Identifying Operational Risk Exposures in Islamic Banking

Abstract

Operational risk management in financial institutions has undoubtedly attracted more attention from the regulators, practitioners, and also academics over the last decade. One of the reasons is because of the huge losses incurred by a number of financial institutions such as Barings, Daiwa and Merril Lynch, due to the malfunctioning of their operational risk management (Hoffman, 2002; Hull, 2007; Hussain, 2000). Having learnt the lessons from the current financial failures, regulators and practitioners have, therefore, seriously taken the issue. In spite of the wide range of areas and issues in operational risks that need to be catered, attempts to define and classify operational risk have been made by several institutions, most notably by Basel Committee on Banking Supervision (BCBS), which proposed a definition of operational risk through its consultative document on operational risk (BCBS, 2001). The industry has a wide range of responses to the definition proposed by BCBS. Despite the criticisms received from the industry, a positive side of the proposal is that banks started to realise the importance of managing operational risk, and therefore started to put aside a certain percentage of capital for operational risk, in addition to credit and market risk. In Islamic banking industry, the need to cater operational risk issue has also been discussed by Akkizidis and Kumar (2008), Archer and Haron (2007), Hossain (2005), Iqbal and Mirakhor (2007), Khan and Ahmed (2001), and Sundararajan and Errico (2002). It does not come as a surprise since Islamic banks operate in a similar, if not the same, business environment. Khan and Ahmed (2001) show that operational risk is relatively higher and serious than credit risk and market risk for Islamic banks. Unfortunately, there has not been any single literature which thoroughly tackles the issue. This may be due to the fact that operational risk carries complexities and it is relatively new area which calls for more academic inquiry. This is the reason from which this paper is developed. The paper starts with a discussion on the nature and origin of an Islamic bank and analyse why an Islamic bank has a distinct operational aspect, as compared to the conventional one. It also attempts to examine the operational risk exposures in Islamic banks. The following section discusses how to identify and conduct a mapping of operational risk in Islamic banks, which are also different from conventional ones on the structure of their financial contracts. Thus, they bring different features of operational risks in different イスラーム世界研究 第 3巻 2号(2010 年 3 月)17–53 頁 Kyoto Bulletin of Islamic Area Studies, 3-2 (March 2010), pp. 17–53