk. "Zero Risk" is
the risk of having a risk manager who always says "No" and who comes
up with 50 ways not to do the business. Of course, you will never appear to lose
money. You will never be known for making a wrong decision. It is just that the
business will go elsewhere and your firm will find itself with unemployed
go through your own business and see how your list differs from mine. Particular
Middle East banking risk issues are: Liquidity – undeveloped money
market in Islamic banking; Interest rate risk even in Islamic
banking; Commodity risk in Murabaha; Equity risk - Are you in fund
management or banking?; Operational risk – are controls tight enough?; Religious
– Hallal or Haram? – Would you be obliged to convert to Islamic by
government or client pressure?
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