Risk Management Implementation and Solutions for Islamic Banking and Finance [1 ed.] 9781527526358

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Risk Management Implementation and Solutions for Islamic Banking and Finance

Risk Management Implementation and Solutions for Islamic Banking and Finance By

Omar Masood and Kiran Javaria

Risk Management Implementation and Solutions for Islamic Banking and Finance By Omar Masood and Kiran Javaria This book first published 2018 Cambridge Scholars Publishing Lady Stephenson Library, Newcastle upon Tyne, NE6 2PA, UK British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Copyright © 2018 by Omar Masood and Kiran Javaria All rights for this book reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the copyright owner. ISBN (10): 1-5275-1145-6 ISBN (13): 978-1-5275-1145-3

CONTENTS

Preface ....................................................................................................... vii Introduction ................................................................................................ ix Chapter One ................................................................................................. 1 Islamic Financial Institutions’ Liquidity Risk Measurement and Management Summary of Chapter One ...................................................................... 1 Section 1 : Introduction to Risk Management........................................ 2 Section 2 : Liquidity Risk Measurement Critical Analysis .................... 3 Section 3 : Methods used for Risk Assessment ..................................... 8 Section 4 : Empirical Analysis of Risk Management ............................ 9 Section 5 : Chapter Conclusion ............................................................ 11 Chapter Two .............................................................................................. 13 Basel III Implementation and Outcomes for Islamic Banks Summary of Chapter Two .................................................................... 13 Section 1 : Chapter Introduction .......................................................... 13 Section 2 : Critique Review on Basel III Implementation ................... 17 Section 3 : Methodology ...................................................................... 21 Section 4 : Empirical Analyses and Discussion ................................... 22 Section 5 : Chapter Conclusion ............................................................ 25 Chapter Three ............................................................................................ 27 Practical Enterprise Risk Management Practices in the Global Takaful Industry Summary of Chapter Three .................................................................. 27 Section 1 : Introduction of ERM Practices .......................................... 28 Section 2 : Theoretical evidence of the Takaful industry ERM ........... 29 Section 3 : Methodological overview of ERM Practices ..................... 35 Section 4 : Empirical Evidence of the Takaful Industry ...................... 36 Section 5 : Chapter Conclusion ............................................................ 38

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Chapter Four .............................................................................................. 39 Understanding and Managing Liquidity Risk by Leading Islamic Banks Summary of Chapter Four ................................................................... 39 Section 1 : Introduction to Risk Measurement ..................................... 39 Section 2 : The Theoretical Foundation of Liquidity Risk Measurement .................................................................................. 41 Section 3 : Methodological impression of Risk Measurement tactics . 42 Section 4 : Evidence and Analysis of Risk Measures .......................... 43 Section 5 : Chapter Conclusion ............................................................ 49 Chapter Five .............................................................................................. 53 The Success Story of the Global Takaful Industry’s Enterprise Risk Management Program Summary of Chapter Five .................................................................... 53 Section 1 : Chapter Introduction .......................................................... 53 Section 2 : Enterprise Risk Management Critique Review .................. 55 Section 3 : ERM Methodological basis................................................ 60 Section 4 : Empirical Evidence of Risk Management.......................... 61 Section 5 : Chapter Conclusion ............................................................ 63 Chapter Six ................................................................................................ 65 Key Drivers of the Islamic Risk Management System Summary of Chapter Six ...................................................................... 65 Section 1 : Chapter Introduction .......................................................... 65 Section 2 : Theoretical Foundations of the Liquidity Concept ............ 67 Section 3 : Methodological overview of Islamic Banks....................... 71 Section 4 : Quantitative Analysis of Islamic Banks’ Liquidity Risk.... 72 Section 5 : Chapter Conclusion ............................................................ 75 Chapter Seven............................................................................................ 77 Risky Microeconomic Factors in the Takaful Insurance Industry Summary of Chapter Seven ................................................................. 77 Section 1 : Chapter Introduction .......................................................... 77 Section 2 : Critical Review of Family Takaful Consumption Risks .... 79 Section 3 : Methodological overview of the Takaful Industry ............. 85 Section 4 : Analysis of an Emerging Economy (Pakistan) .................. 86 Section 5 : Chapter Conclusion ............................................................ 87 Policies and Recommendations for Islamic Institutions ............................ 89

PREFACE

Islamic banking is growing quickly in different parts of the world. The concept of Islamic finance is not new as it is as old as the religion itself and has its own principles. These principles are derived from the Quran which was written 1400 years ago. Islamic banking works under Islamic rules and regulations which are laid down by Islamic Shariah. In Islamic banking, it is important to manage the risk and return policy and also implement these policies in order to get better results. The major risk which Islamic institutions need to focus on is liquidity risk management. A well-managed financial institution should have a precise mechanism for the identification, monitoring, measurement, and mitigation of liquidity risk. The key focus of this book is to manage risk in Islamic financial institutions and to follow Shariah law in order to achieve the goals of an organisation. The major question that arises here is: how to overcome or manage the risk in Islamic institutions? What strategies should Islamic financial institutions follow which will lead them towards higher performance and profit maximisation? This book will answer the question: why focus on risk management? What are the solutions and policy implementation tactics that Islamic banks should follow? The book will explain the Basel committee policy implementation, how to tackle risk, how to manage enterprise risk, and so on. The Basel committee of banking supervision defined funding liquidity as “the ability of banks to meet their liabilities, unwind or settle their positions as they come due” (BIS, 2008). Liquidity risk management is a vital component of the global risk management agenda of the financial services sector regarding all financial institutions. Even though Basel II required regulators and banks to implement an improved framework for dealing with liquidity risk, the measurement and management of bank liquidity risk did not receive sufficient attention. This book addresses the risk mitigation techniques which Islamic institutions are using these days. The chapters of this book explain and contribute new ideas and analysis. They target different Islamic institutes from all over the globe and investigate their risk management solutions and implementations. This book also discusses the issues and challenges faced by Islamic banks. It analyses the Basel III implementation and outcome, practical enterprise risk management practices, liquidity risk management and understanding in leading Islamic banks, the success story

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of the global takaful industry, and also some key drivers of Islamic risk management systems.

INTRODUCTION

Application of Key Risk Management Techniques Islamic finance is a growing part of the financial sector in the world. It is spreading wherever there is a sizeable Muslim community, Ummah. Rapid innovations in financial markets and the internationalisation of financial flows have changed the face of conventional banking, in particular after the recent financial crisis. New information-based activities, like trading in financial markets and creating income through fees, are a major source of a bank’s profitability. Financial innovations lead to an increased market orientation and entail the use of assets such as mortgages, automobile loans, and export credits as backing for marketable securities; this is known as the securitisation process. Rapid developments in conventional banking have also affected the reshaping of Islamic banks and financial institutions. This general introduction and the first chapter rely heavily on the work by Hennie and Zamir (Hennie van Greuning, Amir Iqbal, in Risk analysis for Islamic banks, World Bank document). Financial systems are crucial for the efficient allocation of resources in a modern economy. The acquiring and processing of information about economic activities and entities, the packaging and repackaging of financial claims, and financial contracting are common elements that differentiate financial intermediation from other economic activities. Information plays a central role in financial contracts and financial markets. Today, information is considered as a valuable commodity. The main functions of a financial intermediary are asset transformation, conduct of orderly payments, brokerage, and risk transformation. Asset transformation takes place in the form of matching the demand for and supply of financial assets and liabilities (for example, deposits, equity, credit, loans, and insurance) and entails the transformation of the maturity, scale, and location of the financial assets and liabilities of the ultimate borrowers and lenders. The Shariah provides a set of intermediation contracts that facilitate an efficient and transparent execution and financing of economic activities. Islamic finance was practised in the Muslim world throughout the Middle Ages, fostering trade and business activities with the development of credit. Islamic merchants in Spain, the Mediterranean, and the Baltic

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Introduction

states became indispensable middlemen for trading activities. Several techniques and instruments of Islamic finance were later adopted by European financiers. Financial intermediation in Islamic history has an established historical record and has made significant contributions to economic development over time. Financiers in the early days of Islam— known as sarrafs “moneychangers”—undertook many of the traditional, basic functions of a conventional financial institution, such as intermediation between borrowers and lenders, operation of a secure and reliable domestic as well as cross-border payment system, and provision of services such as the issuance of promissory notes and letters of credit. Commercial historians have equated the function of sarrafs with that of banks. Historians like Udovitch consider them to have been “bankers without banks” (Udovitch, 1981). For more details, the reader can refer to Hennie and Zamir (Hennie van Greuning, Amir Iqbal, in Risk analysis for Islamic banks, World Bank document). Sarrafs, “moneychangers”, operated through an organised network and well-functioning markets, which established them as sophisticated intermediaries, given the tools and technology of their time. It is claimed that financial intermediaries in the early Islamic period also helped one another to overcome liquidity shortages on the basis of mutual help arrangements. The goal of financial management is to maximise the value of a bank, as defined by its profitability and risk level. Financial management comprises risk management, a treasury function, financial planning and budgeting, accounting and information systems and internal controls. The key aspect of financial management is risk management. This covers strategic planning, asset-liability management, and the management of the bank’s financial risks. Credit or counterparty risk is the chance that a debtor (or issuer) of a financial instrument will not repay principal and other investment-related cash flows according to the terms specified in a credit agreement. It means that payments may be delayed or not made at all, which can affect a bank’s liquidity. As financial instruments and markets have become more complex and processing has been automated, the treasury function has been made more complex. Typical treasury functions include at least the following elements. 9 Funding and liquidity management; 9 The overall policy framework, including general policy guidance and directions, ALM (asset-liability management), strategic asset allocation, benchmark approval, and use of external portfolio managers;

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9 Investment and cash flow management, (asset management); 9 Risk analysis including model validation, risk measurement for liquidity, counterparty or credit, market, commodity, and currency risk, performance measurement, analysis, and reporting, compliance with broad investment guidelines, and quantitative strategies and risk research (model development, benchmark construction); 9 Treasury operations including correspondent bank accounts (banking relations), settlements, accounting, and information systems and services. Like conventional banks, Islamic banks are also exposed to some forms of asset-liability mismatch risk. In addition, typical treasury risks for Islamic banks are liquidity, equity-investment, market, rate-of-return, and hedging risks. Market risks are similar to the market risks of conventional banks, except that there is no interest rate risk. Instead of interest rate risk, Islamic banks are exposed to mark-up risks and are further exposed to the risks of changes in the benchmark indexes used to determine “mark-up rates” and other rates on return. Islamic banks are exposed to operational risks and to several specific risks. These specific risks stem from the nature of their business, business environment, competition, and certain prevailing practices. These risks include displaced commercial risk, withdrawal risk, fiduciary risk, Shariah risk, and reputation risks, among others. Specific aspects of Islamic banking could heighten the operational risks of Islamic banks: 9 Cancellation risks in the nonbinding murabahah (partnership) and istisnah (manufacturing) contracts; 9 Failure of the internal control system to detect and manage potential problems in the processes and back-office functions. Potential difficulties in enforcing Islamic contracts in a broader legal environment: 9 Need to maintain and manage commodity inventories often in illiquid markets; 9 Failure to comply with Shariah requirements; 9 Potential costs of monitoring equity-type contracts and the associated legal risks; 9 People risk is another type of operational risk arising from incompetence or fraud;

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9 Technology risk is also an operational risk associated with the use of software and telecommunications systems that are not tailored specifically to the needs of Islamic banks. Capital absorbs possible losses and provides a basis for conserving the confidence of depositors. It is the ultimate determinant of a bank’s lending capacity. A bank’s balance sheet cannot be expanded beyond the level determined by its capital adequacy ratio (CAR). The availability of capital determines the maximum level of assets. Capital provides stability and absorbs losses. It also provides a measure of protection to depositors and other creditors in the event of liquidation. Conventional bank capital consists of equity capital, retained reserves and certain non-deposit liabilities. Capital represents a means of funding earnings-generating assets and a stability cushion. Capital is part of a bank’s sources of funding that can be applied directly to the purchase of revenue-earning assets. A bank’s capital structure relates to the ratio of capital to deposits and the ratio of debt capital to equity capital. In the late 1980s, the Basel committee on banking supervision took the lead in developing a risk-based capital adequacy standard. The minimum capital adequacy requirements for both credit and market risks are set out for each of the Shariah-compliant financing and investment instruments. Like for conventional financial institutions, in the IFSB standard, the minimum capital adequacy requirement for Islamic banks is not lower than 8% of the total capital in any country. In terms of future challenges, the immediate need is to develop instruments that enhance liquidity; to develop secondary, money, and inter-bank markets; and to perform asset-liability and risk management.

This Book is organised as follows. Chapter one presents the liquidity measurement and management of Islamic banks. This chapter explains that Islamic banking is a key area for all Muslims, one which is of interest for deposit purposes nowadays. It aims to examine the impact of different liquidity ratios on the performance of Islamic banks. To justify the theoretical basis, the author conducted an empirical analysis and selected 25 international Islamic banks over a period of 10 years from 2006 to 2015. Eight differently composed liquidity ratios from the balance sheets of current items were used in the study. The chapter concludes that the financial performance of Islamic banks has improved by maintaining liquidity at a good level and by holding liquidity

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further which can have an inverse impact on the financial performance of Islamic banks. Chapter two reveals the implementation of Basel III and its outcome in the Islamic banking sector. Pakistan, with its recent economic expansion and slow rate of Basel III implementation, is one of the countries that has had to confront such obstacles. In this paper, our empirical analysis is based on a survey of risk managers. The goal of Basel III is to improve capital standards and its scientific treatment of risk ensures that it is well regarded, specifically in the Islamic banking sector of Pakistan. Chapter three develops the experience of the global takaful industry. This chapter has been developed with the aim of discovering the impact of enterprise risk management (ERM) implementation on the financial performance of the global takaful industry. In this regard, the ERM implementation level has been measured through the availability of a Chief Risk Officer (CRO), the establishment of a risk management committee in the firm, the board independence level within the firm, the hiring of an auditor from big four auditor firms, and many more aspects. The conclusion of the chapter reveals that financial performance is highly affected by ERM implementation in the takaful industry. Chapter four studies the current situation of liquidity risk management in Islamic banks. The purpose of this particular chapter is to determine if any liquidity risk exists in the Islamic banks of Pakistan and if it does, what effect it has on the resilience of the industry in that country. This chapter also sheds light on the existing situation in liquidity risk management. Further, it takes a look at the attitudes of central and Islamic banks towards liquidity risk management policies. Chapter five investigates the different perspectives of enterprise risk management. The level of ERM implementation in Islamic institutions is measured in this chapter. Two control variables also employed in the study are age and Gross Domestic Product (GDP). The findings of this chapter can be utilised for the advancement of enterprise risk management within the takaful industry, making it a strength of the industry rather than a business risk. Chapter six explains the novel and unique characteristics of Islamic banks in handling liquidity. This chapter utilises different ratios which include current ratio (CR), liquid to asset ratio (LA), quick ratio (QR), cash and due from banks to asset ratio (CDA), investment to asset ratio (IT), cash and due from banks to deposit ratio (CDD), investment to deposit ratio (IDR) and cash deposit ratio (CD) in order to determine the drivers of liquidity risk management in Islamic banks.

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Chapter seven presents the empirical evidence in the takaful industry of an emerging economy (Pakistan) where the population is composed of 98% Muslims. This chapter explains the prevailing risk in the economy faced by a takaful firm in their consumption of family takaful. This chapter empirically verifies the link between risky macroeconomic variables (i.e. risk of per capita income, savings, risk of increase in inflation, stock index risk) with the demand for family takaful in the context of Pakistan using time-series data from 2006 to 2015 of “PakQatar family takaful company and Dawood family takaful company”. The chapter’s finding is applicable in all Muslim and emerging economies.

CHAPTER ONE ISLAMIC FINANCIAL INSTITUTIONS’ LIQUIDITY RISK MEASUREMENT AND MANAGEMENT

Summary of Chapter One Islamic banking and conventional banking are two parallel pillars of the banking sector. Conventional banks are interest-based while Islamic banks have interest-free banking. Islamic banking is a key area for all Muslims and one which interests them for deposit purposes nowadays. This study aims to examine the impact of different liquidity ratios on the performance of Islamic banks. The study selected 22 international Islamic banks over a period of 10 years, from 2007 to 2016. Seven differently composed liquidity ratios from the balance sheets of current items were used in the study; cash and due from banks to asset ratio (CDA), current ratio (CR), quick ratio (QR), liquid to asset ratio (LA), cash and due from banks to deposit ratio (CDD), investment to deposit ratio (IDR) and cash deposit ratio (CD) as independent variables. Whereas return on asset (ROA) and return on investment (ROI) are used as dependent variables. The age and size of the bank are used as control variables. Different analysis techniques were used to analyse the results. Two models were incorporated in the study. The results show that LA, QR, CDA and CDD contribute to explaining ROA and ROI. Whereas, the IDR, CD, AG, LTA impact on financial performance but not as strongly as the abovementioned because they do not explain all the financial performance indicators. Overall, it is concluded that financial performance is influenced by the independent variables of the study. The financial performance of Islamic banks improved by maintaining liquidity at a good level, and by holding liquidity further which can have an inverse impact on the financial performance of Islamic banks. The study incorporates a few control variables which have an impact on relationships. Keywords: liquidity, financial performance (ROA, ROI), Islamic banks.

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Chapter One

Section 1: Introduction to Risk Management The banking industry consists of two pillars; one is the conventional banking system and the other is the Islamic banking system. In early times, there were only conventional banks which performed operations based on interest; later on, Islamic banks were introduced as the result of the conservatism movement, in which followers of Islam showed their need to follow banking practices in light of Shariah laws and ensure the soundness of their Muslim economies, as explained by Taylor (2003). Islamic financial transactions follow basic principles, some of which are: first, finances must not involve any activity which is prohibited by Islamic laws; second, it must not include any type of riba (interest); third, economic activity must not involve any type of oppression (zulm); fourth, the activity should not consist of speculation (gharar); fifth, zakat payments must be done; and sixth, products and services that oppose the laws of Islam must be avoided (for instance haram products) (Inyangala, 2014). Islamic banks were less affected by the global financial crises due to the nature of their practice in which all transactions are trade based and asset linked (Hidayat & Abdullah, 2012). It is not the case that the crises did not completely impact on the Islamic banks. They were affected, but not as badly as conventional banks, and one reason is that Islamic banks hold and maintain their levels of liquidity more than conventional banks (Kassim, Majid & Yousaf, 2010). The importance of liquidity can be seen by the comments of many researchers in their studies. Liquidity is the ability of an Islamic bank to pay off or meet its short-term immediate and unpredicted obligations. Liquidity is very important for any type of institutional survival, in the case of Islamic banks. Liquidity also attracts potential depositors and investors. Liquidity is like a lifeblood for every institution and specifically for Islamic banks (Siegel & Shim, 2000; Masood & Bellalah, 2013). The basic motivation of this work is to check the liquidity risk of Islamic banks. A lack of liquidity causes banks to face a liquidity risk, and this risk arises when the banks’ ability to match the maturity of its assets and liabilities is affected. This study fills a gap regarding how to overcome liquidity risks in Islamic banks and also examines the importance of liquid assets in the area of Islamic banks. The aim of this study is to understand liquidity risk and performance measure concepts and also to define different variables of liquidity and then examine the relationship of these variables with performance in terms of Return on Asset (ROA) and return on investment (ROI). This chapter is divided into four further sections. The second section will give the literature review which explains the

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Islamic banking system, its development and performance and liquidity risks faced by banks. The third section demonstrates the research methodology of the paper. The fourth section will give empirical findings and the fifth section finally concludes along with short recommendations.

