A lexicon of Risk in Middle East Banking - an extract from Key Financial Instruments: understanding and innovating in the world of derivatives" Financial Times Prentice Hall

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Warren Edwardes is CEO of Delphi Risk Management, the London-based financial product creativity, communication and control consultancy.

Warren was previously on the board of Charterhouse Bank and has worked in the treasury divisions of Barclays Bank, British Gas and Midland Bank. He first researched into what were later to be called "derivatives" in 1975 and was part of the team that executed one of the world's first currency swaps in 1981. Since then he has devised and transacted numerous structures that form part of the history of derivatives. Warren can be contacted via we@dc3.co.uk

Warren Edwardes <note spelling of edwardes> is author of best seller "Key financial instruments: understanding and innovating in the world of derivatives" which includes an appendix on Islamic Banking. see http://dc3.co.uk/kfi

Edwardes is a Board Governor of The Institute of Islamic Banking & Insurance

Edwardes was previously on the board of Charterhouse Bank and has worked in the treasury divisions of Barclays Bank, British Gas and Midland Bank. He first researched into what were later to be called "derivatives" in 1975 and was part of the team that executed one of the world's first currency swaps in 1981. Since then he has devised and transacted numerous structures that form part of the history of derivatives.

Soon after being commissioned to write “Key financial instruments” I happened to be listening to an old Paul Simon song – “50 ways to leave your lover”. With increasing awareness of operational risk concerns in banking and the forthcoming Basle II capital requirements, with operational risk an integral part, I decided to write down a list of “50 ways to lose your money”. There may well be some risks that you feel should be included and some of the risks below may be regarded as trivial. In fact, Basle II has its own selection of risks it defines as “operational risk” which differs from my list. But just because a regulator may not recognise a risk does not mean that such a risk is immaterial. After all Basle II places no stress at all on operational risk. Most of the major banking catastrophes, regulated under the current regime, such as Barings, Allfirst/Allied Irish and Sumitomo have been connected with operational risk.

Consider recent Middle East banking news items to illustrate risk: “Moody’s upgrades Bahrain and Qatar”; “Malaysia to hold bond road show at DIFC on June 17“; “GIB issue $325mn FRN”; “Gulf states and Malaysia buy Lebanese Eurobond”; “Pakistan Muslim Commercial Bank to buy 51pc stake in United Bank Ltd “; “Union Bank Ltd buys Emirates Bank International branch network in Pakistan”; “Legal Perspective: Different warranties in international finance”; “HSBC launches Healthcare protected investment fund”; “Al Ahli launches controlled-risk investment funds”; “Gulf Finance House launches new company to invest in real estate in the UK”; “meFortunes, the investment scheme from Emirates Bank Group gives customers the chance to win up to Dh100,000 every week.”; “Repatriation by Arabs evident”; “Banks in UAE have no exposure to Rastogi Group” “Mashreqbank Bank recovers 20pc of Madhav Patel's dues”; “Banks to implement risk management in phases”; “Banks becoming more conservative on credits”. One could categorise all of these risks by the risk types below.

Do you really know what you are buying? Enron and World Com shows that accounting can be highly creative. On the other hand, as the target of acquisitive companies, are you spending too much management time fending off predators? Can you marry the different cultures between banks?

Over confidence leads to errors. I still vividly remember as a raw but confident dealer over twenty years ago, saying, "buy dollars" when I meant, "buy pounds". It was highly embarrassing but it was quickly sorted out. If you have a good relationship with your counterpart errors can be sorted out. But fix the problem immediately. Human error should be forgiven but law does not cover this.

Don't put off that product too long even if it is going to compete with existing products. Somebody else will build a better home loan product if you do not. Be innovative or ready to immediately react to competitors. Unsurprisingly, LIBOR influences mark-ups in Islamic banking.

Are your customers subject to gold or other commodity prices? Gold producers have their liabilities linked to the gold price. If you take delivery under an Islamic contract can the commodity price be managed?

Send that confirmation now! And avoid jargon. Don't talk about strangles and straddles when you refer to derivatives. Is it Al Wadiah or Musharaka? Define terms clearly.

Are the latest guaranteed investor products really understood by the banks’ senior management? Do you understand your dealers? Don't be afraid of your own ignorance. Go on a course - or buy a book. And don't be afraid to ask seemingly stupid questions.

Large Exposure Risk is obvious but sometimes governments direct banks to lend to champion industries. This is a problem for Islamic finance as no tobacco, banking and alcohol investments can lead to heavy weighting in property and technology. Non-correlated investments need to be identifies.

Does your fund depend on one or two investors? Retail bankers have fewer liquidity problems than wholesale bankers. Do not place yourself at the mercy of a few lenders.

Financial supermarket or nimble niche player are both fine. But can you reinvent yourself if markets change? But if market appetite or regulations change, can you reinvent your institution?

Can the currency be converted and delivered into a freely tradable currency? Non Deliverable Forwards are widely used in Asia in an attempt to neutralise this Deliverability risk.

Is lending carried out in local emerging markets really riskier from your banks’ perspective than an investment in the US?

So how much has the customer borrowed elsewhere? Has your client used off-balance sheet finance excessively? Will the parent really stand behind that “letter of comfort”. Do you understand the terms behind Credit derivatives? In Islamic banking risks are perhaps not loans but equity not loan risk.

Contracts are sometimes seen as a basis for negotiation. And there is a difference between the Middle East and Malaysia in Islamic banking.

Japanese producers faced competition from Korean producers post the devaluation of the Korean Won giving them Economic exposure with respect to the Won. GCC currencies are USD based. Will they become EUR linked with an increase in politically driven trade? Economic exposure is seldom hedged.

