Risk management practices and attitude of Pakistani Islamic banking system employees

Financial institutes are considered to be one of the important role playing sectors in the financial establishment and economic growth of any country. Banks are part of this sector. In country like Pakistan, we have two types of banking system: one is conventional banking system and the other is Islamic banking system. This study concentrates on the Islamic banking system. Risk is one of the important factors for the success of any institute. This study focuses on risk management practices (RMP) of Islamic banking system in Pakistan. Data population of the study is Islamic banking system of Pakistan. For the data collection we used questionnaires. For this study there are five independent variables: understanding risk and risk management (URM), risk assessment and analysis (RAA), risk identification (RI), risk monitoring (RM), credit risk analysis (CRA) and one dependent variable, RMP. Initially, data reliability was found by applying Cronbach’s alpha, after that we adopted Pearson’s correlation test to detect the multi co linearity problem. No such potential problem was detected; so we applied regression model to analysis the impact of independent variables on dependent variables. From the analysis we concluded that there were four variables which have positive significance impact on the dependent variable RMP.


INTRODUCTION
Financial institutes or banks are considered to be one of the most important industries of any country.Financial institutes are playing very major role in the development of any country's economy; once a country's economy base is strong it can compete in the world.That is why every country always tries to emphasis on its financial institutes.
Now, what are the financial institutes?They are the institutes that deal with money.Financial institutions provide service as intermediaries of capital and debt markets.They are responsible for transferring fund from investors to the person/organization that needs it.In this research work the major emphasis is on the banking industry, so we will target and elucidate the banking industry, by its different characteristic.
In practice, we have two major categories of financial instates/banking industry.The institutes that are following the normal practice of interest are known as the conventional financial industry or conventional banking industry.The institutes that are following the teaching of Islam and introduce the practices of Islamic (Halal) financial system are known as the Islamic banking *Corresponding author.E-mail: naveedazim@gmail.com.Tel: 009203337643059.

industry.
Now, we will introduce the conventional banking industry after that we will go forward to the Islamic banking industry.

Conventional banking industry
As humans have taken step in the modern/advanced world, with the passage of time their needs and social demands will increase.It shows that there should be an institution/organization which controls and helps in financial transactions.So, in order to fulfill these needs the first experiment was made in the 16 century when first conventional bank was established.And within a short time period it became very popular in the world.

