Risk Analysis for Zakat Institutions – II

In Part I of this document on risk analysis for Zakat Institutions, we identified certain risk factors within the broad category of reputation risk. Here are other risks within the broad categories of business risk and operational risk.

Business Risk: Business risk is associated with a ZI’s business environment, including macroeconomic and policy concerns, legal and regulatory factors, and the overall financial sector infrastructure such as payment systems. ZIs are particularly exposed to financial sector infrastructure risks, especially in the context of inter-country flow of funds. While global concerns about money laundering and financial terrorism taking shape of AML and CFT regulations involve an investigative approach (in obtaining details on identity of the muzakki and respective source of funds), these concerns also involve institutional risks for the ZIs.

Country and Transfer Risk: Perhaps a subset of the above, country and transfer risk become significant for ZIs, as they seek to transfer zakat funds into another country. Such risks may arise due to inability of ZIs in the donor country to access relevant data and information from the recipient country (confidentiality issues etc.), absence of international standards defining eligibility criteria of beneficiaries, conflicting Shariah and legal systems and all other factors that act as hindrances to inter-country transfers.

Allocation Risk: Allocation or disbursement risk is the risk of failure to meet ZI’s obligation to disburse zakat funds to the asnaf or eligible beneficiaries in accordance to the Shariah. ZIs have financial obligations that arise from their operational activities. A failure to meet financial obligations may initiate disputes or claims by other parties that will potentially cause significant disruption to the ZI’s operational sustainability. Disbursement risk arising in ZIs is akin to liquidity risk that arises due to a mismatch between collection and disbursement of zakat funds and difficulty in accessing external funds to meet the shortfall. Liquidity risk as it applies to ZIs essentially implies lack of liquidity making it difficult for the institution to meet its liabilities and financial obligations, which are essentially related to disbursement of funds to beneficiaries.

Related the above is mustahiq risk that arises from a possible failure to effectively address the needs of the mustahiq. This could be due to misidentification of mustahiq, or bureaucracy in the system adversely affecting the disbursement of zakat funds. Also related to above, is holding risk, or possibility of the ZI not being able to meet the target allocation-to-collection ratio. Another subset of allocation risk is partner risk that implies the vulnerability of ZI in selecting partners for zakat allocation, where the partner could misallocate or breach the contracts made by both parties. Another subset is asnaf priority risk that seeks to capture the vulnerability of ZIs to misallocate zakat based on asnaf priority.

Operational Risk: Operational risk is defined as the risk of loss resulting from the inadequacy or failure of internal processes, as related to people and systems, or from external risks. Operational risk also includes the risk of failure of technology, systems, and analytical models.

People risk is another type of operational risk arising from incompetence or fraud. While individuals with either knowledge of Shariah rules or with managerial competencies are not hard to find, it is not easy for a ZI to hire the services of people with both. This has also been covered under governance risk above.

Technology risk is another type of operational risk, whose significance is on the rise in the emerging era of technology-enabled zakat platforms and gateways.

Finally, we have risk factors that are usually very significant for banks and financial institutions, but not so for zakat institutions.

Credit Risk: This single-most important risk factor for a bank or financial institution does not appear to very significant in the context of zakat management. A zakat institution is not a bank though it may be seen to engage in a unique type of financial intermediation. It does not buy money. Nor does it sell money. It does not owe money. Nor does it lend money (barring exceptions, e.g. a zakat-funded credit pool).

Market Risk: This risk results from changes in the prices of financial and real assets, commodities, currencies etc. that affect the market value of investments and returns of a financial institution. In the context of a ZI, market risk may not be significant, given that ZIs are exhorted to expend all their resources during the current period and not to seek investment opportunities. Investment function for a ZI is more an exception, not a rule (unlike a waqf, for example).

A ZI has unique risk factors. The list of such risk factors cited above is not exhaustive. Since the economic environment of zakat is constantly changing, the management of such risk factors involves regular analysis and assessment of the risks, the appetite to take on those risks and the mechanisms for mitigation.