This is the risk that future foreign currency receivables will change in home currency terms. If derivatives not permitted an Islamic institution cannot hedge the exchange rate. However, a number of institutions including Delphi are developing derivatives substitutes for Islamic institutions.

It is the risk of revaluation of foreign assets or liabilities as a result of a movement in currency value. No cash flow here. If GCC currencies de-link from the US dollar, the balance sheet value of dollar assets or liabilities will fluctuate in home currency terms.

Do your customers like doing business with you? Will they come back for more of the same? Do they call you for other products? If you are running an Islamic Banking Profit and Loss product and you make a loss will you pass that on to your customers?

Are you prepared? Think of September 11^th. Remember Iraq / Kuwait. Be sure to carefully watch traders who are making substantial profits. If the profits are speculation generated, they will probably turn into losses! Recall Barings and Allied Irish.

A slowdown in economic activity will affect your business. Dubai is in close proximity to two of the US’s “axis of evil” countries. Tourists will stay away if there is trouble.

Mexico has had the interest rate on its liabilities linked to the price of oil. Most Islamic countries’ economies are linked to the oil price. Your oil-producing clients could provide a hedge to airlines?

If you lend to polluters, you may be faced with competition from a bank such as the Co-operative Bank of the UK that does not. Are environment unfriendly policies Haram? Does a conventional bank have to look at the Hallalness of its policies?

Islamic banking is ideally profit and loss sharing. This is venture capital or equity investment. If the funds are own account then beware as equity investments have a higher capital requirement than loans.

Make sure you tape all conversations. Transparency is required. Avoid the risk of misinterpretation.

Will your client say that he did not understand that complex structure? All will be fine if the client is winning. He will only cry "foul" if he loses. I am regular “expert witness” in cases and there are only complaints when deals go sour.

This often follows a covered-up disaster. And watch staff who don't take holidays. Many an irregularity has surfaced when a banker who never took a holiday fell ill and his position was taken over by a colleague. Reward whistle-blowers.

Recovery from bad publicity is extremely difficult. Keep the media, rating agencies and your Counterparties fully informed of any potential difficulties. No fund manager or treasurer wants to hold an asset or do business with a bank that suffers from adverse reporting in the media. There was an initial global reaction against all Gulf banks in the aftermath of September 11. There should have been proactive PR.

Even a small piece of information may be somebody else's missing link. And beware of the boastful. In my experience the most leaky are the most senior.

Putting up real assets as security in an asset-backed Islamic transaction may lead to over- securitisation.

Property is linked to interest rates. Islamic finance is not a closed economy. If interest rates rise sharply in relation to mark-up rates, deposits will flow out of Islamic banks and into conventional banks (and vice versa).

Are GCC currencies really fixed to the US Dollar? Could Gulf countries become linked to the Euro?

Are Credit Derivatives insurance contracts and therefore prohibited to banks in many countries?

Liquidity is much less about holding liquid assets than about managing and diversifying liabilities. Remember Continental Illinois! Events like Sep 11 can lead to a freeze on lending. This is a major problem for Islamic banking is the absence of a developed Islamic money market.

Are your staff sickly? Don't be too reliant on any one person. Or is someone likely to impact on others' performance through racist or sexist remarks? Make sure you can cope if your staff fall ill during world cup matches.

Catch separate flights on trips. And don't even think about buying key-man insurance. A sure sign of a badly run firm or team is when such insurance is even considered. It may be good for the ego of the person in question, but the solution is not the purchase of insurance but internal hedging; just make sure that at least two people can do the job.

Any banker worth hiring can manage his management accounts and can show book profits at the expense of real losses. Just make sure you check the character of the person you are hiring. Most measures of performance are crude and slavish adherence to rules can lead to poor real performance.

September 11 and events in Palestine have made an impact on Middle East Banking. What will be the impact of a US attack on Iraq?

Do your property asset-backed loans have sufficient cover? Is the property liquid?

A downgrading or even credit watch can impact on liquidity and the entire business. Investment grade bonds do not default. They become Junk and then default. On the other hand an upgrading, as has been seen for Bahrain and Qatar, can have an impact on appetite for other regional debt.

A Hallal product may later be deemed Haram. Zero coupon bonds were Hallal. Non Islamic banks may have to become Islamic.

Will the star team move to a competitor after you buy the bank? This has happened on several occasions in The Gulf.

This is the risk that you meet your part of the bargain and your Counterparty does not. Escrow accounts could have averted the only Murabaha default case to have gone to court.

Islamic banking has a tax impact. Do the sale and repurchase transactions face purchase tax? Are economically identical products treated differently in an Islamic and Conventional bank in the same country?

Can your systems manage in a disaster or war? Can you cope with system failure? Are your fax confirmations going to your customer or a competitor? Email can take a long time – perhaps days.

Kuwait’s burning oil fields probably had an adverse impact on employees’ health and tourists. Weather derivatives are being traded but are Haram. Weather Takaful?

This final risk is the most insidious and dangerous risk. "Zero Risk" is the risk of having a risk manager who always says "No" and who comes up with 50 ways not to do the business. Of course, you will never appear to lose money. You will never be known for making a wrong decision. It is just that the business will go elsewhere and your firm will find itself with unemployed capital!

So go through your own business and see how your list differs from mine. Particular Middle East banking risk issues are: Liquidity – undeveloped money market in Islamic banking; Interest rate risk even in Islamic banking; Commodity risk in Murabaha; Equity risk - Are you in fund management or banking?; Operational risk – are controls tight enough?; Religious – Hallal or Haram? – Would you be obliged to convert to Islamic by government or client pressure?

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