Abstract
The
main focus of this study relates to the importance of financial risk management
to Islamic Banks in UK. This considers
surveying of participants related to the Islamic Banks in UK. The use of both
quantitative and qualitative analysis was considered. As for the quantitative
analysis, the questionnaire with 5-point Likert Scale has been used. The results
identified that the respondents seen to understand the real situation of Islamic
Banking practices particularly in managing financial risks. In support to the responses of the subjects,
extensive reviews of the literature on articles, journal articles, books, and
magazines relating to operational risks in lending processes was also reproduced
as part of the qualitative analysis.
In
this study, typical risk management systems were identified. It is comprise of two elements namely “internal control
system” and “specific risk controls”. From the results, it was identified that risk management also has to be linked
to internal auditing. Controlling framework responsible for providing the
information necessary, cross-checking the risk measures used, and linking
insights gained to planning procedures. Risk
reporting consists of situation report, forecast report, and risk report.
Literature Review
2.1
Financial Risk Management and the Global Financial Market
Investment appraisal is a strategic decision-making
process for determining how a firm’s management should allocate limited capital
resources to long-term investment opportunities. Investment decisions will not
be made in isolation from other business decisions and plans; the question of
strategic fit arises. Accordingly, investment decisions should be made in the
context of the firm’s strategic business plan, with the goal of maximising the
long-term market value of the firm and the realisation of its strategic
objectives. The investment decision-making process involves identifying,
evaluating and implementing long-term investment opportunities which will
enhance shareholder wealth and achieve the firm’s objective (Fried,
Sondhi, & White, 2003).
The costs and benefits of these investment
opportunities will be spread out over time. Because the outcome of long-term
investment decisions, more so than any other type of business decision, will
directly affect the firm’s future and its value, it is vitally important that
investment proposals be properly evaluated before they are implemented. The
essence of investment is to forego present consumption of resources in order to
increase the total amount of resources which can be consumed in the future. The
objective of an investment decision is to acquire an asset for less than its
value, this way corporate or personal wealth can be increased. Acquiring an
asset for at least its value will maintain wealth or value. It would not make
good financial sense to acquire an asset for more than its value as wealth
would be eroded (Fried, Sondhi, & White, 2003).
Although the global financial markets remained in a
state of flux throughout the twentieth century, transformations since the early
1970s have been nothing short of dramatic. The Global forces for change
included advances in information communication technology (ICT), making remote
access to trading systems ubiquitous. In addition, innovations in ICT and the
development of new instruments in the financial market became self reinforcing.
Furthermore, financial deregulation and liberalisation at the national level,
opening up to international competition, and globalisation of financial and
real markets, were significant change agents (Das, 2004).
Additionally, changes in corporate behaviour, such as
growing disintermediation and increased shareholder pressure for financial
performance, were the prime movers behind the transformation in the financial
services sector in the emerging market economies (Das, 2004). Advancing
globalisation during the 1980s and the 1990s increased trans-border capital
flows and tightened the links between financial markets in the emerging markets
and global financial centres (Dunning, 1999). Growth of global financial
markets was further accelerated by improvements in the fundamentals,
particularly by more rapid economic growth in the emerging market and matured
industrial economies. It was also assisted by economic and structural reforms
in the emerging market and transition economies. Actually, the recent spate of
banking and financial crises has accentuated the pressures for transformation.
Notwithstanding the recent decline in capital flows, the evidence of the
preceding quarter-century suggests that financial markets in the emerging
market economies have become increasingly deep and resilient (Das, 2004). The
state of global financial markets changes as different things happen in the
environment. The global financial
markets are affected by different situations such as increase or decrease of
the interest rates. It is also affected by improvements in the society, such as
new trends in different industries.