Section 2: Liquidity Risk Measurement Critical Analysis a) History and Development of the Islamic Banking Sector The basic difference between Islamic and conventional banks is “Riba”. Riba is an Arabic word with the literal meaning of an “increase”. Riba is prohibited in Islam as, according to Taylor (2003), the riba prohibition does not mean that money cannot be lent to any borrower. In fact, it can be, but under the laws of Shariah. This prohibition in Islam is to avoid any unearned profit, or illegality of any form of profit or gain, unearned in a sense that they result from risky transactions which cannot be calculated with contracting parties in advance. The Islamic bank works under the light of Islamic laws and incorporates an interest-free banking system, as it prevents its functions from riba. Many countries around the globe incorporate a twofold banking system which means that conventional banks operate in parallel to Islamic banks (Akhtar, Ali, & Sadaqat, 2011). b) Liquidity risk in Islamic banks Liquidity is a description of an institution’s ability to convert its assets into cash at short notice and without any loss in its asset value. The assets which have a high quality of liquidity are those assets that can be instantly transformed into cash (Committee on Banking Supervision, 2013). In banking, the liquidity ratio plays a very important role, because banks usually deal with demand deposits and time deposits, and both take the form of large funds borrowed from depositors (Anyanwu, 1993). Liquidity risk is a very important issue to tackle in the banking sector. Different ratios exist through which banks measure liquidity; financial institutions need to maintain a balance between both the inflow and outflow of the institution over time. Cash and due from banks to deposit ratio (CDD): The cash and due from banks to total deposit ratio was calculated as cash and due from banks divided by total deposits (Iqbal, 2001; Rasul, 2013; Fatima & Ibrahim, 2013). Cash and due from banks to total deposits ratio was used

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in many studies to measure the liquidity and mixed results were found. Rasul (2013), used cash and due from banks to total deposit ratio to reflect the liquidity of the Islamic banks of Bangladesh and found that cash and due from banks to total deposits has a significant relationship with return on asset and return on deposits, whereas an insignificant relationship with return on equity at 10% level of significance. Investment to deposit ratio (IDR): This ratio was used in many studies for assessing liquidity. Investment to deposit ratio is calculated as investments of the bank divided by the total deposits of the bank. The illiquidity and insolvency of the bank are indicated by a high investment to deposit ratio. Samad and Hassan (1999), in their study, measure the liquidity ratio by the cash deposit ratio in addition to some other proxies. They calculate the cash deposit ratio by dividing the cash on deposit, as the most liquid asset of any bank is cash, so, the cash deposit ratio indicates the liquidity of the bank; the higher the ratio, the more liquid the bank is, compared to a bank which has a low ratio. Cash deposit ratio (CD): Samad and Hassan (1999), in their study, used the cash deposit ratio in addition to some other proxies. They calculated the cash deposit ratio by dividing the cash on deposit, as the most liquid asset of any bank is cash, so, the cash deposit ratio indicates the liquidity of the bank; the higher the ratio, the more liquid the bank is, compared to a bank which has a low ratio. Mansoor Khan, Ishaq Bhatti, and Siddiqui (2008), while examining the different modes of Islamic finance, used a cash deposit ratio along with some other indicators and found a significant impact. The results showed that the performance of Pakistani banks is good in terms of ROA and ROE, and the banks also maintain liquidity. In addition, Loghod (2010), in his study, also found that this cash deposit ratio had a significant association with the enlargement of banks’ profitability. Current ratio (CR): The current ratio is used to determine the liquidity of a company. The current ratio shows the ability of the company to meet its short-term debt obligations. Malik, Awais, and Khursheed (2016), in their study, also calculate the liquid ratio by performing an addition of cash and investments and then dividing it by current liabilities. The current ratio is used to measure liquidity. As Samad and Hassan (1999) found while conducting an exploratory study on the profitability of Malaysian Islamic banks, this shows the ability of a bank to pay and meet the current liability demand of depositors. Similarly, Khan, Ali, and Khan (2015), also

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use the same ratio to measure liquidity along with some more ratios. The results show that the current ratio has a significant relationship with profitability and is improving for Pakistani Islamic banks whereas it is declining for Malaysian Islamic banks. Liquid to asset ratio (LA): Mansoor Khan, Ishaq Bhatti, and Siddiqui (2008), examined Islamic modes of finance including two Islamic banks of Pakistan, namely Al Baraka and Meezan bank. Their study includes different ratios of capital adequacy, asset composition, and liquidity, earning and profitability ratios. Their study incorporates liquid asset to total asset in order to measure liquidity along with liquid asset to total deposits and cash deposit ratio. Liquid asset to total asset has a significant association with profitability, and also shows that the liquid asset to total asset ratio is high for the Al Baraka Islamic bank. Quick ratio (QR): The quick ratio is a liquidity ratio which is used to display the speed of the institution for quickly transforming its assets into cash to repay a short-term debt. According to Ishaq et al. (2016), quick ratio is a measure of the company’s ability to meet its obligations in the short term. Quick assets are assets that can be easily converted into cash without a significant depression of book value. It is a measure of financial strength or weakness of a company. Their study used quick ratio in addition to some more proxies to measure the liquidity ratio of commercial banks of Pakistan. Cash and due from banks to asset ratio (CDA): Cash and due from banks to total asset ratio is also a proxy used to measure the entities liquidity level, and is defined as the ratio of cash and cash due from banks to net assets (Yu & Jiang 2010; Bokpin, 2013). Fatima and Ibrahim (2013), also measure liquidity by cash and due from banks to total assets. They selected five Islamic banks of Bangladesh and collected data from 2005 to 2007. The result shows that cash and due from banks to total asset is significantly associated with profitability. c) Performance Measures (ROA, ROI) of Islamic banks Banks which are solid and profitable have the ability to withstand negative shocks, and also to ensure the stability of the financial system (P. P. Athanasoglou, Brissimis & Delis, 2008). The study also suggests that profit is not only a tool to indicate the performance of a bank, but it also helps to determine the planning and efforts made by management in order

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to increase the bank’s performance, and also to increase the chances of the bank remaining in competitive markets. The performance ratios examine the ability of a business to earn a profit by making its activities profitable (Alshatti, 2015). Return on Investment (ROI): According to Bashir (2003), before tax profit ratio is defined as the net income accumulating in a bank from noninterest activities (such as fees, service charges, foreign exchange, and direct investment) divided by total assets. Samad and Hassan (1999), define the profit expense ratio as the division of profit by total expense; the higher the ratio, the more cost-effective the bank is, and it also generates great profits within the given expenses. Return on Asset (ROA): Previous studies used different indicators to measure performance. Return on Asset (ROA) is a financial ratio that is used to measure the financial performance of a bank. It is defined as net income divided by total assets (Ariffin, 2012; Obudho, 2014; Daly & Frikha, 2015). This ratio depicts the proportion of the bank’s assets that contribute to achieving results. d) Management of Liquidity Risk and its impact on Performance The liquidity of any organisation (bank) is reflected by its amount of liquid assets; the higher the liquid assets, the more the organisation (bank) is in a liquidate state (as in having more liquid assets) (Akhtar, Ali & Sadaqat, 2011). Whereas, the reward that appears as a result of taking risks is called profit in Islam. Malik, Awais and Khursheed (2016) conducted a study and asserted that ROA and ROI are proxies of profitability (dependent variables). Whereas current, liquidity and quick ratios are proxies used for liquidity, the findings show a significant relationship between measures of bank liquidity and ROA. However, the relationship between profitability and liquidity became statistically insignificant when ROE and ROI were used as proxies of profitability. Arellano and Bond (1991) suggested that to manage liquidity, the banks must assess and restructure their strategies, and it will improve both the yields on shareholders’ equities and the use of assets by banks. The results show the rejection of a null hypothesis and show there is a significant positive relationship, and that liquidity affects the performance of commercial banks. Accordingly, the study also finds that in Nigeria, the significant determinants of a bank’s performance are the size of the board, bank liquidity, and debt structure. Based on the results, the study suggested that

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to achieve superior bank performance, banks must raise their liquidity; on the other hand, it was suggested that the performance of banks can also be increased by effectively managing the debt structures of banks. Irfan and Zaman (2014) examined the efficiency of Islamic banks of Asian countries. The study findings showed that Islamic banks are efficient, and banks can be placed according to their efficiency rank; Brunei stands at the top, then Pakistan, Iran, and Bangladesh. Liquidity is an important financial ratio to determine the efficiency of the Islamic banking system. Hypothesis Development: ¾ H1a: There is a significant and positive relationship between current ratio and return on asset. ¾ H1b: There is a significant and positive relationship between current ratio and return on investment. ¾ H2a: There is a significant and positive relationship between liquid asset ratio and return on asset. ¾ H2b: There is a significant and positive relationship between liquid asset ratio and return on investment. ¾ H3a: There is a significant and positive relationship between quick ratio and return on asset. ¾ H3b: There is a significant and positive relationship between quick ratio and return on investment. ¾ H4a: There is a significant and positive relationship between cash and due from banks to asset ratio and return on asset. ¾ H4b: There is a significant and positive relationship between cash and due from banks to asset ratio and return on investment. ¾ H5a: There is a significant and positive relationship between cash and due from banks to deposit ratio and return on asset. ¾ H5b: There is a significant and positive relationship between cash and due from banks to deposit ratio and return on investment. ¾ H6a: There is a significant and positive relationship between investment to deposit ratio and return on asset. ¾ H6b: There is a significant and positive relationship between investment to deposit ratio and return on investment. ¾ H7a: There is a significant and positive relationship between cash deposit ratio and return on asset. ¾ H7b: There is a significant and positive relationship between cash deposit ratio and return on investment.

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Section 3: Methods used for Risk Assessment A. Statistical Tool: The focus of the analysis of this study is Islamic banks. Islamic banks are interest-free banks and operate according to Islamic Shariah laws. Panel data can detect the effect of variables that cannot be easily detected by purely cross-sectional data or time series data. So, this study uses panel data. The present study uses secondary data as it has already been collected and prepared by the Islamic banks in the form of their official financial reports. Secondary data is good for the handling of longitudinal studies (over a long period of time). Because of these advantages, the present study incorporates secondary data. The sampling technique used in this study is purposive sampling. Similarly, according to Kothari (2004), purposive sampling is a technique to select the subjects for the study based on certain characteristics or criteria in order to fulfil the study objectives. B. Data: The data was extracted from balance sheets and income statements and their respective notes. Data was collected from 2004 to 2016, but as all banks were not in operation in 2004, certain banks were analysed which were in operation since 2007. 22 Islamic banks were selected for this study, from 2007 to 2016. The data was collected for 22 Islamic banks which are operating in different countries and fulfil the criteria selected for this study. Abu Dhabi Islamic bank, ABC Islamic bank (E.C), Al Baraka Islamic Bank B.S.C., Al Rajhi bank, Al Baraka Bank (South Africa), Bank Al-Jazzier, Bahrain Islamic bank B.S.C., Bank Islam Malaysia Berhad, Boubyan bank, bank Muamalat, Dubai Islamic bank, European Islamic investment bank, Faysal bank (Pakistan), Hong Leong Islamic Bank, Islamic bank of Britain, Islamic bank Bangladesh limited, Jordan Islamic bank for finance and investment, Kuwait Turk participation bank, Meezan bank, Qatar Islamic bank, Sharjah Islamic bank, and Tadhamon International Islamic bank are the Islamic banks selected for the present study.

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Section 4: Empirical Analysis of Risk Management Tests confirmed the existence of heteroscedasticity, autocorrelation and endogeneity in the data set. Therefore, a generalised method of moment test is used to assess the relationship between liquidity variables and profitability measures (ROA, ROI). As the p-value is smaller than the prescribed value, it is stated that heteroscedasticity is found in both models. The results of the autocorrelation test show that autocorrelation exists in both models as the null hypothesis is rejected in Model 1 and Model 2. The Hausman specification test shows that IT and CDD are endogenous against ROA; LA, CD and CDD are endogenous against ROI at 5% level of significance. Model Specification: Different authors and researchers suggest using some instrumental models for estimation in case of failure of OLS assumptions, more specifically in the existence of endogeneity (Arellano & Bond, 1991); (Arellano & Bover, 1995). In econometric models, some independent variables and the lag term of dependent variables are used as instruments for the endogeneity problem. A fixed effect model is used for the data analysis. Table 1: Heteroscedasticity and Autocorrelation in panel data ROA Wald test for groupwise heteroscedasticity

ROI

chi2 (25) 2869.36 1.70E+05 Prob>chi2 0.0000 0.0000 Wooldridge test for autocorrelation in panel data 9.206 6.937 F-stat 0.0057 0.0145 P-value Hausman specification test for Endogeneity Chi-Sq 23.327 35.525 0.0096 0.0014 P-value

Chapter One

10

Table 2: Descriptive summary of data Mean

Maximum

Minimum

Std. Dev.

Observations

ROA

0.82

5.88

-13.41

1.91

250.00

ROI

7.09

88.86

-103.48

19.22

250.00

CR

88.31

609.10

0.26

101.03

250.00

LA

17.31

64.66

0.03

11.27

250.00

QR

44.23

551.36

0.03

70.14

250.00

CDA

16.05

64.66

-0.09

11.40

250.00

CDD

52.16

637.50

-0.05

91.26

250.00

IDR

86.91

791.99

0.00

120.59

250.00

CD

7.79

97.88

-0.05

13.62

250.00

AG

25.42

110.00

1.00

19.14

250.00

LTA

10.06

12.97

5.84

1.16

250.00

ROI was used in the present study to quantify the financial performance of Islamic banks. The highest ROI is 88.86 of Al Baraka Bank (South Africa) among all Islamic banks in the year 2015. ROA means the value is 0.82 which depicts the ROA of all Islamic banks on average. The standard deviation of ROA is 1.91 which shows that the deviation in the financial performance is not very large across all countries and all Islamic banks, as all banks perform in light of Islamic Shariah. The CR is lowest at 0.26 in 2007 by ABC Islamic bank (E.C). The CR minimum value is not negative which shows that in financial crises, Islamic banks did not suffer from a negative liquidity position. No single LA ratio has a negative sign which shows that in the years of global financial crises, all the Islamic banks maintained their LA ratio to some extent. The average value of QR is 44.23 overall. The trend of mean shows a positive sign with fluctuations. Overall, average CDA is 16.05. The trend of CDA average shows a slight increasing trend in 2008 as compared to 2007 and again drops a little value in 2009. Positive CDD values mean that all Islamic banks maintain their liquidity position and this secures them from bankruptcy. The average value of IDR is 86.91 which is positive in nature by its sign, which depicts that all sampled Islamic banks consist of this ratio for their liquidity purposes. The overall mean of the CD ratio is 7.79, and its trend shows a decrease in the average ratio from

Islamic Financial Institutions’ Liquidity Risk Measurement and Management

11

2007 to 2008. The dispersion of AG is overall 19.14 standard deviation. The mean of LTA is 10.06 which is positive in nature because no bank can have negative total assets. Correlation analysis: The range of the correlation coefficient lies between +1 to -1. The +1 indicates a perfect positive correlation, which depicts that with an increase of one variable, the other variable will also increase, or in other words, both variables are directly proportional. Fixed Effect Model Return on Asset Result: A null hypothesis of the j-statistic is accepted on the basis of the p-value and instruments are found to be valid. The model includes cross-section weights as GMM (Generalised Method of Moments) weights. The Durbin-Watson statistic falls in the range near to 2 which shows there is no autocorrelation. The value of R-square is 69%, whereas the adjusted R-square value indicates that combined liquidity variables explain 64% of financial performance in terms of ROA when other factors remain the same. Return on Investment Results: No autocorrelation is detected by the value of Durbin-Watson which lies in the range near to 2. The R-square of the model is 61% and the adjusted R-square shows that the liquidity explains financial performance as measured by an ROI of 53% when other factors remain the same.

Section 5: Chapter Conclusion All Islamic banks follow the teaching of Islamic Shariah in their operations and practices. The interest-free banks’ earnings are not dependent on any kind of interest; instead, they largely depend on liquidity for their survival and capital enlargements. This chapter aims to trace the importance of liquidity and also to check the impact of liquidity on the enlargement or shrinkage of the financial performance of Islamic banks. The study defines different variables as liquidity measures and uses current ratio, liquid ratio, quick ratio, cash and due from banks to asset ratio, investment to asset ratio, cash and due from banks to deposit ratio and investment to deposit ratio as independent variables to measure the liquidity of Islamic banks. The dependent variables used in the study are Return on Asset (ROA), Return on Equity (ROE) and Return on Investment (ROI). The study also incorporates some firm-specific variables as control variables, which are the size of the Islamic bank (LTA) and the age, which is the number of years the Islamic bank has

12

Chapter One

been in operation (AG). The study used a set of 22 international Islamic banks to investigate the relationship between liquidity and the financial performance of Islamic banks over the period from 2006 to 2015. The overall study found that Islamic banks try to maintain a good level of liquidity in order to prevent them from bankruptcy and to perform smooth operations. This highlights two important issues, “liquidity” and “financial performance”. The study found that Islamic banks cannot achieve expected profit enlargements without confirmation of their proper liquidation (liquidity level not too high, nor too low). The study also found a very weak impact of control variables on the financial performance of the selected sampled Islamic banks.

CHAPTER TWO BASEL III IMPLEMENTATION AND OUTCOMES FOR ISLAMIC BANKS

Summary of Chapter Two Basel is basically a voluntary regulatory framework which is used globally to check stress testing, market adequacy and market liquidity risk. Although it was designed to improve and stabilise the financial system worldwide, especially in developing and emerging countries, the implementation of Basel III has presented a number of challenges and obstacles. Pakistan, with its recent economic expansion and slow rate of Basel III implementation, is one of the countries that has had to confront such obstacles. In this paper, our empirical analysis is based on a survey of risk managers. Its goal is to improve capital standards and its scientific treatment of risk ensures that Basel III is well regarded, specifically in the Islamic banking sector of Pakistan. The hindrance to its implementation is an operational risk; this problem has only been partially addressed. The publicly owned banks are considered less proficient than the privately owned banks. Keywords: Basel Accord; governance; Islamic banks; regulation.

