BANKS’ RISK MANAGEMENT: A HOLISTIC APPROACH NEEDED TO MITIGATE REPUTATIONAL AND FINANCIAL RISKS
The management of risks in banks is a critical aspect of their operations, and failure to do so can have far-reaching consequences for their reputation, profitability, and liquidity. In the case of Islamic banks, the risk landscape is even more complex, with Shariah non-compliance being a major concern.
Reputational Risks: A Major Concern
According to new guidelines issued by the Central Bank of Afghanistan, banks are exposed to reputational risks arising from failures in governance, business strategy, and processes. Negative publicity about their business practices can damage their market position, profitability, and liquidity. To mitigate these risks, supervisory authorities are urged to adopt a risk-based approach when assessing and evaluating the banks’ risk management activities.
Key Elements of Risk Management
The guidelines emphasize the importance of active oversight by the Board of Directors (BOD) and senior management in ensuring that risk management policies and procedures are in place. The BOD is responsible for:
- Approving the bank’s risk management objectives, strategies, policies, and procedures
- Communicating these to all levels of staff involved in implementing risk management policies
The guidelines also highlight the need for an effective risk management structure, including:
- Adequate systems for measuring, monitoring, reporting, and controlling risk exposures
- A body in place to oversee compliance with Shariah rules and principles, approved by each jurisdiction
Concentration of Risk and Capital Adequacy
Banks are required to set limits on aggregate financing and investment exposures to avoid concentration of risk and ensure that they hold adequate capital against these exposures. The BOD is also responsible for reviewing the effectiveness of risk management activities periodically and making necessary changes.
Independent Risk Management Function
Senior management plays a critical role in executing the strategic direction set by the BOD and ensuring that the risk management function is independent from risk-taking activities. The guidelines recommend that banks establish an independent risk management unit or develop other checks and balances to ensure effective risk management, even if they do not have a separate risk management function.
Sound Process for Risk Management
The new guidelines emphasize the importance of a sound process for executing all elements of risk management, including:
- Risk identification
- Measurement
- Mitigation
- Monitoring
- Reporting
- Control
Banks are required to implement policies, limits, procedures, and effective management information systems (MIS) that are commensurate with their scope, complexity, and nature of activities.
Adequate System of Controls
The guidelines also highlight the need for an adequate system of controls with appropriate checks and balances in place, which must comply with Shariah rules and principles, as well as regulatory and internal policies and procedures. Banks are required to ensure the quality and timeliness of risk reporting available to regulatory authorities and be prepared to provide additional information as needed.
Conclusion
Overall, these guidelines underscore the importance of a holistic approach to risk management in Islamic banks, which requires active oversight, effective risk management structures, and a sound process for executing all elements of risk management. By adopting these guidelines, banks can mitigate reputational and financial risks and ensure long-term sustainability.