Apparently, it has been evident that the context and
issues related to global financial markets also reflects to the issues about
globalisation. Actually, globalisation has become the most-talked about theme
of the 1990s in the Western social sciences and various world discussions
(Dunning, 1999). The concept of globalisation encompasses a host of interwoven
processes which include increasing transnational movement of capital, goods,
and people; closer ties through new communications technologies. A more complex
international division of labour as a result of the dispersal of the production
of goods and services to a number of different locations; a rapid turnover of
ideas, of images, and of patterns and objects of consumption; a growing
awareness of risks and dangers that threaten the world as a whole; a
quantitative increase in, and growth in importance of, transnational
institutions and globally interlinked political movements (Dunning, 1999). It involves the interpenetration of these
processes both horizontally and vertically, and at national, sub-national, and
transnational levels (Tetzlaff 1998).
Globalisation is a huge step away from the traditional localism which
has pervaded the mode of living in most countries of the world throughout the
years. Localism is the innate tendency
of nations and communities to put constrictions on their openness to global
issues. It is a way of thinking that
advances seclusion and emphasizes traditional concepts of community.
2.2 Conventional Banks and Islamic
Banks System
Over the last decade, Islamic banking has experienced
global growth rates of 10-15 percent per annum, and has been moving into an
increasing number of conventional financial systems at such a rapid pace that
Islamic financial institutions are present today in over 51 countries. Despite
this consistent growth, many supervisory authorities and finance practitioners
remain unfamiliar with the process by which Islamic banks are introduced into a
conventional system.
For instance, the finance type in Saudi Arabia called
Islamic finance is financial services that conform to the creed of Islam. It
offers a prospective market of 1.5 billion Muslims that should continue to
offer opportunities for foreign and domestic banks. For the last five years,
the said financial services have grown by 15-20% annually, with a probable $270
billion in assets controlled by about 300 Islamic banks in more than 25
countries (Maurer, 2002). In accordance to country’s population and per capita
income, the largest Islamic finance markets include Turkey, Indonesia, Saudi
Arabia, the United States, and France. In addition with respect to the fastest
growing markets, Bahrain, Malaysia, UAE, Indonesia, and Pakistan should be
considered (Maurer, 2002).
2.3 Islamic
Financial Market Growth
As reviewed in the paper of Maurer, (2002), the
Islamic financial market has the potential to continually grow. It is estimated that within eight to ten
years as much as half the savings of the world’s 1.5 billion Muslims will be in
Islamic banks. This could represent $905 billion in total assets in Middle
Eastern countries alone (Maurer, 2002). On the other hand, Muslim people living
outside of the Middle East, are actually representing the largest population
and they are all potentials of the Islamic financial market. This market
includes countries such as Indonesia, India and Malaysia, and within developed
countries including France, United Kingdom, Germany, the United States and
Netherlands. Similar to other business industries Islamic banks also face quite
a few essential hurdles in order to compete with conventional banks. Presently,
Islamic finance instruments are less service oriented, more expensive and not
as responsive to innovation. These drawbacks could hold significant
repercussion for developing consumer markets and financing trade in Muslim
countries.
2.4
Islamic Banking Potentials
In history, Islamic finance promoted trade and
business activities in the Muslim world throughout the Middle Ages (Maurer,
2002), but only emerged as a competitor with conventional banking with the
profusion of petrodollars in the mid 1970s (Khorshid, 2004). The development of
Islamic finance has helped to diversify markets and institutional structures,
particularly in oil-rich Muslim countries, but also in countries with large
Muslim minorities (Khorshid, 2004).
Islamic banks manage in countries that have adopted
Islamic principles (e.g. Iran, Pakistan, and Sudan), Muslim countries with both
Muslim and conventional banks, and in developed countries side-by-side with
conventional banks (Khorshid, 2004).
In the United States, Islamic finance has grown
rapidly in states such as New York, California and Michigan. As indicated in
the report of Norris, (2005), there is an estimated six million Muslims in the
United States and almost one third of 1.8 million Islamic household wanted to
have Islamic Finance, particularly for home mortgages.