Section 1: Chapter Introduction The Basel Accords arose from a need to provide steady structures and secure budgetary frameworks via a set of principles, considered to be worthy in fiscal centres around the world, which advocate the logical mediation of danger. As a component of the Accords, banks confront various least-capital prerequisites. Such governance is beneficial to the economy, as it ensures banks are protected against misfortunes coming about because of exposure to business, credit and operational hazards. It also binds banks to endorse capital points of confinement and ensure that they are prepared for systemic danger. This chapter presents the hypothesis that Pakistani banks are relying heavily on the implementation

Chapter Two

14

of the Basel Accords, and results can be achieved if proper policy-making is instigated and employee skills are developed. Hypothesis This hypothesis was derived from a survey filled out by risk managers, which highlighted the following areas of interest. These were used through the dissecting deviations present in Pakistan, maintaining the roadmap money segment for the execution of the Basel Accords in Pakistan. x Are there contrasts in the execution of the Basel Accords in the private and public banking sectors of Pakistan? Is one sector more inclined to use the Basel Accords? x Have banks started to prepare outer Basel Accord connections via external training? x What are the respondents’ assumptions regarding the competency of employees in the risk management department? x What are the respondents’ suppositions regarding the viability of the bank’s plan for implementing the Basel Accords? x Is there any need for change in the system to guarantee compliance with the Basel Accords? x How many years’ worth of data is covered by the default time series? The more extended this time series and the more data that is accessible, measures, in a roundabout way, the consistency with which the Basel Accords have been implemented, and the bank’s preference for these Accords and related benchmarks. x What is the degree of compliance with exposure prerequisites according to the international financial reporting standards (IFRS) and other Basel Accords necessities? x Does the bank bring to light issues among its clients regarding compliance with the Basel Accords? This is very important in terms of sharing data on universal encounters with the financial crisis and problems being highlighted in the Basel Accords. History of the implementation of the Basel Accords The financial system is responsible for the functioning of the economy as well as modern life. The aim of the financial system is to support both investors and savers so their money can be put to work. The savings of one person are said to be the finance for another’s investment, like household savings made via the funding of a pension being issued by companies in

Basel III Implementation and Outcomes for Islamic Banks

15

order to expand their business. The financial system plays an important role in getting people to have confidence in the economy, which helps it function properly. Many different banks contribute towards maintaining financial stability because it is an essential ingredient for a successful and healthy economy (Maio, 2012). In February 1975, the first Basel committee on banking supervision (BCBS) meeting took place; such meetings continued regularly three or four times a year after that (Basel committee on banking supervision 2009). The members of the committee are from all over the world, including Brazil, Australia, France, China, Hong Kong, India, Indonesia, Spain, Africa, the United Kingdom, the United States, Turkey, Switzerland, Mexico, Korea, Japan, South Africa, Saudi Arabia, Russia, the Netherlands, Luxembourg, Italy, Mexico, and Singapore. All of these countries are represented by their central bank, or by the formal responsibility of banking businesses where there is no central bank. One of the biggest problems relating to regulatory authorities is the soundness of the banking system. All banks were measured via the soundness of the leverage ratio in the 1990s: leverage capital/leverage ratio D total asset. If this ratio is high, it is said that banks are well protected against risk. However, this ratio cannot tell us about the difference between assets and their risks. If asset risk increases with the passage of time but the capital does not change, banks fail in terms of insolvency and soundness (Hassan, 2002). i. Basel I The main requirement of the first Basel Accord (Basel I) was that all financial institutions held at least 8% capital of their risk-weighted assets. A bank’s capital consists of mainly two parts. The first part is shareholder equity and retained earnings (Tier 1 capital). The second part includes all kinds of external and internal resources (Tier 2 capital). It was necessary under Basel I for the Tier 1 capital to represent almost half of the total capital, or for the Tier 1 capital to be 100% of the Tier 2 capital (Hassan, 2002). With the help of Basel I, different kinds of risk weights were assigned to debtors’ assets, e.g., 100%, 50%, 20% or 0%. This tells us that if an asset has 0% risk, then this type of asset (e.g., government securities) requires no capital. However, if the asset has a risk weight of 50%, then the bank requires 4% capital, and if the asset has a risk weight of 100%, then the bank requires 8% capital. If the asset has a risk weight of 20%,

Chapter Two

16

then the bank contains 1.64% capital of the asset’s value. Basel I was measured via the following equation: Capital / risk-based capital ratio D risk-adjusted assets A decade after Basel I was implemented, a lot of changes in finance, technology and other sectors led to it developing many weaknesses. For example, banks’ high-risk assets off-balance-sheet and operational risks were not considered by Basel I (Mohanty, 2008). ii. Basel II Due to all the weaknesses of Basel I, the BCBS decided to change Basel I into a more sensitive type of regulation. For this reason, Basel II was introduced (Akhtar, 2006). The more sensitive framework provided through this new Basel Accord was especially for banks. The Basel II risk measure consists of the following equation: Risk-based capital D: capital/credit risk C market risk C operational risk Basel II dealt with all kinds of risks, e.g., operational, credit and market risk. The difference between Basel I and Basel II was that Basel I did not deal with operational risk. In addition, Basel II set up 8% credit requirements for operational and credit risk (Ahmad, 2008). Many weaknesses were seen five years after the implementation of Basel II. The reasons for its failure are given below. Reasons for Basel II failure Procyclicality: Due to the procyclicality of the financial system, if there was an economic boom in a country, its banks contained less capital for recovering risk, but if the economy was down, its banks required more capital for risk recovery (Udeshi, 2004). Credit ratings provided by external sources: Another cause of Basel II’s failure was its use of many ratings provided by external sources. As a lot of nations do not contain a department of credit assessment, they rely on the credit rating provided by institutions. Therefore, these external credit-rating institutions grew in importance, which created many problems, such as mispriced risk. “Because of this, many conflicts arose and it became necessary to revise Basel II” (Maio, 2012).

Basel III Implementation and Outcomes for Islamic Banks

17

Advanced measurement approach and advanced internal ratingsbased approach: It had been stated many times by US supervisors that two approaches to operational and credit risk, the advanced internal ratings-based (AIRB) approach and the advanced measurement approach (AMA), are complex. This is the main reason they are implemented in only a few banks. Hence, the financial institutions having assets of US$250 billion or above are required to implement an advanced approach (Mohanty, 2008). .

iii. Basel III The liquidity and capital requirements that meant banks were experiencing financial crises were improved with the help of the revised Basel III. There was an increase of common equity from 2% to 4.5% under this new regime, as well as an increase in the reserve capital of Tier 1 from 4% to 6%. This resolved the problem of liquidation. Basel III required that banks have external and additional reserves and introduced a “capital conversation buffer” of 2.5%. This was not present in Basel II. This buffer is helpful in situations of stress (Mehta, 2012). Another thing that was not present in Basel II was a counter-cyclic buffer. This is the additional reserve maintained by banks. This was not fixed and varied from 0% to 2.5% under Basel II. This was maintained by the banks to increase Gross Domestic Product (GDP) if credit increased. Another instrument introduced by Basel III was the liquidity converge ratio (LCR), which was designed to solve the liquidity problem. The main purpose behind this ratio was that high-quality assets could be easily converted into cash to meet cash requirements within 30 days. This ratio should not be less than 100% (Mehta, 2012).

Section 2: Critique Review on Basel III Implementation As we have already mentioned, after taking all of the weaknesses of Basel I into account, it was decided by the BCBS to change the existing framework and create one that would be more sensitive to risk. Hence, Basel II was introduced (Akhtar, 2006). Basel II consists of three main pillars (Ahmad, 2008): (1) Market discipline. This is a new pillar in Basel II. It requires that banks disclose their risk, capital adequacy, and soundness so that the market can understand a bank’s risk portfolio, soundness, and adequacy of capital (Hassan, 2002).

Chapter Two

18

(2) The process of supervisory review. This is also a new pillar in Basel II. It helps to weigh the risks that are given to fixed assets. It was absent in Basel I. Through this review, a bank can use different types of approaches to measure market, credit, and operational risk. Choosing all kind of approaches, the supervisor can review a bank’s position and decide whether it meets the minimum requirements for approach implementation (Hassan, 2002). (3) Requirements for minimum capital. The rate of capital adequacy is 8% in Basel II, but market and operational risks are not included. 50% is total capital and 100% is Tier 2 capital. This change arose in approaches of risk measures and operational risks (Hassan, 2002). Basel II implementation A lot of issues were faced by the authorities of European regulation, management and supervisors concerning Basel II implementation. The main problems were financial stability and accountability (Lannoo, 2005). The implementation of Basel II required high expertise, and this was a big challenge for bank managers. The framework has a very complex design; its regulations and components are both very complex, which affects a bank’s effectiveness and costs (Härle, 2010). A large amount of data was required for Basel II implementation. Banks had to pay a lot of money for this, which was one of the major challenges they faced. In addition, a lot of difficulties were faced when trying to identify relevant data and risks. The implementation of this incarnation of Basel cost European banks around €45 million to €70 million (Härle, 2010). The success of Basel II was dependent on the abilities of bank supervisors, who played an important role in its implementation. Many expert and experienced supervisors were required for its implementation, and this was a big challenge (Caruana, 2006). Basel II causes of failure A lot of challenges were faced by those implementing Basel II. It required high-quality data and for supervisors to upgrade their expertise and skills. The other challenge was that this version of Basel had to be fair, consistent, and transparent (Parreñas, 2002). There was also the need for a high-quality internal ratings-based approach, but banks had no data for such a purpose, and this created a

Basel III Implementation and Outcomes for Islamic Banks

19

huge problem in the assessment of risk. In order to meet the requirements of Pillar 3, it was necessary to meet accounting and financial standards (Parreñas, 2002). The main issue was a regulation problem in that complex and modern models, such as AIRB and AMA, were used, but there was a lack of sufficient and reliable databases in banks (Gottschalk & Griffith-Jones, 2006). Many financial organisations such as life insurance companies (LICs) needed to implement Basel II, as they linked up with foreign banks and had to apply advanced Basel approaches. A lot of difficulties arose if an LIC was not operating according to the Basel framework (Gottschalk & Griffith-Jones, 2006). Basel II tried to improve the competitive equity among banks but could not succeed. Although many banks became winners under Basel II, the number of losers was greater. The large organisations that adopted the AIRB approach received more important gains than small organisations (Lall, 2010). Basel III Some long-term provisions and reserves were established in Basel III for covering and avoiding the effects of counter-cyclicality. This is the main reason that banks maintain more capital for absorbing uneven shocks. Basel III has the proper standards for measuring the risk of liquidity (Cosma & Prunea, 2010). The framework provided by Basel III is very effective and comprehensive in treating the risks linked to Basel II (Dardac & Grigore, 2011). The crises of summer 2007 were due to a lack of liquidity risk management in almost every financial institution. Because of this, the BCBS updated Basel II, and in 2008, the principles for sound liquidity risk management and supervision were added to Basel (Bindseil & Lamoot, 2011). The BCBS provided the LCR, which ensures that banks have high-quality assets that can be easily converted into cash for meeting cash requirements within 30 days (Bindseil & Lamoot, 2011). There was more regulation in Basel III than in Basel II in order to help institutions survive financial crises. The fundamental and basic effects were on financial institution profitability (Nucu, 2011). Basel II’s emphasis was on the risks surrounding capital adequacy, as the basic problem was risk management (Kahf, 2005).

20

Chapter Two

a) Basel III implementation in the institutions of Islamic finance A lot of Islamic bank transactions create debts, such as Ijarah. Such claims have categories, rather than the modes of Islamic finance mentioned in Basel II and follow Islamic banking accounting standards (issued by the accounting and auditing organisation for Islamic financial institutions, or AAOIFI). The AAOIFI does not categorise all types of claims that are mentioned in Basel II (Kahf, 2005). The fifth AAOIFI accounting standard discusses how there is a need to disclose a bank’s profit ratio, which should be distributed among investors and Islamic banks. The rule of profit distribution should be disclosed to banks and investors, who are considered to be necessary participants, which is not mentioned in Basel II (Kahf, 2005). The main assumption of Basel II is that the counterparty of a whole asset in balance sheets must be capital and liability. This assumption had not been met in Islamic banks (Kahf, 2005). Basel II provided an opportunity for Islamic financial institutions to improve the management of their risk processes as well as their financial stability (Khan, 2003). According to the AAOIFI definition, Islamic financial institutions are very different from those in a conventional type of banking system. They have different forms, such as Istisnaa, Musharakah, Modaraba and Salam. These are cash and cash equivalents; hence, the risk linked with such assets is much different from that in a conventional type of banking system, so it is difficult to apply Basel Accords to Islamic institutions (Obaidullah, 1998). b) Challenges of Basel in Islamic financial institutions Depositors are safe from risk in a conventional type of banking system, and it is necessary for banks to pay sufficient capital and interest. The Islamic banking system, however, is mainly based on loss and profit sharing that is not returned at fixed interest rates; hence, Islamic banks have no need for Basel to protect the interests of the depositor (Ahmad, 2008). Another problem with regard to Basel Accord implementation in Islamic financial institutions is that it ignores the asset side of the Islamic banking system; such assets are backed by real estate and commodities, which are much more risky than those in a conventional banking system (Ahmad, 2008). The restricted Modaraba transactions were treated like an item off a balance sheet, and the unrestricted Modaraba transactions were treated like an item off a balance sheet in the Islamic banking system when the Basel Accord was applied. Such a unique process was also a hurdle in Basel Accord implementation (Ariss & Sarieddine, 2007).

Basel III Implementation and Outcomes for Islamic Banks

21

Section 3: Methodology The main purpose of this chapter is to study the hindrances that occurred while using the Basel Accord (in Pakistan). The adoption of this Accord changed the end goal of this study. There were 52 inquiries in our last questionnaire. These were questions related to the risk profile of banks and respondents, questions regarding the conditions of every bank individually and their assets, accessibility of IT and HR for Basel Accord implementation, questions regarding the dangers secured in Pillar 1, questions regarding Pillar 2 (review was supervisory), and questions regarding Pillar 3 (market discipline). Our aim was to inspect attitudes towards Basel Accord execution arrangements across Pakistani Islamic banks and to figure out which components have all the earmarks of being the greatest impediments to using Basel Accords in these banks. The survey involved questions on the noteworthiness of Basel Accord use (Q1–2) and inquiries regarding general thoughts on execution (Q3–8) along with various, more extensive issues. It also incorporated questions about the down-to-earth execution of the Accord (Q10–11, Q17–20, Q31), information and preparing of staff (Q12–14), risk administration (Q15– 16), whether practices right now agree with the Accord (Q21–22, Q32), whether more changes took place in addition to the Accord (Q23–24), problems related to information security and assurance (Q25–29), irrelevant resource necessities (Q9, Q30), credit risk (Q34–37), business hazards (Q38–40), operational hazards (Q41–43), identification of problems with the survey process (supervisory review) (Q44–48) and discipline regarding business (Q49–Q52). Our first analysis of the information revealed that respondents’ thoughts on the use of the Basel Accords were both positive and negative. To discover this, we analysed each individual’s response to Q3–8. If they “strongly agreed” or just “agreed” with the proposition, they scored 1, whereas if they “strongly disagreed” or just “disagreed”, they scored -1. If they neither agreed nor disagreed, they scored 0. If the proposition has negative implications regarding the implementation of the Basel Accord (Q4), these scores are multiplied by 1. Finally, a score is allocated to an individual by adding their scores for each question between Q3 and Q8. High values demonstrate a favourable outlook on using the Basel Accord. Low values show resistance to it. An estimation of zero shows the respondent to be neutral.

22

Chapter Two

Section 4: Empirical Analyses and Discussion Our hypotheses can be tested statistically in a thorough way, focused on the information from survey responses. The findings tell us that managers feel positive about using the Basel Accord. Our t-test (sample) gave us a t-statistic of 4.502 at 59 degrees, with the freedom giving 0.000 (p-value). An estimation of the kernel density (smoothed histogram) of the review reactions strengthened our general impression that managers are, for the most part, prepared to execute the Basel Accord, despite the fact that a level of restriction towards usage is also evident. High probability is present (a greater than 0.5 obtained score that is positive), and the modal value, or the most commonly observed value, is clearly positive. For privately and publicly owned banks, no statistical significance is evidenced. An unpaired two-sample t-test, which is actually unpaired pooled, gives a result with a t-value of 1.597 and a p-value of 0.116. In any case, an impression is created which might portray better results by following the Basel Accord, as has been claimed publicly. In general, it has been shown that directors are well prepared for Basel Accord execution. We inspected the study information all the more completely, with the specific end goal of determining potential deterrents and related limit building needs for banks. This is done by regression, the estimated scores against variables (illustrative), and by linking this with the information of the study Q9–52, as portrayed previously. The aftereffects of the study demonstrated in Table 1 highlight potentially restrictive elements regarding credit risk implementation, the implementation of practical issues for HR and IT, minimal capital requirements, operational risk, and data security. Table 2 expands this interpretation. Our final regression model results highlight the significance of credit risk. As the information on default builds, the backing level for Basel Accord execution grows. Hence, local development of credit risk models is likely linked with greater support for the Basel Accord. Overall, the experience level for expanding the credit risk increases positivity for ensuring the execution of the Basel Accord. The final regression demonstrates the importance of credit risk. As the number of years of information on historical default expands, so does the level of support for the implementation of the Basel Accord. However, the results also tell us that the Basel Accord presents serious issues with regard to operational risk.

Basel III Implementation and Outcomes for Islamic Banks

23

24

Chapter Two

In the model, extra values (Q30) show whether a bank’s present IT structure backs up the operational risk requirements for the Basel Accord. Insignificant capital requirements constitute a critical part of the operational risk, with results additionally indicating that huge amounts of administrators imagine that for new banks the Basel Accord would really lower capital necessities. a) The Basel Accord expands The improvement of credit risk models is likewise connected with expanded support for the Basel Accord. In aggregate, as the level of experience in credit risk expands, the desire to use the Basel Accord builds. Our results recommend that managers who help in the implementation acknowledge more extensive issues that emerge as a major aspect of this more extensive methodology. Directors who highlight the vitality of information security (Q27) likewise have a tendency to be all the more positively inclined towards the Accord. In addition, it is recommended that more positive managers have effectively perceived that HR and IT issues may hinder Accord usage.

Basel III Implementation and Outcomes for Islamic Banks

25

Administrators have a tendency to be very supportive of Accord implementation if a department of Basel Accord implementation has been secured. Overall, it is highlighted that operational hazards are an obstruction to the implementation of the Basel Accord. Other than this, it has been demonstrated by our findings that a variety of issues have just been raised due to a partial degree of success in implementation. These include problems regarding credit risk modelling, needing a dedicated division to execute the Basel Accord, information security and IT and HR considerations.

Section 5: Chapter Conclusion This chapter discusses some very important current issues regarding the implementation of the Basel Accord in Pakistan. We discuss the Basel Accord for two reasons: first, to safeguard the stability of the entire budgetary framework, and second, to represent the particular hurdles associated with implementing the Basel Accord in developing and emerging economies. Due to the recent expansion to Basel III, many difficulties have been confronted in Pakistan. This paper discusses many issues related to this and offers a mixed study on risk managers in Pakistani banks coupled with exact statistical analysis. The survey data also sheds light on the potential differences between privately and publicly owned banks. It has been suggested in a variety of ways that privately owned banks appear to be more prepared for Basel Accord implementation. The survey also shows that exclusive banks are more likely to have divisions for Basel Accord implementation and utilise historical information to evaluate business hazards. In addition, our results demonstrate that exclusive banks would be more positively inclined towards Basel Accord implementation if extra-specialised technical skills were a factor. The results suggest a higher level of support for Basel implementation among privately owned banks, although the observed sample lacks the significance of formal statistics (p D 0:116). There were many reasons for the failure of Basel II. (1) One of the major reasons was procyclicality, i.e. that there is less need for capital adequacy when the economy booms, but, if the economy falls, there is more need for capital adequacy. (2) Basel II did not meet the liquidity requirements of banks, which became a major reason for the financial crisis.

26

Chapter Two

(3) In terms of data collection, there was a need for high-quality data that was costly and not easy to handle. (4) Banks required a credit rating that was provided by external financial institutions. (5) For Islamic financial institutions, the capital adequacy ratio was very low, as these institutions experience higher risk than conventional banks. The assets and risks involved in Islamic banking are also different from those in the conventional banking system. (6) The restricted and unrestricted Murabaha have unique transactions that were not maintained in the conventional banking system. (7) Basel Accords work with customer interest, which is necessary in the conventional banking system. It is a system in which contracts are made on a fixed-interest basis; however, in the Islamic banking system, contracts are based on loss and profit sharing ratios, which is not an attractive factor for depositors. We conclude that Basel III has removed all the deficiencies that were present in Basel II; for instance, it has removed the procyclicality problems via a countercyclic buffer and removed liquidity by increasing the LCR and capital adequacy ratio.

