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  • CA-6.1 CA-6.1 Definition of Operational Risk

    • CA-6.1.1

      Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events which includes but is not limited to, legal risk and Sharia compliance risk. This definition excludes strategic and reputational risk.

      January 2015

    • CA-6.1.2

      Sharia compliance risk is an operational risk facing Islamic banks which can lead to non-recognition of income and resultant losses.

      January 2015

    • CA-6.1.3

      Operational risk in Islamic bank licensees can be broadly divided into three categories:

      (a) General risks: Such risks are consequential upon various kinds of banking operations conducted by Islamic bank licensees that are common to all financial intermediaries.38 Nevertheless, the asset-based nature of financing products in banks such as Murabahah, Salam, Istisna' and Ijara may give rise to additional forms of operational risk in contract drafting and execution that are specific to such products;
      (b) Shari'a non-compliance risk: This is the risk of non-compliance resulting from the failure of an Islamic bank licensee's Shari'a governance mechanism (systems and personnel) to ensure its compliance with Shari'a rules and principles as determined by its Shari'a board or other relevant body in the related jurisdiction. This risk can lead to non-recognition of an Islamic bank licensee's income and resultant losses. The risk can take two broad forms in banks: (i) risks relating to potential non-compliance with Shari'a rules and principles in the Islamic bank licensees' operations, including the risk of non-permissible income being recognised, when there is a failure in Shari'a compliance; and (ii) the risk associated with the Islamic bank licensee's fiduciary responsibilities as Mudarib towards fund providers under the Mudarabah form of contract, according to which, in the case of misconduct or negligence by the Mudarib, the funds provided by the fund providers become a liability of the Mudarib. Sukuk structures may also be exposed to Shari'a non-compliance risk which may adversely affect the marketability, and hence the value, of the Sukuk; and
      (c) Legal risks: Legal risk includes, but is not limited to, exposures to fines, penalties or punitive damages resulting from supervisory actions as well as private settlements. Such risk can arise from either: (i) the Islamic bank licensee's operations — that is, from legal risks common to all financial intermediaries; or (ii) problems of legal uncertainty in interpreting and enforcing contracts based on Shari'a rules and principles. Legal risks also include the risk that a Sukuk structure in which an Islamic bank licensee is originator, sponsor, manager or investor fails to perform as intended because of some legal deficiency. The current section is concerned, not with exposures to legal risk as a Sukuk investor, but with potential losses due to exposures to legal risk as originator, sponsor or manager.

      38 Though operational risk related to the banking operations of banks can be considered similar to that of conventional banks in many respects, the characteristics of such risk may be different in banks in certain cases — for example: (i) Shari'a-compliant products may involve processing steps distinct from those of their conventional counterparts; (ii) banks typically hold different types of assets on their balance sheets compared to conventional banks — for example, physical assets or real estate; and (iii) banks may encounter varied risk related to information technology products and systems due to the requirements of Shari'a compliance.

      January 2015