Apparently, in Saudi Arabia, Islamic finance has
rapidly recognized itself in several markets, but its spread, growth, and
ultimately its character, will depend on how it confronts several key
challenges. This includes the general acceptance of Islamic finance, regulatory
and soundness compatibility, obstacles to innovation, and other important
barriers such as building economies of scale and training professionals in the
intricacies of Islamic financial products (Dunning, 1999). Numerous potential
customers did not understand the nature of Islamic Banking and how it differs
from conventional banking. But the strong and increased desire of Muslims to
more closely link their investment and lending decisions with their religious
views is the key distinction in a market segment that might otherwise suffer
from large disadvantages in price, performance, service, and innovation. The
willingness of customers to accept added complexity, higher costs, and lower
performance in exchange for a closer alignment with religious beliefs will
determine the near-term future of Islamic banking (Dunning, 1999).
2.5
Islamic Banking Licensing and other Issues
Licensing and examination are important regulatory
concerns that affect developed and developing countries differently. Many
Islamic banks have not yet implemented accounting and control systems related
to those used in conventional banks, making it difficult for regulators to
sufficiently identify a bank’s internal health and soundness (Khorshid, 2004).
Some countries allow only ‘pure-play’ Islamic banks, excluding banks that merge
an Islamic unit and a conventional banking parent (Ali,
2007).
Another significant problem for developing Islamic
banking is keeping pace with investor demand for new and innovative products.
Interpretations of Islamic finance often stall new projects, or at the other
extreme, risk alienating a bank’s client base. The ability of a bank to
innovate depends on its capacity to get its products approved by its Sharia
supervisory council, made up of esteemed scholars conversant in Islam,
economics, and finance, which recognise and sanction a bank’s compliance with
the requirements of Islam (Benaissa, Mayank & Wiegand, 2005).
Islamic banks must conquer other competitive issues if
they are to offer competitive pricing and the same innovative advantage as
conventional banks (Benaissa, Mayank & Wiegand, 2005). In some countries,
market demand for Islamic banking services may never be large enough to warrant
the creation of banks with efficient scale, so national consolidation of
existing Islamic banks may not always be a feasible answer (Benaissa, Mayank
& Wiegand, 2005). Even though merging with a conventional bank might be a
possible alternative, this could endanger the legitimacy and credibility of an
Islamic bank’s financial products.
From these discussions, the differences in the
structure of products across countries – or even from one bank to the next –
add to the difficulties of cross-border expansion and back-office outsourcing.
2.6
Islamic Banks’ Financial Risk Management Needs
The Islamic finance market is a rapidly growing and
dynamic sector (Khorshid, A. 2004). Successfully entering this market will
require careful planning, flexibility to change as the sector evolves, and a
broad understanding of not only Islamic finance and Islam in general, but the
particular region, or sub-population to be targeted by a market strategy (Benaissa,
Mayank & Wiegand, 2005). To best capitalise on the recent and projected
growth of the Islamic finance market, banks in Saudi Arabia should understand
how each country’s entry strategy complements their overall market strategies
for a country.
The speedy development and wild progress of the Islamic
financial industry was not originally created in conformity to the
international accounting standards. In effect, Islamic institutions globally
had to find and create financial accounting solutions for their services and
products which results to issues regarding transparency (SBP,
2008).
Thus, the necessity to create of an accounting
standard purposely designed to reflect the specificities of Islamic products
became even more vital as new and more complex instruments were being marketed.