Islamic banking system:
In the view of religious scholars (Ullama Keram and Mufti), interest is prohibited in Islam; banks or other financial institutions have no privilege to charge/allow fixed rate of interest/return on deposits and loans.This concept is defined in the Hadith (saying of Prophet Hazreth Mohammad PBUH) as follows: Abu Said Al-Khuri said that Bilal brought the prophet some Barni dates, and when he asked him where he had gotten them he replied;"I had some inferior quality dates so I exchange two SAs for one SA ' (of this)."Theprophet responded;"Ah!This is the very essence of Riba, the very essence of Riba! Do not do so, but when you wish to buy, sell the dates in a separate transaction, then buy with what you get" (Bukhari. Muslim).
In another place the message of Riba (interest) has been delivered in Hadith as follows: Abi Sa'id al-Khudri reported Allah's Messenger as saying: "Gold for gold, silver for silver, wheat for wheat and barley for barley, dates for dates, and salt for salt.(When a transaction is) like for like, payment being made on the spot, then if anyone gives more or asks for more, he has dealt in Riba, the receiver and the giver being equally guilty" (Muslim).In Muslim communities the concept of limited banking, like the acceptance of deposits can be traced in the 600AD, in the period of Prophet Mohammad (S.A.W.), when people deposit money with Prophet or with the Khalifa Awal, Hazrat Abu.Baqar Sadique (R.A.) that actually refers to the simplest form of banking concept.And we can say that it was the first mile stone that was achieved about 14 hundreds years ago by the Islamic banking system.But after that there was no further work has been done to modernize that Islamic concept, in the new era banking.
That is why the Islamic world must need such financial system where they do not disobey their religious thoughts; so they worked hard and introduce a new financial system which is known as Islamic financial system.The conventional banking system is introduced in the Muslim countries when Muslim world has no other option than accepting that system.The main purpose of the foreign banks in the Muslim states was to fulfill their own foreign business requirements.The conventional banking system is purely based on interest system and is opposed to Islamic teaching and Muslim school of thoughts.In the initial stages Muslim were avoiding foreign banking system due to religious reasons.But it became more difficult for them to make trade without involving in the banking transaction.
So, the Muslim community of the world too had required such a financial institution where they could make their financial transaction without the fear of enrolment in activities which are against the norms of Muslim school of thought.
Regarding the implementation of Islamic banking the first step was taken in the middle of 1960s when The Mit Ghamr Saving bank was established, in Egypt.That is considered to be the first step towards the expansion of Islamic financial institutions.In the first meeting of organization of Islamic Conference (OIC), the idea regarding the abolishment of the fixed interest rates (Riba) and to promote the Islamic based financial institutions was discussed.
After that, regarding the Islamic banking system, several successful experiments were taken and the growth of Islamic banking system appreciated.
In Pakistan the first step regarding Islamic banking system implementation has been taken in 1980, when State Bank of Pakistan made some changes in the rules and laws of banking ordinance.With regard to this, from 1st July, 1985 all commercial banks were made interest free by introducing PLS system.That was not a successful experiment.After that in December 2001 the first certificate had been issued to Meezan Investment Bank as the first standing alone Islamic Bank in Pakistan.And now with the blessing of Allah in Pakistan till the end of 2009 there were six (6) full-fledged Islamic banks (Meezan Bank, Albarka Islamic Bank, Dubai Islamic Bank, Dawood Islamic Bank, Global Emirate Islamic Bank, Bank Islamic Pakistan).

Theme of the research
Now, the most important thing that must be considered is the different products that Islamic banking system offers to its customers.Different financial products introduced by the Islamic banking system are based on two basic principles: Profit-loss principle and mark-up principle.
The financial products that are based on the principle of profit-loss include Mudarabah (venture capital) and musharakah (partnership contract) and the principle of mark-up includes: producing these products such as, murabahah (resale with pre-agreed profit), bay'al-salam (forward sale contract), ijarah (leasing) and ijarah-waiqtina (operation and financial lease).
The Islamic banking/financial industry is involved in introducing many financial products that do not exist in the conventional banking/financial industry.With respect to this the Islamic financial products have introduced many risks for the Islamic banking /financial industry.That is why in the current conditions considered to be the most volatile, Islamic banking industry is facing several risks with these products, such as, credit risk, liquidity risk, foreignexchange risk, market risk, and interest rate risk, etc. (state bank of Pakistan).These risk factors which Islamic banking industry is facing may affect its survival in the current financial market.Walter (1993) explains in his research work that banking industry is basically a business of managing risk.If we focus on the operations of Islamic banking system, we can easily come to the conclusions that it is mostly involved in installment based financing.As Kuran (1995) suggests in his studies that commonly used financing method in Islamic banking system is Murabahah financing system.When banks involve in this transaction, then it is predominantly exposed to credit and default risk.When the Islamic banks were involved in the non-banking financing activities like, Mudarabah and Musharakah, they were directly exposed to market risk and agency risk.And if we study the Salam and Istesna financing, we could easily understand that the Islamic bank is also associated with delivery and payment risk.
To supervise and control the different activities of banking industry the Basel Committee has introduced a new pact that is known as "Basel II".The basic principle of Basel II is to stabilize the international banking system that is currently in practice in the world.Now, if the Islamic banking system has to get space in the international banking market, they must have to comply with the approaches that are specified by the Basel II, and should measure the risk exposure for capital adequacy.And the Islamic banking industry should consider the risk management techniques.As stated by Hassan (2006), the Islamic banking industry should give priority to the area of risk management practices (RMPs).
Regarding risk management there are several studies conducted in conventional banking industry and the risks that are faced by different financial products that are in practice by conventional banking industry.But on Islamic banking industry there is a large space for research studies on risk management, different techniques and practices that are followed by Islamic banking industry.There is a small number of empirical studies done on risk management practices in Islamic financial institutes (Khan, 1997;Hassan, 2003;Muljawan et al., 2004, Abul Hassan, 2009).
The main purpose of this study is to understand and explore the risk management practices and risk management techniques that are adopted by Islamic banking industry of Pakistan to control risk.

