MODELLING OPERATIONAL RISK MEASUREMENT IN ISLAMIC BANKING: A THEORETICAL AND EMPIRICAL INVESTIGATION

Abstract

With the emergence and development of Islamic banking industry, the need to cater operational risks issues has attracted the attention of academics in recent years. Such studies commonly agree that operational risk is relatively higher and serious than credit risk and market risk for Islamic banks. However, there is not any single research in the context of Islamic banking which thoroughly tackles the issue of operational risks by tackling it in three main aspects: theoretical, methodological, and empirical. This may be due to the fact that operational risk is relatively new area, which requires further research to understand the complexities it carries. This is the sources of motivation for the research, which aims to fill this observed gap in the literature by responding to the mentioned three aspects.
This research, hence, aims to develop a new measurement model of operational risk exposures in Islamic banking with the objective of theoretically determining the underlying features of operational risk exposures and its measurement particularly for Islamic banks.
In its attempt to develop a theoretical framework of the proposed model, the research provides a classification of operational risks in major Islamic financial contracts. In addition, rather than adopting the existing operational risk measurement methods, this research develops a proposed measurement model attributed as Delta Gamma Sensitivity Analysis- Extreme Value Theory (DGSA-EVT) model. DGSA-EVT is a model to measure high frequency-low severity (HF-LS) and low frequency-high severity (LF-HS) type of operational risks. This is the core of this research’s methodological contribution.
As regards to the empirical contributions, in analysing operational value at risk (opVaR), this research carefully analyses the behaviour of the data by taking into account volatility, skewness and kurtosis of the variables. In the modelling, volatility analysis employs two models: constant-variance model and exponential weighted moving average (EWMA) model. Results of the empirical tests show that the operational risk variables in this research are non-normal; thus, non-normality involving skewness and kurtosis as well as volatility has to be taken into account in the estimation of VaR. In doing so, this research employs Cornish-Fisher expansion upon which the confidence interval of operational variables is an explicit function of the skewness and kurtosis as well as the volatility.
Empirical findings by deploying a set of econometrics tests reveal that for financing activities, the role of maintaining operational efficiency as part of an Islamic bank’s fiduciary responsibilities is immensely high. However, people risk is enormous and plays a dominant role in affecting the level of operational risk exposures in Islamic banks in investment activities.