CHAPTER THREE PRACTICAL ENTERPRISE RISK MANAGEMENT PRACTICES IN THE GLOBAL TAKAFUL INDUSTRY

Summary of Chapter Three In the E&Y global report on the takaful industry, it has been observed consecutively that an ineffective enterprise risk management (ERM) is among the top five business risks of the takaful industry. The present study has been conducted with the aim of finding out the impact of ERM implementation on the profitability of the world’s takaful industry. In this regard, the ERM implementation level has been measured through the availability of a Chief Risk Officer (CRO), the establishment of a risk management committee in the firm, the hiring of an auditor from big four auditor firms, the board independence level within the firm, firm size, percentage of institutional ownership in the shareholding structure, the operational diversification of a firm (national or international), and the percentage change in the revenues of the firm. Two control variables are also employed in the study and they are age and Gross Domestic Product (GDP). On the other hand, financial performance is measured in terms of accounting performance and market performance. For this purpose, two profitability indicators, Return on Asset (ROA) and Return on Equity (ROE), have been used. A sample of 25 takaful firms from eight countries has been taken over a period of four years (2013-2016). The study is quantitative in nature and secondary data has been used for this purpose. Hypotheses are being tested one by one through correlation and regression analysis by using Stata and EViews. The results of the study indicate that the majority of the hypotheses are accepted and this shows a positive impact of ERM implementation on the financial performance of the takaful industry. Keywords: Enterprise Risk Management (ERM), Financial Performance (FP), (ROA, ROE), Regression, Takaful industry

28

Chapter Three

Section 1: Introduction of ERM Practices Risk is not particle physics, it’s chemistry. The risks cannot be separated (Mikes, 2011). Risk has been something of a strategic combination which is comprised of both vulnerabilities and opportunities; and ERM is actually a tool with a drive to manage the risk of an organisation in such a way that it also exploits the value-enhancing opportunities (Aabo et al., 2005). Traditionally, the management of risk has been executed in an uncoordinated way, by categorising the risks separately. Different risks are managed in isolation, where corporate risk managers handle the pure risks and the treasury department is responsible for the management of financial risks. The main point where ERM differentiates from a traditional risk management approach is that it is more focused on the interactions of different risks and understands them in a more systematic way. The main deterrence behind the smaller amount of implementation of ERM is the lack of successful cases of firms implementing ERM (Aabo et al., 2005). ERM has contributed towards organisations in the following ways: ¾ The cost of capital has been reduced ¾ The shareholder’s value has progressed which is caused by a reduction in both earnings volatility and stock price volatility ¾ Those risks have been utilised which have the experience of a competitive advantage ¾ Organisations have become up to date regarding different risks, ultimately improving their decision-making ability ¾ Investors are now more confident The motivation behind this chapter is that the results of the study would extend the limits of existing literature on ERM and the takaful industry. It will be insightful for the world’s takaful industry, as it will determine which financial indicators are most affected by ERM implementation. In addition, it will also define which elements of ERM implementation are significant and insignificant concerning the total financial performance. On the other hand, the study will outline the direction of ERM implementation and the level of its impact too. The study would contribute to the academia of the takaful industry with a purposeful approach. By inculcating ERM throughout the industry, ERM implementation will no longer feature as a top business risk for the global takaful industry, but among the top business strengths.

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The aim of the study is to analyse the relationship between ERM implementation level and Return on Asset (ROA) and Return on Equity (ROE) of the world’s takaful firms. This chapter is divided into four further headings. The second section will give a literature review which covers the theoretical and empirical literature of the Islamic takaful industry, performance measures, enterprise risk management (ERM) and an explanation of its variables and the link of these variables with ROA and ROE. The third section demonstrates the research methodology of the paper. The fourth section will give an analysis and empirical findings, and the fifth section finally concludes the overall study.

Section 2: Theoretical evidence of the Takaful industry ERM An extensive review of the literature revealed that traditionally different risks were being managed in isolation and this way of risk management was recognised as a “silo-based approach” or rarely as a “stove-pipe approach” (Banham, 2004). This isolated management of risk doesn’t take into account the impact of the mutual interaction of these individual risks in silos. This increased complexity in modern risk management has actually stipulated the demand of an approach that is firm wide and manages all kind of risks, either systematic or unsystematic, in one place. So, ERM evolved as a holistic, integrated, firm-wide approach, which covers all types of risks and the interaction among them. Although ERM is still evolving, a general agreement has been developed about its three fundamental elements (Bromiley et al., 2014). 1st: Management of risk in the form of a portfolio is more efficient than managing the risk individually. The portfolio properties of ERM actually cease the effects of individual risks. 2nd: ERM targets not just the typical risks (disasters and liabilities) but it also takes into account the strategic risks, which are often the major risks associated with the operations of a firm. 3rd: It was agreed that those firms which are capable of managing a risk should take it as an opportunity on the way to a competitive advantage rather than just a problem to deal with. The concept of Enterprise Risk Management? The development of ERM started in the mid-1990s and it has strengthened since the incident of 9/11 in the US. The financial crisis of 2008 has also caused a boost in its progress (Choi et al., 2015). ERM has

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become indispensable for every organisation in pinpointing their potential risks. Effective ERM implementation doesn’t only reduce cost but it utilises the resources of an organisation to generate solutions (JalalǦKarim, 2013). Besides that, a series of eminent business failures and scandals became the reason behind the emergence, adoption, and implementation of the concept. There were two main reasons behind this emergence. First was the failure of the large firms in those situations where it was avoidable for them. So, it encouraged the firms to make an effort to shun the notinevitable risks. Ultimately, it widened the firm’s risk receptiveness, making the top management more answerable to the risks. The second source was the demand for a contemporary business strategy, the need for shareholders’ value. The need for ERM grew when the world had to confront various new kinds of risks at the start of the 21st century. These risks ranged from internal issues to wide external challenges. The scope and nature of these risks drove firms to adopt different risk management techniques. a) ERM Market Rationalisation Casualty Actuarial Society (CAS) In 2003, the Casualty Actuarial Society (CAS) gave a precise definition of the concept of ERM (CAS, 2003) as: “ERM is the discipline by which an organisation in any industry assesses, controls, exploits, finances, and monitors risks from all sources for the purpose of increasing the organisation’s short and long-term value to its stakeholders”. Committee of Sponsoring Organisations of the Treadway Commission (COSO) The Committee of Sponsoring Organisations of the Treadway Commission (COSO) is a mutual initiative which has actually built up a framework and a direction for ERM. In 2004, COSO presented an ERM integrated framework; it’s designated as the most acknowledged definition of ERM: “A process, affected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives” (COSO, 2004).

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COSO’s integrated ERM framework COSO’s integrated ERM framework is broader and companywide. It doesn’t replace the already established internal control framework but pursues a cross-firm risk management process. It is comprised of a threedimensional matrix, including organisational objectives, components of ERM and level of the entity. According to COSO’s report on ERM (2010), COSO’s ERM integrated framework has a share of 54.6 % among other available ERM frameworks. ISO 31000:2009 The adoption of ISO 31000:2009 has been recommended to apply under the supervision of organisational management. This doesn’t question the authenticity of the standard; instead, the main focus here is that the way things are being implemented really does matter (Lalonde & Boiral, 2012). The standard actually encourages an approach of integrating risk management at an enterprise-wide level with the help of a universal framework. This framework must be aligned with the organisational objectives. b) Forces behind the Emergence of ERM The forces behind the development of ERM are continually increasing and the number of forces will ultimately develop more refined risk management practices. Here is a list of the main forces derived from the literature. Advanced Quantitative Technique: In the case study of United Grain Growers (UGG) in their implementation of ERM, the technical support in the quantification of risks was a key element. The presence of complex statistical analyses, finding the probability of exposures to different risks, developing probability distributions and interpreting the results are the obligations and exclusiveness of ERM (Harrington et al., 2002). Globalisation: Globalisation has played an important role in producing global standards, tools and techniques; this is known as boundaryless benchmarking (CAS, 2003). The widespread application of these procedures has been fuelled by the extensive sharing of information globally. Although organisations vary in their risk management practices

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to meet the special needs of organisations, the overall concepts and practices behind this customisation are similar. Exterior Pressure: In addition, external pressure from all stakeholders of organisations has played a significant role in the adoption of ERM. Due to the big failures of corporations in managing their risks, institutional bodies, rating agencies, stock exchanges, regulatory institutions and above all shareholders of publicly traded companies have compelled the senior management of organisations to manage risk on a wide level (Gates, 2006). c) Enterprise Risk Management execution level In the literature, the following indicators have been associated with the adoption and implementation of ERM in any organisation. Chief Risk Officer: There are numerous articles that have investigated ERM implementation by using the proxy of a CRO and have found that the presence of a CRO is positively related to the level of ERM implementation (YAZID et al., 2011) and ultimately, the level of ERM implementation contributes towards the value of firms (Beasley et al., 2005). Audit Committee: Another element which is considered to have an important effect on the ERM implementation level within a firm is the presence of an audit committee. Audit committees have a central role in the management of organisational risk practices, which provide them with sufficient means and resources to implement ERM. Risk Management Committee: According to Amoozegar et al. (2017), the infrequent meetings of risk management committees have also been considered an important element in the failure of risk management during the financial crisis of 2008. Board Size: A direct positive relationship has been recognised between the board size, risk management and organisational performance, but this relationship is more significant in the small size organisations than in the gigantic businesses. These large boards must be heterogeneous in their composition because a homogeneous board might omit the salient feature of diversity (Dalton et al., 1999).

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Board Independence: ERM implementation has been the result of board independence which certainly affects risk management decisions taken by boards. 51% of Canadian companies claimed that they have implemented ERM simply due to the assistance of the board (Kleffner et al., 2003). S&P’s ERM Rating: A positive relationship has been found between ERM rating and the value of firms up to the third level and for the last two levels of ERM rating, this relationship doesn’t exist (McShane et al., 2011). Four Big Audit Firms (FBA): Beasley et al., (2005) have found a positive significant effect of the four big auditors on the ERM implementation of firms. However, negative relationships have also been found in this regard, which shows that there is no association between the big four auditors and ERM implementation levels (Paape & Speklé, 2012). Firm Size: The literature has argued that the basic structure of risk management of all big organisations is almost the same but when it comes to the operational level, the risk management system becomes conditional upon the organisation size, technology in the organisation and the central government policy (Woods, 2009). International Diversification: According to Standard & Poor’s (2005), the firms more likely to implement ERM are those which are more complex in structure. International diversification is about the operation of firms in the international markets, an important dimension which explains the complexity of a firm in a fine way. The firms which target markets other than their home country are diversified internationally. Such firms are complex in their operations and are thus more inclined towards the implementation of ERM (Hoyt & Liebenberg, 2011). Institutional Ownership: When ownership is distributed, the management can easily ignore the spread of shareholders. On the contrary, in institutional ownership, due to the significant voting rights of institutional investors and their direct effect on the organisational cost of capital, the management is forced to take into account as well as understand their preferences (Kane & Velury, 2004). This is the reason that institutional owners are more dominant than individual shareholders and put a lot of stress on inculcating ERM in the operations of the organisation.

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Growth: The risk profile of an organisation is also a contributory factor in better decision-making (Liebenberg & Hoyt, 2003). But it has been noticed that the relationship between ERM implementation and organisational growth is weakly significant (Bertinetti et al., 2013). d) ERM Implementation Level and Financial Performance of a Firm A substantial number of studies have been done in this regard. When the effect of ERM on profitability is checked, it must be visible in the form of increased shareholder value or accounting terms (Meulbroek, 2002). The impact of ERM on the financial condition of a firm is substantial when ERM is embedded throughout the organisational operations. The impact of ERM can be successfully gauged from scientific measures which take into account the collective view of performance (Acharyya & Mutenga, 2013). The introduction of an ERM programme within an organisation yields a strong positive impact on the risk performance of the organisation (Sax & Torp, 2015) and it has been determined that firms with ERM are 20% more valuable than firms which don’t use ERM (Hoyt & Liebenberg, 2011). ERM implementation equally affects both the financial and non-financial firms in respect of increased performance. This performance usually comes in terms of reduced volatility in both earnings and stock prices (Bertinetti et al., 2013). Hypothesis Development H1a: There is a positive relationship between the appointment of a Chief Risk Officer and the return on equity of the takaful industry H1b: There is a positive relationship between the appointment of a Chief Risk Officer and the return on assets of the takaful industry H2a: There is a positive relationship between the establishment of a risk management committee and the return on equity of the takaful industry H2b: There is a positive relationship between the establishment of a risk management committee and the return on assets of the takaful industry H3a: There is a positive relationship between the board independence and the return on equity of the takaful industry H3b: There is a positive relationship between the board independence and the return on assets of the takaful industry H4a: There is a positive relationship between the appointment of the four big audit firms and the return on equity of the takaful industry H4b: There is a positive relationship between the appointment of the four big audit firms and the return on assets of the takaful industry

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H5a: There is a positive relationship between firm size and the return on equity of the takaful industry H5b: There is a positive relationship between firm size and the return on assets of the takaful industry H6a: There is a positive relationship between international diversification and the return on equity of the takaful industry H6b: There is a positive relationship between international diversification and the return on assets of the takaful industry H7a: There is a positive relationship between institutional ownership and the return on equity of the takaful industry H7b: There is a positive relationship between institutional ownership and the return on assets of the takaful industry H8a: There is a positive relationship between revenue growth and the return on equity of the takaful industry H8b: There is a positive relationship between revenue growth and the return on assets of the takaful industry

Section 3: Methodological overview of ERM Practices Statistical Tool: The main data source of this study is secondary in nature. After the collection of secondary data from the official financial statements of takaful firms, the data has been analysed in EViews 8, econometric views software. The current study has panel data which is also known as cross-sectional time series data, because in panel data, all the cases have been observed over two or more periods of time. The research under investigation is basically a quantitative study which is descriptive in nature. Descriptive analysis was performed to describe the general nature of the data. Regression has been performed through GMM. Pearson’s correlation was calculated to describe the correlation coefficients of all variables with each other using a correlation matrix. Data: In the case of the current study, the area of interest which is under investigation is the takaful industry across the world. There is a total of 103 takaful firms in the world (Al Huda, 2016). So, the target of the study is the takaful industry across the world. 25 firms have been selected by employing their four-year financial statements, 2013-2016 inclusive. Takaful firms from the following eight countries were chosen for analysis: Saudi Arabia, Malaysia, Bahrain, Kuwait, UAE, Oman, Sri Lanka and Pakistan. This selection has been made on the basis of availability and all those firms selected from the industry maintain their annual financial statements on a regular basis.

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Section 4: Empirical Evidence of the Takaful Industry In a statistical analysis, descriptive statistics actually describe the data of the selected sample in a more simple, precise and understandable way. Table 1: Descriptive Analysis of Data Variables

Mean

Maximum

Minimum

Std. Dev.

ROA

-0.01817

12.47

-163.339

15.97799

ROE

-0.089

28.52

-575.447

54.72455

ID

0.066667

1

0

0.25049

CRO

0.125

1

0

0.332106

IO

7.212157

84.92

0

20.36931

FBA

0.8

1

0

0.401677

RG

123.5032

13231.37

-432.377

1208.046

BI

27.528

100

0

27.17825

RMC

0.433333

1

0

0.497613

FS

8.126519

10.14925

6.70647

0.797169

GDP

4.730833

9.3

0.5

1.443373

AGE

11.23333

36

0

8.633269

According to the descriptive statistics calculations, ROA has a mean value of -0.0182 with a spread of 15.978. This shows that on average, ROA will have a negative trend. In the same way, the analysis of ROE depicts that it has a mean value of -0.089 and a big standard deviation of 54.7246. Return on equity is also inclined towards a negative value on average. CRO has a standard deviation of 0.332106, which implies that the deviation of the values from the mean is normally spread. The average, 27.528 of the BI shows that the majority of firms are still in a low board independence situation but the dispersion of the data is wide which states that there is availability of differentiated situations in terms of board independence. FS has a strong average of 8.126519 which is quite good and indicates that the lion’s share of the industry is being segmented on the basis of firm size. The mean of ID is 0.066667, which is very low and near to zero. So, it depicts that a tiny share of the takaful firms are internationally diversified. IO has resulted in an average value of 7.212157, which is good enough and shows that on average there is a very

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low ratio of firms which are under institutional ownership. The average of FBA is 0.8, which is definitely a vigorous indicator and it obviously shows that the majority of firms are being externally audited by one of the four big auditing firms. RG has been identified with a mean of 123.5032 which is not that good when under analysis. It is obvious that the revenue growth of firms is not remarkable in the industry and there is a big deviation from the mean value. Table 2: Regression Analysis of ROA and ROE Variable C CRO RMC BI FBA FS ID IO RG AGE GDP R-squared Adjusted R-squared Durbin-Watson stat J-statistic Prob (J-statistic)

Prob (ROA) 0.0000 0.3738 0.0463 0.3796 0.0003 0.0002 0.5297 0.0000 0.0094 0.8093 0.0056 0.421136 0.303000 2.605389 1.797629 0.063016

Prob (ROE) 0.0064 0.4391 0.2902 0.0084 0.2052 0.0001 0.8359 0.0520 0.3069 0.0333 0.0720 0.264350 0.171230 2.542363 1.794146 0.180422

Return on Asset: The goodness of fit test, which is identified through R-squared, is 0.421136. It indicates that the model’s goodness of fit is good enough. Similarly, the Durbin-Watson stat of 2.605389 is proof that the coefficients do not have an issue of autocorrelation. According to the above results, there are six dimensions of ERM implementation which have a significant impact on ROA and the remaining four are insignificant as regards ROA. Among the significant variables, there are RMC, FBA, FS, IO, RG and GDP. All of these are significantly impacting ROA at 5% level of significance.

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Return on Equity: The results have proved that the fitness of the model is good as R-squared has a value of 0.264350. The Durbin-Watson test actually shows that there is no issue of autocorrelation. There are five other dimensions of ERM implementation which don’t significantly affect the financial performance of takaful firms. The list is comprised of CRO, RMC, FBA, RG and ID.

Section 5: Chapter Conclusion The study has focused on exploring the relationship between ERM implementation and the financial performance of the takaful industry. It has taken the important determinants of ERM implementation after a thorough analysis of the literature. On the basis of all the statistical analysis, the results are found to be in favour of the relationship. The majority of the dimensions included in the study which measure the level of ERM implementation do affect the financial performance. Many of the results are in line with the previous literature and claim that the level of ERM implementation has a positive impact on the financial performance of the takaful industry. The financial performance in terms of ROA and ROE is also found to be positively associated with ERM implementation, as has been observed in the literature (Laisasikorn & Rompho, 2014). These findings clarify and conclude that implementation of these ERM dimensions needs to be executed in the takaful industry to boost the financial performance of takaful operators, through the industry and around the globe. The reason for this conclusion is that ERM implementation through these determinants has a positive impact on the financial performance of the takaful industry. Recommendations: x ERM implementation has been seen to strongly affect the market performance of the takaful industry. Hence its impact on shareholder value suggests that its impact on all other stakeholders would also be strong if implemented at all organisational levels. x There is an urgent need to develop a unified ERM framework for the industry, which would target all the industry-specific needs of the takaful industry. This introduction will ultimately cause an increase in the adoption of ERM within the industry. In the longer run, this type of implementation will smooth the process of implementation, giving robust results.

CHAPTER FOUR UNDERSTANDING AND MANAGING LIQUIDITY RISK BY LEADING ISLAMIC BANKS

Summary of Chapter Four The purpose of this particular study is to determine if any liquidity risk exists in the Islamic banks of Pakistan and, if it does, what effect it has on the resilience of the industry in that country. The participants of this study are employees of Islamic banks. Our primary data was collected from four major cities in the country. This paper sheds light on the current situation in liquidity risk management. Further, we take a look at the attitudes of central and Islamic banks towards liquidity risk management policies. Regression models were applied in order to analyse the impact of liquidity risk management on Islamic banks. The findings show the effect of variables such as rational depositors and training on liquidity risk. The central bank provides Islamic banks with adequate rules and regulations, and the latter aim to control liquidity according to these rules as well as the requirements of depositors. The results of this paper offer useful insights for Islamic banks worldwide. Keywords: liquidity risk management; Islamic banking; reserves; rational depositors; regression models.