LITERATURE
Islamic banking industry has developed phenomenally in the recent years, not only in the Muslim world but also in the west (Wilson, 2007).Even though the Islamic banking industry is growing very well in the global financial market and has achieved a very good portion in the overall financial market, there is a threat, weather Islamic banking industry will be able to compete with the conventional banking industry and will they be able to muddle through the international banking standards.The Islamic banking industry is required to comply with the standardized approach of risk measurement for capital adequacy as emphasized in the Basel II pact (Abul Hassan, 2009).
In the world there are different views regarding business activities, most commonly in the financial sector.Like there are some researchers who believe that the Islamic banking industry is very smug, believing that they have a confined market in the Muslim masses who will come to them on religious ground (Haniffa and Hudaib, 2007).Due to this factor certain researchers have observed that Islamic banking system is lacking professionally managed risk process and risk management approaches.That is the factor due to which the Islamic banking industry is heavily involved in the short term loans instead of long term equity financing.
If we look at the attitude and characteristics of the modern banking system, we will see that risk management is about the attitude towards risk and pay off associated with it, and different strategies that are adopted while dealing with them.And if consider and study it as an operational issue, risk management is basically the identification and classification of banking risk, and different methods, measures, procedures for controlling it (Angelopoulos and Mourdoukoutas, 2001).The Islamic banking activities are exposed to risk more than conventional banking because of the introduction of new profit and loss concept and the Shari'ah compliances (Sundararajan and Errico, 2002;Venardos, 2005).
The risk exposure of the Islamic banking different products to the different kind of risk can badly affect its financial performance.Suppose the bank has involved in a large amount of Murabahah financing and that results in large amount of non-performing financing (NPF).That would also be expressed in the provision of bad debt or doubtful debt that reflects the uncollectable loss of the bank.When we report these losses to general and specific provision, the value of the shareholder' capital will depreciate and that would directly affect the performance of the bank (Rosly and Zaini, 2008).
There was early trend in the research studies on the risk management in the conventional banking industry.There were many studies on the risk management practices and the uses of different techniques for managing risk.But in the Islamic financial institute this approach has taken acceleration in 1997 when Scholar Khan conducted the first study on the platform of Pakistan to analyze risk sharing in Islamic finance.After that number of studies were conducted by world several researchers like Karim (1999), Khan and Ahmed (2001) and Adul Hassan (2009).All these researchers come with the arguments that the Islamic banking industry is not exposed only to the risk that conventional banks are facing, but is facing certain new type of risk because it completely omits the inters from the financial transactions and its liability structure.Khan and Ahmed (2001) argue that the risk that Islamic banks are facing is due to their compliance with the Shari'ah (moral laws) requirements (Khan and Ahmed, 2001).
A study that was conducted by Hassan in 2003 also argue that as the Islamic banks have introduced a new banking system, interest free banking system, they are facing additional risk that is different from the conventional banking system (Hassan, 2003).Al-Janabi (2006) observed that, Islamic banking industry is also facing the foreign-exchange risk and equity risk, because it may not have adequate tools to manage these risks with the Shari'ah laws.In this study Al-Janabi recommends certain proper quid lines and procedures for measuring of trade risk for Islamic financial market foreign exchange and equity-trading portfolio (Al-Janabi, 2006) Hobson (2006) argues that Sukuk (Islamic bond) issues entail risk involving interest rates, foreign exchange, credit risk and Shari'ah complaints.That shows that the new product is also facing such risk which has to be managed.