For solution, in 1990, the Accounting and Auditing Organisation for Islamic
Financial Institutions (AAOIFI) was created (Khorshid, A. 2004). The main goal
of this organisation is to create an international accounting standard that
comply to the needs of Islamic institutions globally. Actually, the AAOIFI also plays a critical
role in pursuing the harmonisation of Shariah-based rulings across
jurisdictions. Islamic Institution, as well as conventional banks or even any
user groups of financial statements (FS) in which harmonisation and
standardisation of financial accounting considered includes
investors/shareholders, employees, lenders, suppliers, customers, government
and the public. Shareholders and some
stakeholders are concerned on income (from dividends) and gain (from stocks
price). Employees are concerned on wage, salary and employment opportunities. Lenders
are concerned on the resources of the firm (both cash and non-cash). Suppliers are
concerned on financial stability of cash flow, customers on ability to supply
quality goods, government on performance for the purposes of taxation and the
public on employment, environmental and other social responsibility disclosures
(cited in ACCA 2006). In general, firms
must comply with the FS and harmonised and be standardised in accordance to the
needs of these shareholders and stakeholders to concede their legitimacy to
exist in the society (Deegan & Rankin 1996 p. 62). Otherwise, the latter can implore aggressive
or indirect actions (strikes, pull-out of investments, litigation, etc.) that
can ultimately lead to corporate demise.
Listed or public companies are, more than anybody
else, responsible to these stakeholders and impart in protecting its
legitimacy. This is because they come
full contact with the public, therefore, exposing their companies to several
and trickle-down effects on the public at large. As a result, other than maximisation of
shareholder’s wealth, corporate finance is also intended to aim objectives for
other stakeholders. However, the
question is how they are consistent with shareholder’s primary aim?
Poor accounting feeds speculative beliefs, which can
lead to stock market bubbles, and inefficient markets that ultimately direct to
damage economies (Penman, 2003). This is
because even if entrepreneurs with poor business models can easily obtain cash
through hot IPO markets which in turn affect the chance of more productive
firms to ensure capital for more positive community impact. Further, the primary reason of poor
accounting is non-compliance with sound accounting practice (Penman, 2003)
which can stem from management and accountants’ inability to separate facts
from forecasts (Glover et al, 2005).
This temptation is fuelled with the need to sustain shareholder
confidence to the company as well as attract another set of investors.
Such method will hardly be prioritised and isolated by
international standards (e.g. International Financial Reporting Standards)
because it is bias to capital-providers and undermine the need of other
stakeholders for efficient allocation of resources. In effect, this lead to a conclusion that
companies, to be able to continue operations, should be initially compliant to
the requirements of its legal owners (e.g. shareholders) before it can serve
other stakeholders. Leniency of IFRS is
necessary for companies to obtain flexibility; otherwise, it would not be able
to continue operations due to shareholder dismay and may as well be unable to
serve larger part of the community.
Investor focus, however, is not always the case. For example, employees and managers are
considered as internal stakeholders.
Listed companies are bound to provide them with equitable compensation and
maintain their motivation during growth or recession. Such objective should not be ignored due to
the fact that human resources and capital is the most important asset of the
firm (Hitt, Hoskisson & Ireland 2003).
Consistency on the primary objective is observed when internal stakeholders
are strictly recruited, trained and continuously motivated through certain
reward systems. This would make the labour
force more productive and loyal that can reflect the long-term achievement of
the investor’s objective. However, the
experience of General Motors wherein its financial difficulty arose from
implementation of retirement plans for its employees showed the conflict
between labour force and investor needs.
Chapter
Synthesis
Concerning the
review and the continuing development and progress in global financial market, the
Islamic banking and financial market also grow in order to meet the needs of
the changing society. Actually, the
capacity of the Islamic banking sector to respond to macroeconomic shocks has
been considerably strengthened over the past decade. Historically, the
operating environment has been one of output volatility emanating from
pervasive dependence on the hydrocarbons sector and swings in investor
confidence associated with regional uncertainties. This experience has helped
shape fairly risk-averse portfolios and the bank-led financial system has
functioned with substantial capital adequacy ratios (CARs), loan-loss
allowances, and liquidity buffers. As argued, the sector is profitable, with
returns on assets averaging over 2%, supported by a low-cost demand deposit
base even as lending rates are determined internationally but the need of
financial risk management is necessary among Islamic banks to maintain
stability. Stability is underpinned by an effective regulatory and supervisory
structure that proactively contains risk-taking through the articulation of
lending limits, including to connected parties caps on individual and corporate
indebtedness, and pre-approval requirements on foreign lending.
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