Risk Management Framework for Shari’ah Compliant Banking

Where valuation methodologies are deficient, banks should establish a contractual agreement with the counterparty specifying the methods to be used in valuing the assets or assess the need to allocate funds to cover risks resulting from illiquidity and uncertainty in assumptions underlying valuation and realization. 8.7 Banks' market risk management framework should also account for the risks associated to the following Shari'ah products: 8.7.1 The risks that relate to the current and future volatility of market values of specific assets (for example, the commodity price of a Salam asset, the market value of a Sukuk, the market value of Murabahah assets purchased to be delivered over a specific period) and of foreign exchange rates. 8.7.2 In Salam, banks can be exposed to counterparty credit risk on a long position and commodity price fluctuations while holding the subject matter until it is disposed of. In the case of Parallel Salam, there is also the risk that a failure of delivery of the subject matter would leave the banks exposed to commodity price risk as a result of the need to purchase a similar asset in the spot market in order to honor the Parallel Salam contract. 8.8 Banks must also consider their exposures to foreign exchange risk arising from changes in foreign exchange rate in cross-border transactions and those arising from receivables and payables denominated in foreign currencies. 8.9 Banks must ensure that their exposures to market risk are subject to internally predetermined market risk limits. Banks may as part of its risk management strategy hedge their market risk exposures using Shari'ah compliant instruments. Banks must ensure that market risk exposures are reported to senior management when exposures are approaching or has breached pre-determined limits, and implement measures to bring the exposures to compliance as soon as practicable. 9. Operational Risk 9.1 Principle 4.0: Banks shall have in place adequate systems and controls, including Shari'ah Committee, Shari'ah Compliance and Shari'ah Audit to ensure compliance with Shari'ah rules and principles. 9.2 Operational risk is inherent in all activities, products and services of the bank and can transverse multiple activities and business lines within the bank. Banks shall consider the full range of material operational risks affecting their operations, including the risk of loss, direct and/or indirect financial losses such as loss of business and market share due to reputational damage, due to inadequate or failed internal processes, people and systems or from external events. 9.3 Banks must consider Shari'ah non-compliance risk (SNCR) and failure in performing their fiduciary responsibilities as part of the bank's management of operational risk. 9.4 Banks shall ensure that the policies and related procedures are in place to measure, mitigate and monitor SNCR. Shari'ah compliance is critical to a bank's operations and such compliance requirements must be communicated throughout the bank and their products and activities. 9.5 Banks are also exposed to reputational risk arising from failures in governance, business strategy and processes. Negative publicity about a Shari'ah compliant banking business practices, particularly relating to Shari'ah non-compliance in their products and services, could have an impact upon their market position, profitability and liquidity. Therefore, banks must consider Shari'ah compliance as falling within a higher priority category in relation to other identified risks. 9.6 Banks shall ensure that they comply at all times with the Shari'ah rules and principles as approved/instructed by the banks' Shari'ah Committee with respect to its products and activities. This means that Shari'ah compliance considerations are taken into account whenever banks accept deposits and investment funds, provide financing to and carry out investment services for their customers.