Section 1: Introduction to Risk Measurement The first Islamic commercial bank, Dubai Islamic Bank, was opened in 1974 in the United Arab Emirates (UAE). Over the four decades since its inception, the Islamic banking industry has been growing continuously. This sustained increase in the activities of Islamic banks is one of the reasons they have been receiving global attention (Omar & Mondher, 2010). The total estimated number of Islamic banks around the world has reached about 400, across 53 Muslim and non-Muslim countries. In 2009, the estimated funds of the Islamic banking sector had reached between

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US$500 billion and US$1 trillion, with an annual growth of 10–20% (Eedle, 2009). The banking industry in Pakistan has seen major changes in the last 62 years. It faces several problems, such as capital inadequacy, the socioeconomic condition of the country and uncertainty due to political instability. Changes have been made by the State Bank of Pakistan (SBP) in accordance with the State Bank of Pakistan Act (1956), which motivates the private sector to set up banks and financial institutions. Additionally, in 1992, privatisation developments in the banking sector motivated local investors as well as foreign banks (Ahmad et al., 2010). On January 31, 2002, Meezan bank was granted a licence by the SBP; it started operations as the first Islamic bank in the country on March 20, 2002. Since then, the Islamic banking industry has grown continuously, surpassing the growth rates recorded by conventional banks over the last five years. Now there are six fully-fledged Islamic banks (IBs) and 12 conventional banks with Islamic banking branches (IBBs) operating in Pakistan. Currently, the deposit market share stands at 4.2%. There are now more than 358 branches in over 50 cities and towns covering four provinces of the country and Azad Jammu and Kashmir (AJK; Javed, 2009). a) Objectives of the Study This paper aims to analyse liquidity risk management in the Islamic banking industry of Pakistan by measuring the demand for liquidity withdrawal from depositors as well as banks’ allocation of deposits for managing liquidity. In particular, it analyses the internal Islamic mechanism for liquidity management, with the intention of understanding the liquidity behaviour of depositors and the liquidity management of Islamic banks, and offers management recommendations to improve current liquidity management practices. This paper also examines liquidity management practices designed to meet the liquidity demands of depositors, and to what extent the rules and regulations provided by the central bank to control liquidity risk management in Islamic banks are being implemented.

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Section 2: The Theoretical Foundation of Liquidity Risk Measurement a) Liquidity Risk in Banking Institutions Liquidity risk is a bank’s inability to meet its obligations to depositors due to a shortage of funds or an increase of funds in assets that do not incur any unexpected cost or damages (Ismail, 2010). Liquidity risk in banks arises when a depositor withdraws more funds than are available at the bank (Hubbard, 2002); it can also occur if a depositor is unable to fulfil its financial obligations to a bank. A bank may face liquidity problems if a depositor wants to withdraw an amount that the bank cannot afford at that moment in time. Moreover, banks may decide to cease loans when depositors are not in a position to pay them off. Some techniques for managing the regular demand for liquidity are the following: more investment of funds in more liquid loans and/or maintaining more cash in hand, diversifying the sources of funds from various depositors, and using the central bank as a last option for emergency liquidity (Greenbaum & Thakor, 2007). b) Liquidity Risk Management in Islamic Banks In order to develop a strong liquidity management programme, Islamic banks should make arrangements via real business transactions (Antonio, 1999). That is because such operations in Islamic banks are based on real and asset-based contracts (which link the business life cycle together), collaboration among business partners and the good conduct of stakeholders. This is the cornerstone of all Islamic banking operations. Therefore, the reasons behind a liquidity problem would be disharmony between business partners or the inevitable downturn of business conditions (Ismail, 2010). Due to some specific internal and external aspects of Islamic banks, the risk of liquidity is minimal. The values and principles of Shariah prevail inside Islamic banks, which care for a bank’s management, shareholders and stakeholders as valued business partners (Yaqoobi, 2007). Thus, a system based on these values and principles ensures cooperation, transparency, symmetric information and equilibrium in allocation on both the asset and liability sides. In the Islamic financial mechanism, external liquidity risk problems are reduced; this is because the mechanism only engages in real business activities, as Shariah requires that real assets are attached to every Islamic financial market contract (Kahf, 2000). Islamic

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banking uses a profit and loss sharing (PLS) concept, which reduces liquidity risk by sharing risk among business participants. PLS helps to balance assets and liabilities because the concept of PLS necessitates the full concern and understanding of all parties in the business. If actual return is less than expected return due to the uncertainty of return on deposits, some rational depositors may seek to withdraw their deposits (Ismail, 2010). Banks have to be very careful with their liquidity management because once a liquidity risk problem occurs, they will be left with very limited options. Islamic banks can also face a risk to their reputation if they fail in governance management, Shariah compliance, business strategies or operations. In this case, most of the time, the government will come forward to offer immediate liquidity assistance and, in severe cases, take over the bank; this causes a negative public image of the operations of Islamic banks (Antonio, 1999). According to Ismail (2010), Islamic banks have organised some internal guidelines and principles based on Islamic Financial Services Board (IFSB) guides to improve liquidity management. These guidelines include establishing appropriate liquidity risk management policies, measuring and monitoring liquidity risk, and carrying out prudential and Shariah-compliant Islamic banking operations. Islamic banks have to make appropriate decisions regarding business and the selection of entrepreneurs, and they must balance liquidity-establishing relationships with other Islamic banks.

Section 3: Methodological impression of Risk Measurement tactics This paper incorporates the empirical data analysis approach; the practices of Islamic banks with regard to managing liquidity risk, and the factors affecting both the liability and asset sides as well as the liquidity behaviour of depositors were all analysed using a questionnaire. After conducting different statistical analyses on the facts and figures gathered via our questionnaire, we were able to suggest some guidelines to control liquidity risk and to enhance the productivity of the Islamic banking industry in Pakistan. Our target respondents were those who work in Islamic banks as presidents, directors, general managers or heads of risk management teams or divisions that are involved in the decision-making processes surrounding liquidity risk management in their banks. The responses were collected from Islamic banks in four of Pakistan’s biggest cities: Islamabad, Lahore, Peshawar and Sargodha. The Islamic banks selected

Understanding and Managing Liquidity Risk by Leading Islamic Banks

43

for this study were Meezan Bank, Standard Chartered Bank, Bank Alfalah, Dubai Islamic Bank Pakistan, Muslim Commercial Bank and United Bank Limited. The data collected ranges from 2005 to 2010. The banks selected for this process primarily fell into these two categories: fully-fledged Islamic banks and banks with a limited Islamic window. The sample size for this study was 100 bankers working in Islamic banks. A total of 500 questionnaires were distributed among the employees of these banks, and 460 employees responded. Different statistical analyses were used to analyse each response and its potential effect on liquidity risk management. This process included descriptive statistics and multiple regression models for different sets of variables. In our table of descriptive statistics (see the online appendix), the range, minimum values, maximum values, mean values, the value of standard deviation, variance and skewness of the variables are shown. The range gives us an idea of the spread of the values. The mean value offers insight into the central tendency of the values of the variables. The number of observations for each value is 100. The standard deviation and extreme values (minimum compared with maximum values) give an idea about the dispersion of the value of a variable from its mean value. The skewness is used to see the normality of the variables. Since different units of measurement have been used for different variables, the dispersion of a variable using standard deviation cannot be compared with that of another variable unless both the variables have the same unit of measurement. Nevertheless, these statistics are still helpful in informing us about the central tendencies and dispersion of a variable in absolute rather than relative terms.

Section 4: Evidence and Analysis of Risk Measures A simple regression analysis is conducted on different sets of variables to determine the impact of liquidity risk management on selected Islamic banks in Pakistan. The first regression model is applied to the following set of variables. Dependent variable: Islamic bank practice of regularly calculating and analysing the pattern of liquidity (Y). Independent variables: Islamic bank practice of relying on cash reserves to meet daily liquidity withdrawal (X1).

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Firstly, Islamic bank practice of communicating with depositors, who have large amounts of deposits in their withdrawal time/schedule. (X2). Secondly, Islamic bank practice of relying on the capital adequacy, asset quality, management, earnings and liquidity (CAMELS) approach to make liquidity risk management decisions (X3). Islamic bank practice of asking depositors for extra days when liquidity demand exceeds the bank’s reserves (X4): Pattern D ß0 C ß1 cash reservist C ß2 communicated C ß3 Camel St. C ß4 exceeds reservist:

In Table 1, the results of multiple regression analyses are given. A regression model is applied to determine the best predictors of bank practice with regard to regularly calculating and analysing patterns of liquidity withdrawal in order to manage anticipated liquidity demand from a depositor. The combination of variables to predict relies on bank practices, i.e. relying on cash reserve, communicating with depositors, using the CAMELS approach and reacting to withdrawals exceeding the bank’s reserves, and is statistically significant, as depicted by the significance value of the F statistic, i.e., 0:000 < 0:5. The R-squared value indicates that 19.4% of the variation in Islamic banks’ practice of regularly calculating and analysing the pattern of liquidity management satisfaction is explained by the independent variables in the model. The regression equation with coefficient values will be as follows: Pattern D 0:21 C 0:256 cash reservists C 0:168 communicated C 0:197 CAMEL St C 0:06 exceeds reservist: (6.2) Equation (6.2) shows the values of beta coefficients in the model. It demonstrates that a one-unit change in Islamic banks’ reliance on cash reserves to meet daily liquidity withdrawal will result in a 0.256-unit

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45

increase in the Islamic bank practice of regularly calculating and analysing the pattern of liquidity. Similarly, a one-unit change in the Islamic bank practices of communicating with depositors who have large amounts of deposits about their withdrawal time/schedule, relying on the CAMELS approach to make liquidity risk management decisions and asking depositors for extra days when liquidity demand exceeds the bank’s reserves will cause increases of 0.168, 0.197 and 0.06 units, respectively, in the Islamic bank practice of regularly calculating and analysing the pattern of liquidity. The next set of variables for our regression model is as follows. Dependent variable Islamic banks rely on the SBP’s rules and regulations for liquidity risk management decisions (Y).

Independent variables Firstly, the level of accuracy of the SBP’s rules and regulations provided for liquidity risk management in Islamic banks (X1). Secondly, the level of satisfaction with the quality of the SBP’s rules and regulations for liquidity risk management in Islamic banks (X2). Thirdly, the level of sufficiency of the SBP’s rules and regulations provided for liquidity risk management in Islamic banks (X3): Rely on SBPT D ß0 C ß1 accuracy C ß2 satisfaction with SBPT C ß3 sufficiency C’U t: (6.3) Table 2 shows the regression results of the model, which are applied to investigate the best predictors of reliance on the SBP’s rules and regulations for liquidity risk management in Islamic banks. The combination of variables predicts the reliance on the SBP’s rules and

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regulations, including the level of accuracy, level of sufficiency and level of satisfaction with the quality of rules and regulations provided by the SBP, and is statistically significant, as depicted by the significance value of the F statistic, i.e., 0:000 < 0:5. It also shows that the overall model is significant. The R-squared value indicates that 27.9% of the variation in reliance on the SBP’s rules and regulations for liquidity risk management in Islamic banks is explained by the independent variables in the model. The regression equation with coefficient values will be as follows: Rely on SBPT D 1:176 C 0:11. Accuracy C 0:008 satisfactions with SBPT C 0:59. Sufficiency: (6.4) Equation (6.4) depicts the values of beta coefficients in the model and shows that a one-unit change in the level of accuracy of the SBP’s rules and regulations for liquidity risk management in Islamic banks will result in a 0.11-unit increase in Islamic bank reliance on the SBP’s rules and regulations for liquidity risk management decisions.

Similarly, a one-unit change in the level of satisfaction with the quality of the SBP’s rules and regulations and the level of sufficiency of the SBP’s rules and regulations for liquidity risk management in Islamic banks will cause 0.008- and 0.59-unit increases, respectively, in Islamic bank reliance on the SBP’s rules and regulations for liquidity risk management decisions. The next set of variables for our regression model is as follows.

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Dependent variable i. Level of satisfaction with availability of alternative investment opportunities (Y). Independent variables i. Problems with finding prospective and profitable projects (X1). ii. Problems due to a large portion of short-term deposits in Islamic banks (X2). Effects of non-performing loans (NPLs) on liquidity risk (X3). Potential risk problems due to a rational depositor (X4): Alt investment oppst D ß0 C ß1 projects C ß2 short-term deposits C ß3 NPL St C ß4 rational depositor C’U t: (6.5) Table 3 shows the results of our multiple regression models. This model is applied to test the best predictors of the level of satisfaction with the availability of alternative investment opportunities. The combination of independent variables to predict problems with finding prospective and profitable projects, problems due to a large portion of short-term deposits in Islamic banks, the effect of NPLs on liquidity risk and potential risk problems due to rational depositors are statistically significant, as depicted by the significance value of the F statistic, i.e. 0:000 < 0:5. The R-squared value indicates that 31.9% of the variation in the dependent variable is explained by the independent variables in the model. The regression equation for this model with coefficient values will be as follows: alt investment oppst D 1:463 C 0:384 projects C 0:47 short-term deposit 0:191 NPL St C 0:222 rational depositor: (6.6) Equation (6.6) depicts the values of beta coefficients in the abovementioned regression model. It shows that a one-unit change in problems with finding prospective and profitable projects will result in a 0.384-unit increase in the level of satisfaction with the availability of alternative investment opportunities. Similarly, a one-unit change in problems due to a large portion of short-term deposits in Islamic banks and potential risk problems due to rational depositors will cause 0.47- and 0.222-unit increases, respectively, in the dependent variable. However, with a oneunit change in the effect of NPLs on liquidity risk, the level of satisfaction

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with the availability of alternative investment opportunities will decrease by 0.191 units. The last set of variables for our regression model is as follows. Dependent variable Level of satisfaction with techniques is currently in use to manage market pressure (Y). Independent variables Problems are with finding prospective and profitable projects (X1). Problems due to a large portion of short-term deposits in Islamic banks (X2). Effect of NPLs on liquidity risk (X3). Potential risk problems due to a rational depositor (X4): Market pressured D ß0 C ß1 projects C ß2 short-term deposit C ß3 NPLT C ß4 rational depositor C U t: (6.7) In Table 4, the multiple regression models are applied to measure the best predictors of level of satisfaction with the techniques currently in use to manage market pressure. The independent variables in this model, i.e., problems with finding prospective and profitable projects, problems due to a large portion of short-term deposits in Islamic banks, the effect of NPLs on liquidity risk and potential risk problems due to rational depositors, are statistically significant, as shown by the significance value of the

F statistic, i.e., 0:000 < 0:5. The R-squared value shows that 32.1% of the variation in the level of satisfaction with techniques currently in use to manage market pressure is explained by the independent variables in the model.

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The regression equation with coefficient values will be as follows: Market pressured D 0:645 C 0:181 projects C 0:293 short-term deposits 0:091 NPLT C 0:218 rational depositors: (6.8) Equation (6.8) shows the values of beta coefficients in the regression model. It demonstrates that a one-unit change in problems with finding prospective and profitable projects will result in a 0.181-unit increase in the level of satisfaction with the availability of alternative investment opportunities. Similarly, a one-unit change in problems due to a large portion of short-term deposits in Islamic banks and potential risk problems due to rational depositors will cause 0.293- and 0.218-unit increases, respectively, in the dependent variable. However, with a one-unit change in the effect of NPLs on liquidity risk, the level of satisfaction with the availability of alternative investment opportunities will decrease by 0.191 units.

Section 5: Chapter Conclusion This study proposes several conclusions based on the analysis conducted. The following are our key findings and recommendations for the development of liquidity risk management. Our analysis revealed that there is a satisfactory level of availability for alternative investment opportunities in the Islamic banking market. However, Islamic banks are not taking advantage of these opportunities to invest because of rational depositors. Islamic banks are compelled to stay away from such opportunities to avoid liquidity risk. Whenever an investment opportunity is available, banks tend to pass on those opportunities for fear of sudden demands for liquidity from rational depositors. Our analysis depicts that Islamic banks have a large portion of short-term deposits, which creates problems for Islamic banks trying to fulfil rational depositors’ demands. Further, if the liquidity demand exceeds the Islamic bank’s reserves, this will affect not only the bank’s liquidity but also the good reputation of the Islamic bank and its customers’ belief in it. This situation could lead to the loss of valuable customer accounts. The findings clearly indicate that, due to the presence of rational depositors, Islamic banks are having problems with investing in potentially profitable projects. The rational depositor can, at any time, ask for their deposits back, and they do not want to wait for funds to be made available. As a consequence, Islamic banks tend to keep more reserves

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compared with conventional banks. This results in lost opportunities with regard to investing in potentially favourable long-term projects. Our analysis also demonstrates that, in order to manage market pressure, increasing the adequacy level of rules and regulations for liquidity risk management in Islamic banking is important. Improving the adequacy level of rules and regulations for managing liquidity risk will help Islamic banks to invest in available opportunities. According to our analysis, rational depositors are affecting liquidity risk management in Islamic banks. Although the SBP has provided rules and regulations for liquidity risk management in Islamic banks, the current practices in Islamic banks are not adequate for managing the effect of rational depositors on liquidity risk. The SBP is responsible for making the rules and regulations for liquidity risk management in the banking industry. However, Islamic banks in Pakistan have to communicate with depositors to realise any anticipated demand for liquidity. For this reason, Islamic banks are also carrying out calculations and analyses on liquidity patterns on a regular basis. Recommendations There is an adequate level of rules and regulations in place to manage liquidity risk in Islamic banks; however, due to the improper implementation of practices, it is difficult to manage rational depositors. So, we suggest that Islamic banks implement the rules and regulations effectively. This will help them to manage the demands of depositors. Due to poor liquidity risk management, Islamic banks are not able to invest in profitable projects. Unexpected demands from rational depositors prevent them from taking advantage of investment opportunities; they need to consider liquidity risk management as an essential factor in their growth. Islamic banks are experiencing more distress than commercial banks due to rational depositors. Islamic banks must consider the rational depositor as an integral part of liquidity risk management while developing strategies for liquidity risk management in Islamic banking. Further, to improve liquidity risk management, Islamic banks need to provide their employees with regular training. This training will help bankers to understand the importance of liquidity risk management and allow them to learn new techniques to perform their duties. It will also boost performance, which should ultimately help to control liquidity risk management in Islamic banks. The SBP is responsible for addressing the problems arising in the banking industry in Pakistan. The SBP needs to improve the rules

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regarding the incentives provided for liquidity risk management in Islamic banks. The reserves affect the circulation of liquidity, which leads to liquidity risk in Islamic banks. In such situations, the SBP needs to come forward and help Islamic banks by providing them with support. Holding large amounts of cash in reserve also affects a bank’s ability to utilise this cash to pay debts and results in poor working capital management. The central bank may want to consider establishing a separate funding system that is just for fulfilling urgent liquidity requirements in Islamic banks. Finally, the recommended policies are constructed with an expectation of growth in the Islamic banking industry of Pakistan. It is assumed that the growth of the industry will continue and the number of depositors will increase. So, these recommendations should be viewed as a basis for improvement in liquidity risk management; future areas of development should not involve making major policy changes but rather fortifying and working together with current policies.

CHAPTER FIVE THE SUCCESS STORY OF THE GLOBAL TAKAFUL INDUSTRY’S ENTERPRISE RISK MANAGEMENT PROGRAM

Summary of Chapter Five This study has been conducted with the aim of discovering the impact of enterprise risk management (ERM) implementation on the performance of Islamic institutions in the world’s takaful industry. In this regard, the level of ERM implementation has been measured. There are also two control variables employed in the study, age and Gross Domestic Product (GDP). On the other hand, financial performance is measured in terms of its indicators, Return on Investments (ROI) and Earnings Per share (EPS). A sample of 27 takaful firms from nine countries has been taken over a period of four years (2011-2014). The study is quantitative in nature and secondary data has been used for this purpose. The hypotheses are tested one by one through correlation and regression analysis. The findings can be utilised for the advancement of ERM within the takaful industry, making it a strength of the industry rather than a business risk. Keywords: Enterprise Risk Management (ERM), Financial Performance (FP), Return on Investment, Earning per Share, Chief Risk Officer, Firm size, age, Gross Domestic Product, Regression, Takaful industry

Section 1: Chapter Introduction Enterprise risk management is the invention of this century and it has emerged mainly as an approach which addresses the limitations of traditional risk management. It is undoubtedly an important subject, especially for those firms which desire success in the future. Since its commencement, it has turned into a standard instrument to manage the diversified risks of organisation, dealing with operational as well as strategic risks, and transfiguring the risks into opportunities. The main

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goal behind the advent of ERM is the well-coordinated management of all risks of an organisation, ranging from corporate governance, auditing, information technology, distribution systems to human resources. The arrival of ERM is not an obsession but a natural evolution of risk management so that risks can be managed at an organisation-wide level (Fraser et al., 2011). In ERM methodology, all risks are identified and corresponding risk responses are taken according to the defined risk appetite of an organisation. When it comes to Islamic finance, the concept of risk management is an important part of the ultimate goal of society in terms of its well-being, both social and economic. Takaful is a tool which is used in Islamic finance to perform the function of risk management by protecting people and their properties. In Shariah, the main function of takaful is to lessen worries and uncertainties and to create contingency plans to shield property owners and their belongings. The study is going to discuss the level of ERM implementation in the takaful industry, which has been considered ineffective and presents big risks. The implementation of ERM has not been that fluent because many of its areas are still untouched and require exploration for a better understanding and smoother implementation. So, those firms that are already implementing it are also facing difficulties in spite of the availability of all the main resources. One of the main impediments which makes ERM implementation a more difficult process to perform is a lack of success stories. Evidence has been found that among the various potential risks for the global takaful industry, ineffective ERM is one of the top reasons. Although it has been addressed to a certain extent, it has gone from no. 3 to no. 5 in the list of top business risks for the global takaful industry. So, this research will actually focus on the levels of ERM implementation in the takaful industry and will analyse its proposed impact on the financial performance of the takaful industry. The aim of the chapter is to analyse the relationship between the level of ERM implementation on return on investments and earnings per share of the world’s takaful firms. This paper is divided into four further headings. The second section will give the literature review which covers the theoretical and empirical literature of the Islamic takaful industry, performance measures, enterprise risk management (ERM) and explanation of its variables and link of these variables with ROI and EPS. The third section demonstrates the research methodology of the paper. The fourth section will give an analysis and empirical findings and the fifth section finally concludes the overall chapter.