METHODOLOGY Sample size selection of the study and data collection
In Pakistan the first Islamic bank that was developed is Mezan Bank in December 2001, after that several successful steps were taken and different new Islamic banks were introduced.Currently we have 6 full-fledged Islamic banks and number of conventional banks that started Islamic banking operations as new Islamic window operations.So the population of our research study was 6 full-fledged Islamic banks and 11 Islamic windows of conventional banks.300 questionnaires were distributed in different Islamic banks (except Dubai Islamic Bank because it does not allow one to get response from their staff members).The questionnaires were filled from Lahore, Karachi, Islamabad, Rawalpindi and Peshawar (we have distributed the questionnaire in these cities by handing over the questionnaires to the respective head officer and requested him to circulate the questionnaire to their subordinate staff officers); out of these, 276 were collected back, and in these 276 , we selected 235 questionnaires.
Pakistan is one of the largest Muslim country with the population of about 18-19 billions.This survey is conducted for the purpose of Islamic banks, so, in this survey the target population is the staff of only full-fledged Islamic banks and the Islamic windows of conventional banks of Pakistan.We have targeted staff just because we want to know the understanding of the people who are controlling the operations and management of Islamic banks in terms of risk.That is because the products and services that are produced by Islamic banks are a bit different from that of conventional banks, and there are several types of risk for the Islamic banks.So the staff of the Islamic banks must have knowledge about these products and what type of risk they are introducing and finally how they should manage these introduced risks.

Research questions
The study main purpose is to examine and explore the risk management practices (RMPs) and techniques that are adopted by Islamic banking industry of Pakistan to control the risk.So, in order to explore this purpose certain research questions are adopted as follows; 1. Do the staff of Pakistan Islamic banks understand risk and risk management? 2. Do Pakistani Islamic banks efficiently access and analyze risk in general? 3. Have Pakistani Islamic banks clearly identified the risk associated with their declared aims and objectives? 4. Is the risk monitoring and controlling system efficient in Pakistan Islamic banks? 5. Do the Islamic banks in Pakistan manage risk efficiently?6.What are the methods used in risk management in general?

Hypothesis
On the basis of the introduction, review of literature and the research questions that are stated above, we have the following hypothesis: H1: There is a positive relationship between RMPs and understanding of risk and risk management (URM), RAA, RI, RM and credit risk analysis (CRA) (Abul Hassan, 2009).

Variables
For the analysis there are six variables; in these six variables, five (5) are independent and one (1) is dependent.

Dependent variable
Risk management practices (RMP).

Questionnaire
In order to analyze our hypothesis and to collect the data, a questionnaire has been developed by adopting the methodology of Al-Tamimi and Al-Mazrooei (2007), and Abul Hassan, (2009).The questionnaire is divided into two major sections.Initial part of the questionnaire focused on six different aspects (Figure 1): understanding risk and risk management (URM), Risk identification (RI), Risk assessment and analysis (RAA), Risk monitoring (RM), Credit risk analysis (CRA) and Risk management practices (RMPs).In this section we have 42 questions and the distribution of the question with respect to different aspects is as follows; 1. Eight questions correspond to the URM aspect.2. Five questions correspond to RI. 3. Seven questions correspond to RAA. 4. Five questions correspond to RM. 5. Seven questions correspond to CRA. 6.Ten questions correspond to RMPs.The entire respondents were asked to respond on five (5) point likert scale to each of the question (1 stands for strongly disagree and 5 stands for strongly agree).Finally, in the second section of the questionnaire the respondent were asked about the risk facing the sample Islamic banks; they all were asked closed ended question based on ordinal scale.

