Operational Risk Essay

1659 words - 7 pages

Operational Risk measurement

This is defined as “the risk of loss resulting from inadequate or failed internal processes,

people and systems or from external events. This includes legal risk, but excludes

strategic and reputation risk”.9 Such risks are likely to be significant in Islamic Banks

due to specific contractual features and the general legal environment. Specific aspects

that could raise operational risks in Islamic banks include the following:

(1) The cancellation risks in non binding murabahah and istisnah[’a contracts.

(2) Problems in internal control systems to detect and manage potential problems in

operational processes and back office functions.

...view middle of the document...

In particular, agency services under mudarabah, the associated risks due to

potential misconduct and negligence, and operational risks in commodity inventory

management, all need to be explicitly considered for operational risk measurement.

3.3 Standardized models in measuring different types of risks :

3.3.1 GAP Analysis :

GAP analysis is an interest rate risk management tool based on the balance sheet. GAP

analysis focuses on the potential variability of net-interest income over specific time

intervals. In this method a maturity/re pricing schedule that distributes interest-sensitive

assets, liabilities, and off-balance sheet positions into time bands according to their

maturity (if fixed rate) or time remaining to their next re pricing (if floating rate) is

prepared. These schedules are then used to generate indicators of interest rate sensitivity

of both earnings and economic value to changing interest rates.

GAP models focus on managing net interest income over different time intervals. After

choosing the time intervals, assets and liabilities are grouped into these time buckets

according to maturity (for fixed rates) or first possible re pricing time (for flexible rates).

The assets and liabilities that can be re priced are called rate sensitive assets (RSAs) and

rate sensitive liabilities (RSLs) respectively, and GAP equals the difference between the

former and the latter.

Thus for a time interval, GAP is given by,


Note that GAP analysis is based on the assumption of re pricing of balance sheet items

calculated according to book value terms. The information on GAP gives the

management an idea about the effects on net-income due to changes in the interest rate.

For example, if the GAP is positive, then the rate sensitive assets exceed liabilities. The

implication is that an increase in future

interest rate would increase the net interest income as the change in interest income is

greater than the change in interest expenses. Similarly, a positive GAP and a decline in

the interest rate would reduce the net interest income. 48

3.3.2 Duration-GAP Analysis

Duration model is another measure of interest rate risk and managing net interest income

derived by taking into consideration all individual cash inflows and outflows. Duration is

value and time weighted measure of maturity of all cash flows and represents the average

time needed to recover the invested funds. The standard formula for calculation of

duration D is given by,


(CFt) is the value of cash flow at time t, which is the number of periods the cash flow

from the instrument is received, and

(I) is the instrument’s yield to maturity. The duration analysis compares the changes in

market value of the assets relative to its liabilities. Average duration gaps of assets and

liabilities are estimated by summing the duration of individual asset/liability...

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