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Section 2: Enterprise Risk Management Critique Review For a long time, organisations have been managing their risks through transferring them to insurance firms or through planning. But in this world of globalisation and at the start of the new century, firms were exposed to enormous diversified risks, both natural and man-made, which eventually affected the strategic ability of firms to achieve their goals, both in the short term and the long term. This situation moved the phenomenon of risk management to the executives’ table and named it a responsibility of the senior management. This trend of diversified risks gave birth to the consolidated concept of enterprise risk management (Togok et al., 2014). Enterprise Risk Management The usage of new risk management functions ultimately increased the investments of time and cost. All these encounters have moved the organisations in the direction of managing risk in a completely new way, in a holistic manner. This gave birth to a new concept of risk management called ERM, which discourages a silo-based approach and enforces management of all types of risks in the form of a portfolio. Different visions exist regarding ERM in the circle of regulatory bodies. Some associate it directly with organisational objectives (COSO, 2004; IIA, 2009). On the opposite side, some consider risks to be independent of organisational goals and argue that neither develop links with each other. Another aspect causing some conflict is the way risk is seen. A school of thought considers risks as an opportunity to excel (CAS, 2003) whereas others see risk as a large problem that should be eradicated promptly (RIMS, 2007). a) ERM concept justification Risk and Insurance Management Society (RIMS) RIMS, Risk and Insurance Management Society, is an international, non-profit organisation. According to RIMS “Enterprise Risk Management (ERM) is a strategic business discipline that supports the achievement of an organisation’s objectives by addressing the full spectrum of its risks and managing the combined impact of those risks as an interrelated risk portfolio”.

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RIMS’ Risk Maturity Model The RMM (Risk Maturity Model) is made up of certain important indicators and activities that contribute to the development of a more robust ERM programme, which can be maintained and repeated in the long term. The ERM programme’s self-assessment against the risk indicators identifies the strength of the organisational risk management efforts. In the end, it assigns each organisation’s ERM program with a maturity score, which ranges from level 1 (lowest risk maturity level) to level 5 (advanced risk maturity level) – (RIMS, 2007). Institute of Internal Auditors (IIA) IIA has defined ERM in the following way: “Enterprise-wide risk management (ERM) is a structured, consistent and continuous process across the whole organisation for identifying, assessing, deciding on responses to and reporting on opportunities and threats that affect the achievement of its objectives” (IIA, 2009). This paper explains the roles of internal auditors by suggesting what they should and shouldn’t do in following the ERM process. They have divided the 18 activities of the ERM process into three main divisions. These are: 1. Core internal audit roles in regard to ERM 2. Legitimate internal audit roles with safeguards 3. Roles internal audits should not undertake Standards & Poor (S&P) Ratings In 2005, Standards & Poor (S&P) introduced ERM for financial institutions in its rating criteria. The motive of this introduction was to establish the risk management and strategy characteristics of an organisation in the rating criteria and for this purpose, a portion of the rating criteria was fixed for ERM evaluation (Standard & Poor’s, 2005). The ratings of S&P were developed in the form of an index which has the ultimate goal of evaluating the risk management systems, processes, culture and practices within an organisation. b) Emergence of ERM According to the results of a survey, which has been developed and conducted with the help of experts from a strategic risk management

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council at the conference board, there are main five drivers behind the implementation of ERM (Gates, 2006). It comprised of meeting corporate governance requirements (66%), strategic management of risks (60%), regulatory compliance (53%), board demand (51%) and achievement of certain competitive advantages (41%). Here is a list of the main forces derived from literature. Risk Complexity: The primary force behind ERM is the variety of today’s risks. The global mode of business, terrorist activities and the economic conditions around the globe are producers of these risks. Besides these numerous risks, the organisations are also affected by the mutual interaction of these risks. Consequently, it is not irrational to expect another unique lot of risks in the near future. So, organisations have become aware of the necessity and significance to manage all risks collectively above their size and ability to be measured quantitatively (CAS, 2003). Exterior Pressure: The expectation of companies to increase their ratings is also influencing them to pursue the ERM. The world’s top rating agencies, like Standard & Poor’s, Moody’s and Fitch, are taking into account ERM implementation while evaluating their organisational operations. So, ERM implementation has a strong impact on the ratings that are ultimately being issued. (Gates, 2006) Corporate Failures and Regulatory Requirements: Although firms decide to adopt ERM for other promising benefits, compliance with the regulatory authorities has really compelled ERM implementation (Pagach & Warr, 2010). Some famous compliance requirements around the globe include the Sarbanes-Oxley Act (SOX) in the USA, the UK corporate governance code, the Coco report in Canada, Basel II and New York stock exchange corporate governance rules (Zhao et al., 2014). c) Enterprise Risk Management Implementation level In the literature, the following indicators have been associated with the adoption and implementation of ERM in any organisation. Chief Risk Officer: Chief Risk Officer is a new-fangled position, coined and incorporated at the start of this century. Before that, corporate risk manager was a low-level position in the organisational structure whose key responsibility was to purchase insurance. But with the

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increased importance and complexity of risk management, a senior executive position entitled Chief Risk Officer (CRO) has been incorporated within the organisation to identify and measure all types of risks (Nocco & Stulz, 2006). Audit Committee: Paape and Speklé (2012) concluded that the existence of an audit committee in an organisation contributes towards the ERM implementation of the organisation. Risk Management Committee: The participation of different managerial levels in the implementation of ERM really does matter. A strong association has been found between the formation of a risk management committee and the provision of proper ERM training to the senior executives with ERM maturity (Beasley et al., 2015). Board Size: A push from the regulatory authorities has really impelled organisations to strengthen their risk management processes and question the role of the board of directors in risk oversight. Boards of directors need detailed knowledge on organisational operations in order to make strategic decisions. The relationship between the large number of directors on boards and additional organisational value has been seen in the literature (Lynall et al., 2003). Board independence: Board independence is the percentage of boards of directors which are independent. There is substantial evidence available about the impact of board support on the implementation of ERM. It has been reported by Beasley et al., (2005) that firms with higher board independence are further on the way towards ERM implementation, which means the higher the proportion of independent board members, the higher the stage of implementation of ERM in the firm. S&P’s ERM Rating: After the issuance of S&P’s ERM ratings, it has become important to evaluate the risk management process of a firm. Initially, it focused on insurance firms but later other non-financial firms have also been included (McShane et al., 2011). Firm Size: ERM implementation is also likely to be affected by the size of the firm. ERM is costly to implement fully, and customarily large organisations are more formal, which is why they are more inclined towards ERM recognition than the smaller firms (Paape & Speklé, 2012).

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International Diversification: The relationship between international diversification and the resultant firm value has been mixed. There are many studies which resulted in a strong relationship between both (Denis et al., 2002) but many contrary results are also on the list. Institutional Ownership: Shareholders have a keen interest in ERM implementation as they are the final beneficiaries of the enhanced value creation and better decisions regarding different risks. But the effectiveness of their pressure is dependent upon whether the firm is under institutional ownership or is an owner-managed firm. A strong correlation has been found between the implementation of ERM and the listing on the stock exchange in Europe (Paape & Speklé, 2012). Growth: ERM has greater value for those firms which are going through substantial growth than for others. As a result of this growth, momentum requires the firm to develop a comprehensive risk management system to tackle all the uncertainties which are emerging. d) ERM Implementation Level and Financial Performance of a Firm The relationship between risks and value has been the topic of investigation in research for a long time. The main purpose of inculcating different risk management systems in an organisation is to lessen risks and to increase a firm’s value (Woods, 2009). The different risk management programmes bring about improvements in the performance of a firm because they save the firm from different types of losses like bankruptcy and reputational costs (Gordon et al., 2009). The external pressures of compliance with regulatory authorities have really damaged the role of ERM as a decision-making tool in the organisations. The differences in terms of its measurement techniques and ambiguity in defining its role have compressed the utilisation of ERM. ERM implementation has been turned into a task of sheer compliance with the regulators by conflicting with its central purpose of risk mitigation and improved firm performance and ultimately having no effect on them (Arena et al., 2011). e) Hypothesis Development H1a: There is a positive relationship between the appointment of a Chief Risk Officer and the return on investments of the takaful industry H1b: There is a positive relationship between the appointment of a Chief Risk Officer and the earnings per share of the takaful industry

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H2a: There is a positive relationship between the establishment of a risk management committee and the return on investments of the takaful industry H2b: There is a positive relationship between the establishment of a risk management committee and the earnings per share of the takaful industry H3a: There is a positive relationship between board independence and the return on investments of the takaful industry H3b: There is a positive relationship between board independence and the earnings per share of the takaful industry H4a: There is a positive relationship between firm size and the return on investments of the takaful industry H4b: There is a positive relationship between firm size and the earnings per share of the takaful industry H5a: There is a positive relationship between international diversification and the return on investments of the takaful industry H5b: There is a positive relationship between international diversification and the earnings per share of the takaful industry H6a: There is a positive relationship between institutional ownership and the return on investments of the takaful industry H6b: There is a positive relationship between institutional ownership and the earnings per share of the takaful industry H7a: There is a positive relationship between revenue growth and the return on investments of the takaful industry H7b: There is a positive relationship between revenue growth and the earnings per share of the takaful industry

Section 3: ERM Methodological basis Statistical Tool: The current study has panel data which is also known as cross-sectional time series data because, in panel data, all the cases have been observed over two or more periods of time. The main data source of this study is secondary in nature. After the collection of secondary data from the official financial statements of takaful firms, the data has been analysed in EViews 8, econometric views software. The research under investigation is basically a quantitative study which is descriptive in nature. Descriptive analysis was performed to describe the general nature of the data. Pearson’s correlation was calculated to describe the correlation coefficients of all variables with each other using a correlation matrix. Regression has been performed through Generalised Method of Moments (GMM).

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Data: In the case of the current study, the area of interest which is under investigation is the global takaful industry. There is a total of 103 takaful firms in the world (Al Huda, 2016). So, the population of the study is the takaful industry of the whole world. 27 firms have been selected by looking at their financial statements over four years, 2011-2014 inclusive. Takaful firms from the following nine countries were chosen for analysis: Saudi Arabia, Malaysia, Bahrain, Bangladesh, Kuwait, Qatar, UAE, Oman and Pakistan. This selection has been made on the basis of availability, and all those firms which have been selected from the industry maintain their annual financial statements on a regular basis.

Section 4: Empirical Evidence of Risk Management There are many famous measures of dispersions but to discuss the sample data of this study, only mean, standard deviation, minimum and maximum values are being taken into consideration. Table 1: Descriptive Analysis Results Variables

Mean

Maximum

Minimum

Std. Dev.

ROI

6.778858

165.6752

-163.792

31.6956

EPS

0.166003

1.912314

-0.77245

0.407309

RMC

0.433333

1

0

0.497613

FS

8.126519

10.14925

6.70647

0.797169

ID

0.066667

1

0

0.25049

IO

7.212157

84.92

0

20.36931

CRO

0.125

1

0

0.332106

BI

27.528

100

0

27.17825

RG

123.5032

13231.37

-432.377

1208.046

GDP

4.730833

9.3

0.5

1.443373

AGE

11.23333

36

0

8.633269

In the case of the third dimension of financial performance, ROI comes with a mean of 6.79, and standard deviation of 31.6956. It means that although the average is good, the data consists of values which are too big at one end and too small at the other. This dispersion in data can be due to the fact that the countries chosen are very different in terms of their

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economies, ultimately affecting the financial performance of different institutions. Last but not least, the financial performance indicator under discussion in the following study is the EPS. It has a mean of 0.166003 with a standard deviation of 0.407309. On average, it also appears with a positive mean for the takaful firms. CRO has a standard deviation of 0.332106, which implies that the deviation of the values from the mean is normally spread. The average of 27.528 of the BI shows that the majority of firms are still in a situation of low board independence but the dispersion of the data is wide which states that there is the availability of differentiated situations in terms of board independence. FS has a strong average of 8.126519 which is quite good and indicates that the lion’s share of the industry is being segmented on the basis of firm size. The mean of ID is 0.066667, which is very low and near to zero. So, it depicts that a tiny share of the takaful firms are internationally diversified. IO has an average value of 7.212157, which is good enough and shows that on average, there is a very low ratio of firms under institutional ownership. RG has been identified as having a mean of 123.5032 which is not that good under analysis. It is obvious that the revenue growth of firms is not remarkable as an industry and there is a big deviation from the mean value. Table 2: Regression Analysis of ROI and EPS Variable C RMC BI FS ID IO CRO RG AGE GDP R-squared Adjusted R-squared Durbin-Watson stat J-statistic Prob (J-statistic)

Prob (ROI) 0.0000 0.0943 0.2212 0.0000 0.3251 0.0278 0.0000 0.0066 0.4930 0.0000 0.501962 0.400321 2.360215 0.019181 0.889848

Prob (EPS) 0.0000 0.4304 0.0205 0.0000 0.0107 0.5158 0.0040 0.8817 0.0000 0.0303 0.244748 0.090614 2.179132 0.907459 0.340790

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Return on Investment: The results have proved that the fitness of the model is good as R-squared has a value of 0.501962. Another important indicator, which is the value of the Durbin-Watson test, actually shows that there is no issue of autocorrelation as it has a value of 2.360215, which is near to 2 (no autocorrelation). In addition, the p-value of the jstatistic is 0.889848, which is greater than 0.05, the ultimate proof of the validity that the instrument has been institutionalised to remove issues of endogeneity. The dimensions of the independent variable which are significant at 5 % level of significance are CRO, FS, IO, RG and GDP. There is just a single dimension of ERM implementation which is significant at 10% and that is RMC. Earnings per share: The results have proved that the fitness of the model is good as R-squared has a value of 0.244748. The Durbin-Watson test actually shows that there is no issue of autocorrelation. The four dimensions of ERM implementation have proved a significant regression in earnings per share of takaful firms. These dimensions are Chief Risk Officer, board independence, firm size and international diversification.

Section 5: Chapter Conclusion Enterprise risk management is the concept of this new era, an approach towards efficient and effective risk management by managing the interconnection of all business risks in one place in the form of a portfolio. It discourages the management of risk in a traditional way by isolating the risks, which ultimately does not address the interactions of the variables, proving it an inefficient method of risk management. On the basis of all the statistical analysis, the results are found in favour of the relationship. The majority of the dimensions included in the study which measure the level of ERM implementation do affect the financial performance. Many of the results are in line with the previous literature and claim that the level of ERM implementation has a positive impact on the financial performance of the takaful industry. The financial performance in terms of EPS is also found to be positively associated with ERM implementation, as has been observed in the literature (Laisasikorn & Rompho, 2014). Hence, it is time to convert the element of ineffective enterprise risk management within the takaful industry into a tool. This tool will definitely help lift the financial performance of the industry in both accounting and market terms. By managing the diverse risks into a portfolio, a unique source of competitive advantage would be generated in the takaful industry.

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Recommendations x There is a strong need to manage the risks of takaful firms in a holistic way by integrating ERM. As takaful is also being used to meet ordinary as well as business risks, it’s of utmost importance how the takaful operators handle their own risks. x The study is performed in different countries and suggests that the culture of risk is also an important factor which differentiates the firms in their level of ERM implementation. ERM requires teamwork that needs to be spread over all organisational levels to make its implementation smoother and its results more fruitful. x There is an urgent need to develop a unified ERM framework for the industry which targets all the specific needs of the takaful industry. This introduction will ultimately cause an increase in the adoption of ERM within the industry. In the longer run, this type of implementation will smooth the process, giving robust results. Limitations Every piece of research has some limitations and such is the case with the current study. Every effort has been made in the research to make it more effective and authentic. These are the limitations of the current study: x The study is being performed through a single source of data which is secondary data and this happened because of limited resources. x There is a limitation regarding the non-availability of data. Official websites were not being managed in terms of historical data.

CHAPTER SIX KEY DRIVERS OF THE ISLAMIC RISK MANAGEMENT SYSTEM

Summary of Chapter Six The banking industry consists of two precious diamonds, Islamic banks and conventional banks. Islamic banking is a key area for all Muslims, one which is of great interest for deposit purposes. This chapter aims to examine the impact of different liquidity ratios on the performance of Islamic banks. The study selected 20 international Islamic banks over a period of eight years from 2008 to 2015. Six differently composed liquidity ratios from the balance sheets of current items were used in the study, current ratio (CR), liquid to asset ratio (LA), cash and due from banks to asset ratio (CDA), investment to asset ratio (IT), cash and due from banks to deposit ratio (CDD), and investment to deposit ratio (IDR) as independent variables. Whereas, return on asset (ROA) and return on equity (ROE) were used as dependent variables. The size (LTA) and age (AG) of the banks are used as control variables. The GMM technique was used to analyse results because of the problems of heterogeneity, endogeneity and autocorrelation. Two models were incorporated in the study. In a nutshell, financial performance is affected by the independent variables in the chapter. The financial performance of Islamic banks improved by maintaining liquidity at a good level and holding liquidity further which can cause an inverse impact on the financial performance of Islamic banks. The chapter provides the future direction of increasing numbers of cross sections, years, independent variables etc. Keywords: Liquidity, Financial performance, Return on asset, Return on Equity, GMM, Islamic banks.

Section 1: Chapter Introduction In the fabric of Islamic finance, Islamic banking is the largest growing practical sector. As the years progress, it is going to be one of the key

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elements of Islamic finance. The Islamic banking system has grown rapidly over recent years; in addition, the system is clearly gradually developing in all parts of the world including the countries of Southeast Asia, the Middle East, Europe, and even in North America. In 1953, the first description of Islamic (interest-free) banks was offered by Islamic economists which was based on two tiers namely, either mudarabha (profit and loss sharing contracts) or wakala (account of unrestricted investment in which Islamic banks earn a minimum fee). In 1947, the first Islamic bank, the “Dubai Islamic bank” was established. Islamic banks were not affected very much during the financial global crises because they do not charge any type of interest on loans or advances, nor do they pay interest on deposits (Siraj & Pillai, 2012). It is traditionally believed that the financial intermediaries that do not base their activities on interest (interest-free) are shielded by all the risks which are attached to interest-based instruments and interest rate fluctuations (Khan, 1985). Thus, Islamic banks are responsible for keeping the trust of their depositors and are answerable to them now and in the future. In order to keep the trust of depositors and be on the safe side, Islamic banks maintain their liquidity at a good level in order to meet any immediate future demand of their depositors (short-term obligations). The basic motivation of this chapter is to bridge the gap by checking whether the performance of banks has improved or not by looking at the liquid assets which it keeps for its survival. Many pieces of research have been conducted on the performance of different institutions and banks. Previous studies also discuss the importance of liquidity, but in commercial banks and other profit generating firms. This motivates the present study to examine the importance of liquidity in the area of Islamic banks and to check whether the financial performance of Islamic banks has improved or not by the liquid assets (liquidity) that the banks maintain for their survival. The aim of the chapter is to understand the performance, the concept of liquidity and also to define different variables of liquidity and then find the relationship of these variables to performance in terms of return on asset (ROA) and return on equity (ROE). This chapter is divided into four further sections. The second section will give a literature review which covers the theoretical and empirical literature of Islamic banks, performance measures, liquidity and an explanation of its variables and the links of these variables with ROA and ROE. The third section demonstrates the research methodology of the paper. The fourth section will give an analysis and empirical findings and the fifth section finally concludes the overall chapter.