Analysis
Before going for any empirical analysis, we initially check out the reliability of the data.The reliability of the data is checked by applying Cronbach's Alpha (α).The mathematical formula of

Cronbach's Alpha (α) is α=(N.c)/( +(N-1).c).
Here N is equal to the number of items and c the average interitem covariance among the items and v equals the average variance; as the average inter-item correlation increases, α increase as well.
In this research regression model has been adopted.As there are five independent variables, whenever we have many different independent variables then it is suggested that there may be occurrence of multi-colinearity problem among different independent variables.So the multi-colinearity problem is analyzed by adopting Pearson's correlation among independent variables.After

RESULTS
Results of Cronbach's alpha are shown in Table 1.Cronbach's alpha value is .766,which indicates that the data are reliable for further analysis.

Understanding risk and risk management (URM)
What is risk and what is risk management?In order to get the respondents' view and to know whether they have some knowledge about risk and risk management, there were certain questions added to the questionnaire.Table 2 shows that mean of the responses on the eight (8) questions regarding URM is 4.14.This indicates that the Pakistani Islamic banks (PIB) staff understands risk and risk management.This result indicates that the staff members of PIB have good understanding of risk management, which is a good indication for IBS.

Risk assessment and analysis
To know if the staff of Pakistani Islamic banking system has knowledge about risk assessment and analysis of risk, they were given opportunity to answer certain questions.The questionnaire contains seven (7) questions regarding risk assessment analysis.It indicates that how much PIB assesses the risk that it is facing and how efficiently it analyzes risk (Table 3).
From the results we can easily understand that the PIB is assessing and analyzing it well.

Risk identification
Diagnosis is a very important step in solving a problem; whenever one wants to solve any problem, the problem should be diagnosed accurately so that it can be easy to solve.Whenever we talk about risk management, risk identification is an important step in it.For risk identification purpose we have include five (5) questions.Table 4 shows the results of the respondents' responses towards risk identification.The result shows that the staff of the Islamic banking system has clear vision about the potential risk that is faced by the Islamic banks operating in Pakistan.

Risk monitoring
Whenever we want to analyze any rules, we must have to monitor these implemented rules and regulations.For this we must have to know the monitoring conditions of the risk management practices that are implemented in Pakistan Islamic banking system.So, we add five (5) questions regarding the risk monitoring of the Islamic banking system.And the response of the questions is summarized in Table 5.

Credit risk analysis
Credit risk is one of the most important risks that are faced by the Islamic banking system regulated all over the world.So in order to get information about the credit risk that is faced by the Islamic banking system of Pakistan, we add seven (7) questions.The respondents' response is presented in Table 6.

Risk management practices
Even though the staff of the Islamic banking that is practicing in Pakistan may have good knowledge regarding different methods of risk analysis and assessments, risk identification etc., it does not clarify that risk management practices are followed by the Islamic banking system in Pakistan or not.So in order to address this question we must concentrate on the risk management practices that are adopted by the Pakistan Islamic banking system.For this purpose ten questions were included in the questionnaire.The respondents' response towards these questions is shown Table 7.

Empirical analysis
Before going for the regression model as already been discussed above, the multi co linearity problem must be cleared.So for this purpose first the correlation between independent variables was found.And the results are shown in Table 8.
From these result it could easily be understand that there is very week correlation among independent variables, except between URM and RAA and between RI and RAA.The extent of correlation is not strong, based on the "rule of thumb" suggested by Anderson et al. (1990), that if the correlation value exceeds 0.7, it could create positional problem.By evaluating the results from the above table it could easily be got that there is no multi co linearity problem existing among the different variables.

No Question Mean 1
There is a common understanding of risk management across Islamic bank.