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Section 2: Theoretical Foundations of the Liquidity Concept a) Banking system: Interest-free and interest-based Earning a profit is the main aim of any organisation. The main step in measuring the development of a bank is performance evaluation; usually, the goals and objectives are assessed by interest-based banks (commercial banks). One key objective of an interest-based bank is to maximise profit which enables the bank to continue its operations and provide its services to its clients. In contrast, interest-free banks have other goals in addition to the maximisation of profit, such as a bank’s aim to achieve economic and social prosperity while ensuring no exploitation of clients (Saleh & Zeitun, 2006). b) The concept of Liquidity in terms of ratios Liquidity is a measure of the number of assets in terms of cash, or in other words, the amount of those assets which have a great ability to quickly transform themselves into cash without losing their value in order to fulfil short-term obligations, for instance, liquid assets such as cash in vaults and bank balances, marketable securities and accounts receivable (Bhunia, 2010; Mahavidyalaya et al., 2010; Akhtar, Ali & Sadaqat, 2011). Liquidity will be measured through eight ratios which are given below: Current ratio (CR): The current ratio actively measures a company’s assets to be able to pay its debts for a period of one year (Ishaq et al., 2016). Malik, Awais, and Khursheed (2016), while dealing with liquidity, also use current ratio to measure liquidity. They measure the current ratio as current assets divided by current liabilities. The results revealed that there is a significant relationship between current ratio and ROA. The findings also show that there is no significant impact of current assets on ROE. Saleem and Rehman (2011), use current ratio to measure the liquidity of oil and gas companies. The study shows that the current ratio is significantly affected by ROI ratio and is insignificant in relation to ROE ratio and ROA. Liquid to asset ratio (LA): The ratio can be calculated by the division of liquid assets to total assets. The higher this ratio, the more the bank has liquidity. The bank may face an opportunity cost by holding excess liquid assets. This opportunity cost is for a high return. The bank’s profitability

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relationship is found to be positive with liquidity (Bourke, 1989; Masood & Ashraf, 2012). Tabash and Dhankar (2014), in their study, calculated liquid ratio and suggested that an increase in the liquid ratio is positively related to a bank’s survival. Alshatti (2015) found a significant association between liquid ratio and ROA, and also found no significant impact of liquid ratio on ROI and ROE. The results of the study by Tabash and Dhankar (2014) show an insignificant difference of liquid ratio before and after the global crises on Islamic banks, as Islamic banks hold more liquid assets than traditional banks. Cash and due from banks to asset ratio (CDA): On a balance sheet, most liquid assets are cash in the vaults of a bank. Liquid assets are preferred by Islamic banks for investment purposes as they want to maintain liquidity and also avoid liquidity problems. The cash and due from banks to total assets can be used to measure the liquidity of banks. Rasul (2013) uses the cash and due from banks to total assets to measure the liquidity of Islamic banks of Bangladesh. This study examined the data over 11 years (from 2001 to 2011) and found an insignificant relation of this variable with profitability. As profitability was measured by return on asset, return on equity and return on deposits are in the study. Investment to asset ratio (IT): Investment to asset ratio is also a liquidity ratio. Investment to total assets is the rate used to show the ability of a bank to meet its financial obligations for its depositors. It shows the amount or percentage of a bank’s assets that are tied up with investment; a higher investment asset ratio shows that a bank’s liquidity is low (Javaid, 2011; Shahchera, 2012; Abduh & Alias, 2014; Tabash & Dhankar, 2014; Nandi, 2014). According to Fatema and Ibrahim (2013) in their study on the banks of Bangladesh, the investment to total assets significantly affects profitability. Rasul (2013) also uses the same ratio, and the findings of multiple linear regression suggest that investment to total asset has a significantly negative association with profitability (ROA, ROE, and ROD). Cash and due from banks to deposit ratio (CDD): Iqbal (2012) used the ratio in his study to reflect liquidity along with some other ratios. The study found that Islamic banks were not suffering from excess liquidity in the nineties, instead, they were well capitalised, stable and profitable. The higher the ratio, the more the bank has liquidity. Furthermore, Fatema and Ibrahim (2013), in a study of Islamic banks in Bangladesh over seven years, used cash and due from banks to deposit ratio with the ratio of some

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other proxies to measure the liquidity of Bangladesh Islamic banks. They calculated the ratio by dividing cash and due from banks on total deposits, and the results show that cash and due from banks to total deposits is significantly positive with ROA and ROE. Investment to deposit ratio (IDR): Investment to deposit ratio indicates the capability of a bank to pay back the withdrawal of funds made by depositors, by supervising investments as it is one of the sources of liquidity. The study by Stiawan (2009) on investment to deposit ratio and return on asset, found a significant effect of investment to deposit ratio on ROA. In addition, Loghod (2010) found a significant association between investment to deposit ratio and profitability. Similarly, investment to deposit ratio was found to be positively significant with profitability (Sabir et al., 2012). Whereas, in the study by Suryani (2011), investment to deposit ratio has an insignificant association with ROA. c) The concept of Financial performance in terms of ROA and ROE A bank can face unforeseen situations at any time which are not good for the bank’s health, so, a bank should check its performance from time to time and must receive updates on its performance. The performance is the association between the profit of a business and investments made by a business that contribute to generating profits (Alshatti, 2015). According to Muda, Shaharuddin, and Embaya (2013), profit is an important factor in indicating the bank’s survival and also indicates how well the bank is performing. Return on Asset (ROA): Previous studies have used different indicators to measure performance. Return on asset (ROA) is a financial ratio that is used to measure the financial performance of a bank. It is defined as net income divided by total assets (Ariffin, 2012; Obudho, 2014; Daly & Frikha, 2015). This ratio depicts the proportion of a bank’s assets that contribute to achieving results. Return on Equity (ROE): Return on equity (ROE) is another ratio which indicates the performance of a bank. It indicates the proportion of equity that contributes to its results. It is defined as net income divided by equity (Ariffin, 2012; Daly & Frikha, 2015; Malik, Awais & Khursheed, 2016). In addition, Abduh and Alias (2014) define ROE as the return of the amount of money or net income as a percentage of shareholders’

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equity, as it provides the idea of how much profit a bank generates by using shareholders’ money. d) Impact of Liquidity on profitability in Islamic banks Liquidity prevents any organisation from becoming bankrupt. If a bank or any other organisation with poor liquidity is unable to meet its shortterm obligations, this can damage the trust of its stakeholders which shows that liquidity has an important effect on every institution, not only on banks but also on different sector organisations. The study by Saleem and Rehman (2011) measures liquidity by using current ratio, asset test ratio and liquid ratio, and profitability by return on asset, return on equity and return on investment. The regression analysis of the study reveals that liquidity plays an important role in profitability. The study also suggested that both liquidity and profitability are closely related to each other; as one increases, the other decreases. The liquidity ratio has a significant impact on ROA and ROE. Further, Ishaq et al. (2016), conducted a study to examine the performance of conventional banks operating in Pakistan. The findings revealed that ROA and ROE were significantly positively correlated to the profitability of a bank, and total deposit to equity, nonperforming loans ratio and gross advances to total deposits ratio have a significant negative correlation to bank performance. Interest income to total asset ratio has an insignificant impact on bank performance. The cash ratio is insignificantly correlated to the performance of a bank, whereas the regression result displays that the cash ratio is significant to the performance of a bank. Metwally (1997) also investigated Islamic banks in terms of leverage, profitability and efficiency. The results of the study show that Islamic banks were more cost-effective and did not suffer from excess liquidation, and indeed the Islamic banks outperformed during the period of the study. Hypothesis Development: H1: There is a significant impact of current ratio on financial performance. 1. H1a: There is a positive relationship between current ratio and return on asset. 2. H1b: There is a positive relationship between current ratio and return on equity. H2: There is a significant impact of liquid asset ratio on financial performance.

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¾ H2a: There is a positive relationship between liquid asset ratio and return on asset. ¾ H2b: There is a positive relationship between liquid asset ratio and return on equity. ¾ H3: There is a significant impact of cash and due from banks to assets on financial performance. ¾ H3a: There is a positive relationship between cash and due from banks to asset ratio and return on asset. ¾ H3b: There is a positive relationship between cash and due from banks to asset ratio and return on equity. ¾ H4: There is a significant impact of investment to asset ratio on financial performance. ¾ H4a: There is a positive relationship between investment to asset ratio and return on asset. ¾ H4b: There is a positive relationship between investment to asset ratio and return on equity. ¾ H5: There is a significant impact of cash and due from banks to deposit ratio on financial performance. ¾ H5a: There is a positive relationship between cash and due from banks to deposit ratio and return on asset. ¾ H5b: There is a positive relationship between cash and due from banks to deposit ratio and return on equity. ¾ H6: There is a significant impact of investment to deposit ratio on financial performance. ¾ H6a: There is a positive relationship between investment to deposit ratio and return on asset. ¾ H6b: There is a positive relationship between investment to deposit ratio and return on equity.

Section 3: Methodological overview of Islamic Banks A. Statistical Tool: Islamic banks are moral guardians for depositors, so to keep the trust of depositors, Islamic banks maintain more liquidity compared to traditional banks. So, the object of analysis for this study is Islamic banks. The data of the current study is balanced panel in nature. It provides more information, less co-linearity among variables, more variability, more efficiency and certain degrees of freedom. The present study uses secondary data as it saves time and money; quality wise, it is more reliable in contrast to primary data, and it often facilitates the division of the population into further samples and subgroups (Bryman & Bell, 2007). The sampling technique used in this study is judgemental

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sampling which is a non-probability sampling technique. Judgemental sampling is used and the criteria to select the sample size are set. B. Data: The data was extracted from balance sheets and income statements and their respective notes. Data was collected from the years 2004 to 2015, but as all banks were not in operation in 2004, the banks chosen to be analysed were in operation since 2006. Twenty Islamic banks were selected for this study, between the years of 2008 and 2015. The data was collected for these 20 Islamic banks which operate in different countries and fulfil the criteria selected for this study. Abu Dhabi Islamic bank, Al Baraka Islamic Bank B.S.C., Al Rajhi bank, Bahrain Islamic bank B.S.C., Bank Islam Malaysia Berhad, Boubyan bank, Bank Muamalat, Dubai Islamic bank, European Islamic investment bank, Faysal bank (Pakistan), Hong Leong Islamic Bank, Islamic bank of Britain, Jordan Islamic bank for finance and investment, Kuwait finance house, Meezan bank, Qatar Islamic bank, RBH Islamic bank, Sharjah Islamic bank, Turkish Finance participation bank, and Tadhamon International Islamic bank are the Islamic banks selected for the present study.

Section 4: Quantitative Analysis of Islamic Banks’ Liquidity Risk The results of the diagnostics test of heteroscedasticity, autocorrelation and endogeneity confirm the existence of these factors in the data set. Therefore, the GMM test is used to assess the relationship between liquidity variables and profitability measures (ROA, ROE). Table 1: Test of Heteroscedasticity, Autocorrelation and Endogeneity ROA Wald test for groupwise heteroscedasticity

ROE

chi2 (25) 2869.36 42199.34 Prob>chi2 0.0000 0.0000 Wooldridge test for autocorrelation in panel data 9.206 8.384 F-stat 0.0057 0.0093 P-value Hausman specification test for Endogeneity Chi-Sq 23.327 20.309 0.0096 0.0265 P-value

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As the p-value is smaller than the prescribed value, it is stated that heteroscedasticity is found in both models. The results of the autocorrelation test show that it exists in both models as the null hypothesis is rejected in Model 1 and Model 2. The Hausman specification test shows that IT and CDD are endogenous against ROA; LA, IT and CDD are endogenous for ROE. Model Specification: Different authors and researchers suggest using some instrumental models for estimation in case of failure of the OLS assumptions, more specifically in the case of endogeneity (Arellano & Bond, 1991); (Arellano & Bover, 1995). In econometric models, some independent variables and the lag term of dependent variables are used as instruments for the problem of endogeneity. A fixed effect model is used for the data analysis. Table 2: Descriptive summary of data Mean

Maximum

Minimum

Std. Dev.

Observations

ROA

0.82

5.88

-13.41

1.91

250.00

ROE

6.73

29.86

-191.84

17.85

250.00

CR

88.31

609.10

0.26

101.03

250.00

LA

17.31

64.66

0.03

11.27

250.00

QR

44.23

551.36

0.03

70.14

250.00

CDA

16.05

64.66

-0.09

11.40

250.00

IT

32.89

131.31

0.04

27.69

250.00

CDD

52.16

637.50

-0.05

91.26

250.00

IDR

86.91

791.99

0.00

120.59

250.00

CD

7.79

97.88

-0.05

13.62

250.00

AG

25.42

110.00

1.00

19.14

250.00

LTA

10.06

12.97

5.84

1.16

250.00

The ROA mean value is 0.82 which depicts the ROA of all Islamic banks on average. The standard deviation of ROA is 1.91 which shows that the deviation in financial performance is not very large across all countries which have Islamic banks, as all banks perform in light of Islamic Shariah. ROE shows that Bank Islam Malaysia Berhad enjoys the

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highest income on equity compared to all banks in the year 2013. The CR is lowest at 0.26 in 2008 for the ABC Islamic bank (E.C). The CR minimum value is not negative which shows that in financial crises, Islamic banks did not suffer from a zero or negative liquidity position. No single LA ratio has a negative sign which shows that in the years of global financial crises, all the Islamic banks maintained their LA ratio to some extent. Overall average CDA is 16.05. The trend of the CDA average shows a slight increasing trend in 2008 as compared to 2006 and again drops with little value in 2008. The trend of the mean IT shows a positive value and increasing trend from 2006 to 2008. Positive CDD values mean that all Islamic banks maintain their liquidity position and secure themselves from bankruptcy. The average value of IDR is 86.91 which is positive in nature by its sign, which depicts that all sampled Islamic banks consisted of this ratio for their liquidity purposes. The dispersion of AG has an overall 19.14 standard deviation. The mean of LTA is 10.06 which is positive in nature because no bank can have negative total assets. Correlation analysis: The range of coefficients of correlation lies between +1 to -1. The +1 indicates a perfect positive correlation, which depicts that with an increase of one variable, the other variable will also increase, or in other words, both variables are directly proportional. Fixed Effect Model Return on Asset Result: The null hypothesis of the j-statistic is accepted on the basis of the p-value and instruments are found to be valid. The model includes cross-section weights as GMM weights. The DurbinWatson statistic falls in the range near to 2 which shows there is no autocorrelation. The value of R-square is 69%, whereas the adjusted Rsquare value indicates that combined liquidity variables explain 64% of financial performance in terms of ROA when other factors remain the same. Return on Equity Result: The model also includes cross-section weights as GLS weights while 2SLS is used as GMM weights. On the basis of the j-statistic, it can be said that “instruments used are valid” in this model. The R-square of the model is 54% and the adjusted R-square shows that liquidity variables of 45% explain the financial performance measured by ROE when other factors remain the same.

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Section 5: Chapter Conclusion Islamic banking is not a very new concept and thus, it exists in different countries around the globe. This study aims to trace the importance of liquidity and also to check the impact of liquidity in the enlargement or shrinkage of the financial performance of Islamic banks. The study defines different variables as liquidity measures and uses current ratio, liquid ratio, quick ratio, cash and due from banks to asset ratio, investment to asset ratio, cash and due from banks to deposit ratio and investment to deposit ratio as independent variables to measure the liquidity of Islamic banks. The dependent variables used in the study are return on asset (ROA), return on equity (ROE) and return on investment (ROI). The study also incorporates some firm-specific variables as control variables, which are the size of the Islamic bank (LTA) and the age, which is the number of years of operation of the Islamic bank (AG). The study uses a set of 20 international Islamic banks to investigate the relationship between liquidity and the financial performance of Islamic banks over the period 2008 to 2015. The overall study found that Islamic banks try to maintain a good level of liquidity in order to prevent them from bankruptcy and to perform smooth operations. This highlights two important issues, “liquidity” and “financial performance”. The study found that Islamic banks cannot achieve expected profit enlargements without confirmation of their proper liquidation (liquidity level not too high, nor too low). The study also found a very weak impact of control variables on the financial performance of selected sampled Islamic banks.

CHAPTER SEVEN RISKY MICROECONOMIC FACTORS IN THE TAKAFUL INSURANCE INDUSTRY

Summary of Chapter Seven The last chapter of the book is about risky microeconomic factors which have a major influence on the takaful consumption of individual families. Takaful is an Arabic word stemming from the verb “kafal”, which means to help one another at a time of peril. According to the concept of takaful, the members or participants in a group jointly agree to guarantee themselves against any loss or damage. This chapter empirically verifies the link between risky macroeconomic variables (i.e. risk of per capita income, savings, risk of increase in inflation, stock index risk) with the demand for family takaful in the context of Pakistan using time series data from 2006 to 2015 of the Pak-Qatar family takaful company and the Dawood family takaful company. The family takaful business in Pakistan has experienced encouraging growth in spite of its formative years, having started in 2006 by the Pak-Qatar family takaful company. The takaful market is still underused despite its annual growth rate; less than 5% of Pakistanis have been covered by family takaful since 2006. It was concluded from this study that per capita income is a strong forecaster of family takaful demand in an emerging economy such as Pakistan, while other risky macroeconomic factors such as the KSE composite index have a significant and positive relationship with takaful demand in Pakistan. The other three variables, i.e. saving, interest rate and inflation, have an insignificant relationship with family takaful demand in Pakistan. Keywords: Takaful demand, per capita income, Stock (KSE Index), Saving, Interest rate and Inflation

Section 1: Chapter Introduction Islamic finance has developed mainly in two directions: Islamic banking and Islamic insurance (takaful). Information regarding Islamic

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banking has been increasingly dispersed but the features and models of takaful are little known in Pakistan. There is always a possibility of human beings meeting with catastrophes and disasters such as death, accident, destruction of business or wealth, etc. Islam suggests that one must find ways and means to avoid such catastrophes and disasters wherever possible, despite the belief of all Muslims in Qadha-o-Qadr. One possible solution is to buy an insurance policy as in the conventional system but there are different aspects that are not allowable regarding the status of conventional insurance from an Islamic point of view. The majority of the Shariah scholars believe that it is unlawful due to certain elements like riba (interest), maisir (gambling) and gharar (uncertainty) and the alternative to this insurance is takaful (Islamic insurance) which avoids all these elements. Takaful is a legally binding agreement between all participants of a scheme to pay any of its members who suffer a loss as specified in the takaful policy document. According to Catherine, it is an Islamic system of mutual assistance built around the concept of donation [1]. Takaful is an Islamic insurance primarily based on the concept of mutual assistance and solidarity. In a takaful insurance contract, a group of participants generally agrees to support one another mutually against a specified loss. Muslim societies in different parts of the world are now practising takaful schemes to share financial responsibilities and to assist each other. They have invented an Islamic way of mutual assistance to deal with the uncertainties of life. According to Ma’sum [2] takaful means Islamic insurance, where takaful operators perform as management agents to provide risk coverage to its policyholders in return for a certain premium paid to them. In case of any loss, the risk coverage is financial security for its takaful policyholders. The takaful operator is legally bound to cover any loss of the participants in case of any mishap during the life of the policy. However, if no loss occurred during the life of the policy before maturity, the surplus is then returned to the members. The motivation behind this chapter is to explore the insurance sector in the developing economy of Pakistan which has become an important and leading market with 37 general insurance companies, seven life insurance companies, and five takaful and re-takaful companies. In accordance with the SECP (Security and Exchange Commission of Pakistan) takaful rules from 2012, more than 40 insurance companies can start takaful window operations. However, the distribution of insurance in the country is less than 5% and the takaful market is still in a formative stage and growth rate was projected to be 15% to 20 % over 10 years, reaching US$7.4 billion by 2015. This study aims to provide a brief history of insurance in general and takaful insurance in particular. The growth rate scenarios for life

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insurance and family takaful in this developing country remained at 7%, 9% and 11% for 2015 like in the years 2013 and 2014 (SECP Report, 2014). This study aims to understand the factors that influence insurance and takaful consumption in Pakistan to appreciate the full potential needed for the growth of the takaful industry in Pakistan. This chapter is divided into four further sections. The second section gives a deep theoretical and critical review on Islamic takaful insurance and it explains types of Islamic takaful insurance and its development in Pakistan and also explains the factors affecting the consumption of takaful in Pakistan. The third section demonstrates the methods used in the chapter. The fourth section will give an analysis and findings and the fifth section finally concludes the chapter with short recommendations.