2
Responsibility for risk management is clearly set out and understood throughout the bank.

3
Accountability for risk management is clearly set out and understood throughout the bank.

4
Managing risk is important to the performance and success of the.

5
It is crucial to apply the most sophisticated techniques in risk management.

6
The objective of Islamic bank is to expand the applications of the advanced risk management technique.

No Questions Mean 1
The IB carries out a comprehensive and systematic identification of its risk relating to each of its declared aims and objectives 4.15 2 The IB finds it difficult to prioritize its main.

3
Changes in risk are recognized and identified with the IB's rules and responsibilities.

4
The IB is aware of the strengths and weaknesses of the risk management systems of the other banks.

5
IB has developed and applied procedures for the systematic identification of investment opportunities.4.00 average 3.98

Regression results
The regression model summary can be evaluated from the value or Adjusted R 2, and the value of adjusted R 2 is .81.This suggests the strength of the regression model.The value of adjusted R 2 represents how much the five independent variables explain the variation in a dependent variable RMP..81means that 81% of the variable variation can be explained from the given independent variables.
And the coefficient values suggest that four (4) variables (URM, RAA, RI, RM) out of five (5) independent variables have significant positive impact on RMP.This can easily be understood from Table 9.

Result summary
From Table 10, it could be concluded that hypothesis H 1 of the research study is confirmed.And also it is concluded that the independent variables, URM, RAA, RI and RM have significant impact on the RMP of Pakistan

No Questions Mean 1
Monitoring the effectiveness of risk management is an integral part of routine management reporting.

2
Level of control by the IB is appropriate for the risk that it faces.

3
Reporting and communication processes within your Islamic bank support the effective management of risk.

4
The IB's response to risk includes an evaluation of the effectiveness of the existing controls and risk management.

5
The IB's response to risk includes action plans in implementing decisions about identified risk.3.15 average 3.40 It is preferable to require collateral against some capital and not all of it.

7
The level of capital (credit) granted to defaulted clients must be reduced.3.5 average 3.55

Type of risk faced by the Islamic Banking System
The Islamic banking system that is regulated in Pakistan is facing different types of risk.In this study, respondents were given opportunity to indicate clearly and rank the importance of risk that is faced by the Pakistan Islamic banking system.The respondents' views are summarized in Table 11.
From the table it could easily be seen that the Islamic banking in Pakistan is facing liquidity problem as it is ranked 4.4, and also operating risk.So the Islamic banking of Pakistan must consider these risk factors.

CONCLUSION AND SUGGESTION
With the growth of financial market and the financial institute the associated risk also increases.And the Islamic financial institutes which are competing in the conventional financial market are facing different type of risks.So the Islamic financial institute must consider the different risk management practices, in order to overcome the effect of risk that they are facing.In this study we analyze the impact of different independent variables URM, RAA, RA, RM, CR on the RMP and we come to the conclusion that these independent variables have positive impact on risk management practices.For this we can say that if the Islamic banking system of Pakistan wants to overcome the effect of risk, they must have to consider these variables, most importantly the URM, RAA, RI and RM.Secondly, the Pakistani Islamic banking systems are exposed to different kind of risk; in these the most important risks which the Islamic banking system is exposed to are liquidity risk, operating risk, interest rate risk.So, Islamic banking system must have to consider some policies and actions in order to overcome the effect of these risks factors.
Finally, the respondents were given the opportunity to express their views regarding BASEL-II, and the response was very encouraging.This suggests that the Islamic banking system of Pakistan must consider it for further policy making and must follow the BASEL-II, for their success and to be in the financial market Further, researchers could target the impact of these risk management practices that are applied by the Islamic banking system on the customer's perception towards Islamic banking system in Pakistan.

Figure 1 .
Figure 1.Diagrammatic representation of the research process.

Table 5 .
Risk monitoring of the Islamic banking.

Table 6 .
Credit risk that is faced by the Islamic banking system of Pakistan.

Table 7 .
The risk management practices that are adopted by the Pakistan Islamic banking system.

Table 11 .
Ranking the importance of risk.