Section 2: Critical Review of Family Takaful Consumption Risks a) Islamic Takaful Insurance The concept of takaful insurance is not new in Islamic Shariah law. At the time of the Holy Prophet (SAW), the concept of shared responsibility or takaful insurance was prescribed by the system of “Aaqilah”, which was an arrangement of mutual assistance or indemnification, customary in some tribes. The community contributes to cover the loss. Similarly, the Aaqilah concept in respect of blood money is the basis for the concept of takaful, wherein payments by the whole tribe distribute the financial burden among the entire tribe. Takaful (Islamic insurance) is a system based on the principle of mutual cooperation and donation in which the risk is shared jointly and voluntarily by a group of participants called policyholders [3]. All the risk involved in the operation of takaful is taken away from the participants. If there is any surplus as a result of takaful operations, the participants are entitled to the whole sum or to a certain pre-agreed percentage and if the fund is insufficient to cover the loss, participants would not be asked to pay an additional premium [4]. Takaful operators will provide interest-free loans to meet the deficit in case of a deficiency in funds from the shareholders’ fund, and this interest-free loan is known as Qard-e-Hasna. Essentially, takaful is a cooperative risksharing plan, and it is based on the elements of mutual cooperation, mutual protection and shared responsibility among participants. Takaful is a type of joint-guaranteed insurance mechanism in which members pool their financial resources together against certain exposures to loss [5].

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Mudbharaba and Wakalah models are widely used by takaful operators. Under either model, to carry out the business, takaful operators are required to comply with the religious canons and prudential requirements. Mudharabah refers to a profit-sharing contract between the provider of capital and the entrepreneur, while in a Wakalah model, the takaful insurer is permitted to deduct a fee from the premium received from the insured. The shareholders may be entitled to a permissive return on the annual surplus arising from insurance operations in addition to their fee. Some types of takaful are explained below. A. Family Takaful: Ali [6] described that in this type of takaful insurance the policy has a definite maturity period and the insured makes periodic premium contributions which are primarily used to meet individual savings targets and to assist financially deprived families of the deceased who was insured. According to the SECP Guide, family takaful means takaful for the benefit of individuals, or groups of individuals and their families, as elaborated in the provisions of the ordinance pertaining to the life insurance business. It is a long-term savings and investment instrument which provides a mutual guarantee of financial assistance in the event of death to the contributor. The main objective of this plan is to save regularly over a fixed period of time, to earn a profit on contributions paid in instalments from Shariah compliance investments and to gain takaful protection in case of the death of the participant prior to the maturity of the plan. B. General Takaful (Non-Life Insurance): Manjoo [7] explained the idea of general takaful as follows: the insurer acts as a trustee and invests funds in Islamic investment portfolios and channels the income received from investment, less investment expenses, back into the fund. The surplus is normally distributed after the expiry of each insured contract maturity. If, however, the sum of the premium and investment income is insufficient to meet the claims, there may be a further levy for additional premiums. General takaful refers to plans designed to provide compensation to individuals and businesses against financial loss of the participants. The contribution paid by the takaful contract participants is wholly on the basis of Tabarru. The participant agrees to donate all of his contribution under a general takaful contract to jointly help and guarantee fellow participants. Compensation is paid to participants out of the general takaful fund. C. Re-Takaful (Re-Insurance): Arbouna [8] explained that re-takaful is a contract between a takaful operator and a re-takaful operator to reduce

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the risk of investment. The difference between re-takaful and takaful is that in re-takaful, the insured are takaful operators instead of individuals. In Islamic re-insurance, the re-takaful operator takes the responsibility of managing and investing the premium of the failing company on a profit and loss share basis. A re-takaful operator also undertakes to compensate the loss of the failing company. Islamic re-insurance involves two parties, the insured (failing company/Takaful operator) and the insurer (re-takaful operator). It is a contract between professionals rather than individuals. The main objective of re-takaful is to enhance takaful activities by reducing the risk of loss or by spreading the risk of loss between the failing company and the re-takaful operator. Re-insurance assures that takaful funds are managed to meet the insurance commitments of the insured and re-insured to continue the takaful business. b) Takaful Insurance in an Emerging Economy (Pakistan) According to a 2013 report, the SECP is the regulatory authority of the insurance industry in Pakistan, which allows a dual system, i.e. conventional insurance and Islamic insurance systems. Currently, there are 45 conventional insurance companies and five Islamic insurance companies operating in Pakistan. An economic survey of Pakistan (2009-10 & 2011) reported that the progress of the insurance industry in Pakistan has not been very striking, yet the industry is not too small to be ignored. The assets of the insurance industry for both conventional and Islamic counterparts were 386 and 501.8 billion rupees for the years 2009 and 2011, respectively. Relatively speaking, the insurance industry is very small in Pakistan compared to other emerging economies but it has huge potential for growth in the near future. Pakistan is a big natural market for takaful, having a population of 165 million people, of which 97% are Muslims, with 100 million under 30 years of age. Growing prosperity, with per capita income doubling over the last five years, at almost $1,000 in 2008, makes takaful cover more affordable. In Pakistan, the global indicators reveal a low adult literacy rate, low GDP per capita, low GDI value that results in low purchasing power of the people, and these are considered major causes for low take-up of insurance in the country. A recent study estimating future potential in Pakistan’s share of takaful for the year 2015 was estimated to be US$75 million which is about 1% of the total takaful premium. This percentage seems to be rather small compared to other countries like Malaysia, Indonesia, the USA, and the UK. There are two family takaful and three general takaful companies working in Pakistan. The recent growth of the takaful industry

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in the country predicts that the potential exists for takaful in Pakistan because there are 150 million Muslims in the population of the country. It is recommended that the policymakers and concerned authorities should espouse strategies to give consideration to global indicators that might become imminent contributors in achieving growth of the takaful industry in Pakistan. According to Khattak and Rehman, [9] their study on customer satisfaction and awareness of the Islamic banking system in Pakistan concluded that most people are unaware of products of the Islamic financing system such as Ijara financing and Murabaha financing. Pakistan is a very large country consisting of 98% Muslims in a population of over 148 million people. Its economic indicators have shown improvements in the insurance industry over the last couple of years but the insurance sector, in general, is highly underdeveloped in the country in terms of market penetration. Less than 2% of the population is covered under any kind of life insurance plan in the country. c) Takaful Companies in Pakistan According to the current applicable laws in Pakistan, takaful companies (takaful operators) are the financial institutions incorporated as limited companies registered with the SECP and licensed from the insurance division of SECP. They are granted permission to conduct general and family takaful (Islamic insurance) business in Pakistan for non-life and life insurance respectively. The first takaful company to operate in Pakistan was Pak Kuwait takaful company limited, who began its takaful operations in the year 2005. Currently, there are five takaful operators comprising three general takaful and two family takaful companies. a)

General Takaful Companies i. Pak Kuwait takaful company limited ii. Pak-Qatar general takaful limited iii. Takaful Pakistan limited b) Family Takaful Companies i. Pak-Qatar family takaful limited ii. Dawood family takaful limited

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d) Impact of Risky Microeconomic factors on Takaful consumption per capita i. Risk of decrease in level of income The level of insurance consumption in any country can be significantly measured by its level of income. Life insurance has a positive relation with the level of income as described by (see, [10], [11], [12]). The positive relationship between income and life insurance consumption has also been confirmed by many cross-country studies (see [13], [14]). Ward [15] and Beck [16] also verified these findings by applying income per capita as a proxy. Income has been measured as a variant of current GDP, or GDP per capita, which can be assumed to provide a substitute for stable income. In this study, the ratio of GDP to the population is also used to represent income per capita. Hypothesis I: Demand for Family Takaful is positively related to the level of income in Pakistan. ii. Decrease in Interest Rate Risk for the Individual Stock [12] and Beck [16] have studied the relationship between longterm interest rates and life insurance demand. It was found that there is a positive relationship between interest rates and takaful consumption. Higher real interest rates will increase the investment returns of the insurer and the insured may enjoy greater benefits from the policies through higher dividends. Beck [16] and [17] also studied a similar concept by using the lending rate to replace the long-term interest rate of the country. Lending rates of all commercial banks with zero mark-ups published by the State Bank of Pakistan have been used in this research to predict the effect on the demand for family takaful. Hypothesis II: Demand for Family Takaful in Pakistan is positively related to the level of interest rate. iii. Risk of high Inflation rate Inflation is a sustained increase in the general price of goods and services in an economy over a period of time. With a high level of price in a country, there would be less demand for goods and services. Higher inflation rates have a significant negative impact on life insurance demand

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in any country. Inflation crumbles the demand for life insurance, making it less desirable. Theories show evidence of a negative relationship between inflation and life insurance consumption in a country. Fortune [18], Beck [16] and Hwang [14] have studied the impact of inflation rate on life insurance demand in any country. There is a negative relation between inflation and demand for life insurance, usually observed during unstable economic times [19]. Choate [20] also hypothesises that inflation rates in previous years set the expectations of consumers. Hypothesis III: There is a negative relation between level of inflation and demand for Family Takaful. iv. Risk of low saving Savings Black [19] and Beck [16] studied the relationship between the demand for life insurance and savings and it has been recommended that if the return on an insurance policy is much greater than the return of other saving instruments, life insurance would look more attractive to potential savers, given its other features like the protection it provides. Similar to other studies, this variable is measured by the rate of return of savings accounts offered by commercial banks in a country. Hypothesis IV: The level of savings is negatively related to the demand of Family Takaful. v. Risk in the Stock exchange index There is a competitive relationship between the flow of funds into stocks and life insurance sales. It is generally concluded that higher prices of stocks would stimulate the flow of funds, and this may lead to a decline in life insurance consumption. There is evidence to describe the attempts that have been made to relate life insurance sales to the behaviour of financial markets (see for instance [18], [21]). These studies observed that some viable relationships exist between the flow of funds into stocks and life insurance sales. It is expected that life insurance sales decline due to higher prices of stocks which would stimulate the flow of funds. In this study, the variable stock is measured by the KSE Stock Index. Hypothesis V: There is a positive relationship between the demand for Family Takaful and the Stock Composite index.

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85

The theoretical framework of this research can be explained in the general form of a functional relationship between dependent and independent variables as follows: Demand= f(income, interest, inflation, savings, stock) + İ A simple theoretical framework can be described diagrammatically as:

Section 3: Methodological overview of the Takaful Industry a) Statistical Tools In this chapter, the study is descriptive in nature and is typically structured by a clearly stated hypothesis or investigative questions which are formulated first, and then an association is found among different variables. Secondary data is used in this research to formulate the hypothesis. Data has been collected from different journals, research case studies, articles and financial reports of the State Bank of Pakistan and different takaful companies operating in Pakistan. A general multiple regression model is designed to test the relationships between the dependent variable (demand for family takaful) and independent variables (level of income, interest rate, inflation rate, savings rate and stock composite). The regression model is expressed as a linear equation as follows: Demand = Į + ȕ1 (INC) + ȕ2 (INF) + ȕ3 (STK) + ȕ4 (SAV) + ȕ3 (IR) + e b) Data It was not possible to make observations over a longer period as the family takaful industry started its business almost 10 years ago. Takaful contributions/premium data of family takaful are taken from the takaful

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reports compiled by the takaful companies, namely Dawood family takaful and Pak-Qatar family takaful for the period 2006 to 2015. The economic data regarding other explanatory variables were obtained from the economic survey of Pakistan, The State Bank of Pakistan annual reports, world development indicators, and the financial review of Pakistan and Karachi stock exchange index. Pakistan’s economy has maintained a recovery path, and GDP growth accelerated to 4.24% in 2014-15 against a growth of 4.03% recorded in the last year. During the span of the ten-year period under study, i.e. from 2006 to 2015, GDP per capita increases almost doubled from about $925 in 2007 to $1513 in 2015. At the end of 2014, the total assets of Pak-Qatar family takaful and Dawood family takaful were Rs 9 billion. It was only 6.5% of the total assets of private conventional life insurance companies, which amounted to Rs139.1 billion in 2014.

Section 4: Analysis of an Emerging Economy (Pakistan) a) Regression Analysis Table 1: Regression Analysis Model R

R2

Adjusted Std. Error of R2 the Estimate

Change Statistics R2Change

1

.970 .940

.937

45879885.361

.940

F Sig. F Change 282.599 .000

DurbinWatson

.659

This table provides the value of R, R2, adjusted R2, and the standard error of the estimate, which can be used to determine how well a regression model fits the data. In the table above, R2 shows that the dependent variable is 93% explained by independent variables which show a highly significant p-value. The Durbin-Watson d test is used to test serial correlation. The above table indicates that the test for serial correlation in this study is 0.659 which is less than 2 and indicates that there is no autocorrelation between the variables.

Risky Microeconomic Factors in the Takaful Insurance Industry

Table 2: Impact of Risky consumption of family takaful Model

Microeconomic

Unstandardized Coefficients

87

determinants

Standardized Coefficients Beta

T

on

Sig.

B Std. Error (Constant) -887700438.45 71890098.572 -12.348 .000 STK 7813.804 1647.026 .291 4.744 .000 INF -2260344.884 1396062.650 -.061 -1.619 .109 INC 881419.219 58511.978 .652 15.064 .000 IR -16533791.42 9220739.573 -.153 -1.793 .076 SVR 24436581.687 9850647.821 .148 2.481 .015 Independent Variable: INC=Income, INF=Inflation, STK=Stock, IR=Inflation Rate, SVR=Savings Dependent Variable: Takaful per capita

The estimated coefficients indicate that the income and stock variables are highly significant as the value is 0.00 and the standardised beta value shows that there is a positive relationship between stock and income with family takaful demand, therefore, it can be said that income and stock are strong predictors of family takaful consumption. Other variables such as inflation, interest rate and savings have significant values of 0.109, 0.076 and 0.15 respectively which shows that all these three variables have no impact on family takaful.

Section 5: Chapter Conclusion This chapter explains an emerging economy (Pakistan) in relation to the takaful industry consumption rate and the formulated model in this study is applicable to economic factors of the entire Muslim world. Pakistan is a very large country consisting of 98% Muslims with a population of over 148 million people. Its economic indicators have shown improvements in the insurance industry over the last couple of years but the insurance sector, in general, is highly underdeveloped in the country in terms of market penetration. Less than 2% of the population in the country is covered under any kind of life insurance plan. In this study, contribution per capita is used as a dependent variable to measure family takaful consumption or takaful density within the Pakistani population. The income variable is found to be a positive and strong predictor of family takaful demand within Pakistan. The stock variable shows a negative relationship with family takaful demand. There is also a negative

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relationship found between the interest rate and takaful demand. However, inflation and savings are found to be statistically insignificant in this study. In this research, a regression analysis model is used in which contribution per capita is used as a dependent variable and income, interest rate, saving rate, inflation and stock are used as independent variables. The results indicate that income and stock variables are statistically significant and a robust predictor of family takaful demand. As income rises, demand for family takaful also increases because insurance becomes more affordable with the rise in income. According to the literature, it is stated that there is a competitive relationship between the flow of funds into stocks and life insurance sales because the higher price of stocks would stimulate the flow of funds, and this may lead to a decline in life insurance consumption. Many studies support this concept but the results of this study contradict the literature as they show that there is a significant and positive relationship between variables, which means that when stock prices increase, the demand for takaful also increases. Inflation, interest and savings are not statistically significant under this model. Rules need to be developed so that takaful operators can be given permission to operate under the guidelines of the Shariah-based rules. It is necessary to consider that under a takaful company, a takaful operator is, in fact, a trustee on behalf of the participants and is managing the pool on their behalf. It is also noted that in certain countries like Malaysia and the Middle East, conventional insurers are not allowed to introduce takaful products and require a separate takaful company and the same policy is also needed in Pakistan to introduce takaful as a separate company. It is important to realise that a takaful operator also needs to be financially feasible. It is also important that takaful rules should be framed keeping in mind the protection for the consumer in terms of controls in operational practices. The government needs to encourage the establishment of a retakaful pool for takaful operators and such a pool is highly desirable in order for the takaful industry to grow, not only in Pakistan but also internationally. This study suggested that family takaful operators and policymakers can augment family takaful in Pakistan by the direct intervention of macroeconomic variables.

POLICIES AND RECOMMENDATIONS FOR ISLAMIC INSTITUTIONS

The book provides a deep understanding of the current situation and the risk management policies of Islamic institutions. It considers different data sets from all around the globe and explains how to minimise risks associated with the transactions and day-to-day activities of financial institutions. In the end, the author has given some recommendations for Islamic banks with reference to his globally conducted analysis. Firstly, if the liquidation ability of an Islamic bank is low, the bank may face a liquidity risk with its associated threat of becoming bankrupt or defaulting. Low liquidity can also damage the good reputation of an Islamic bank in the eyes of its respective depositors. This is a challenge and a difficult task to deal with for Islamic banks. It is therefore recommended that the management of Islamic banks should make such policies in which the minimum level of liquidity prescribed must save the bank in bad times. This policy will not only provide a security and soundness to the bank for its survival but also provides a sense of security and trust to depositors as well. Financial institutions need to focus on all types of risk management activities. ERM is also an important aspect of Islamic financial institutions. There is a strong need to manage the risks of Islamic takaful firms in a holistic way by integrating ERM. As takaful is also being used to meet the risks of ordinary lives as well as business life, it’s of utmost importance how the takaful operators handle their own risks. ERM implementation has been seen to strongly affect the market performance of the takaful industry. Hence, its impact on shareholder value proposes that its impact on all other stakeholders would also be strong if being implemented at all organisational levels. The excess cash kept by a bank can limit or reduce its returns, whereas little cash kept by a bank can expose it to the risk of defaulting. Islamic banks can increase their return and improve their financial performance by tracing that particular point of liquidity and maintaining liquidity at a good level. In Islam, as riba (interest) is prohibited, Islamic banks do not, therefore, incorporate any activity that involves riba. The benefit of practising such strategies and publishing the liquidity of Islamic banks can reassure the depositors about their sound level of liquidity and can thus

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strengthen their trust for the bank. As the products provided by Islamic banks and conventional banks are not the same, as a matter of fact, conventional banks provide interest-based products. It is challenging for Islamic banks to compete with conventional banks, in the sense of returns by non-interest-based products. Therefore, it is recommended that Islamic banks should not limit their products, and by conducting more research, should introduce new products that will not disturb the liquidity of the bank, ensuring that they follow Islamic laws. So, in a nutshell, this book provides policy recommendations to Islamic institutions to increase their growth and maximise their profitability in the long term.