Learning Objectives

Upon the completion of this chapter, the reader

should be able to:
1 Understand the concept of risk management from the Islamic
perspective, with particular reference to Islamic commercial
transactions.

2 Be familiar with the types and characteristics of risk exposure and the
Islamic banking risks under the IFSB's guiding principles.

3 Examine the risk management techniques in Islamic banks and how

such risks can be avoided, absorbed, or transferred.
4 Understand risk management techniques such as hedging through
the use of the following derivatives: forwards, futures, and swaps,
based on Shari'ah-compliant risk mitigation frameworks.

In Islamic finance. profits are associated with risks. Profits cannot be generated
without bearing risks. The rapid growth experienced in the Islamic finance industry
around the world has consequentially exposed Islamic financial products to
a 'number of risks. In fact. a number of products are inherently prone to risks
because a cardinal principle in Islamic commercial transactions is that earning
profit is legitimized only by [Link], in order to effectively manage
the risk vulnerability of the Islamic finance instruments, proper measures for risk
management have been put in place based on different frameworks that are
either Shari'ah-compliant or Shari'ah-based. There is no doubt that Islamic banks
are exposed to business risk just like their conventional counterparts. In addition,
Islamic banks also tcce risks associated with compliance with the Shari'ah in Islamic
financial transactions. The most common risks include credit risk, equity investment
risk, market risk, liquidity risk, rate of return risk, and operational risk. Risks may lead to
unexpected losses in commercial transactions. The impact of losses occasioned by
market risks may be reduced through hedging (a contract entered or asset withheld
as protection against financial loss). Understanding the risks in Islamic banking
business and how they can be effectively managed is important for practitioners in
the Islamic finance [Link] this end, this chapter examines risk management in
Islamic finance through an analysis of key guidelines on risk management issued
by internationally recognized standard-setting bodies such as the Islamic Financial
Services Board (IFSB). The complementary nature of the Guiding Principles of Risk
Management for Institutions (Other than Insurance Institutions) Offering Only Islamic
Financial Services to the Basel Committee on Banking Supervision is highlighted.
 Dr. Zamir Iqbal
Lead Investment Officer. World Bank, Washington, 0. C.

1 How is risk management in Islamic finance different from conventional

finance?
The discipline of risk management can be divided into risk measurement,
risk control, and risk management. As far as the principles and rules of risk
measurement and risk control are concerned, there is no difference between
Islamic finance and conventional finance. However, risk management could
be very different for several reasons. First, and most important, is the nature of
financial intermediation in the two systems. Whereas in the conventional system
a bank's depositors are promised a predetermined fixed return irrespective of
the outcome on the asset side, in the case of Islamic banks, the deposits are not
guaranteed any predetermined returns. Instead, the depositors are investors who
share returns (profit or loss) on the assets side. Due to this built-in 'pass-through'
nature of financial intermediation, Islamic banks are not exposed to the classic
'asset-liabilities mismatch' (ALM} [Link],there is no need for Islamic banks
to pursue active ALM risk management.
The second most important difference is in the fundamental approach to risk
management in each system. Whereas the conventional system uses risk-shifting
•or risk transfer, Islamic finance strongly advocates risk-sharing. This has very
strong implications for risk management. In a risk-transfer system, risk does
not disappear but is shifted within the system from one party to another and
therefore risk becomes concentrated, which could cause systemic risk. However,in
risk-sharing systems, the risks are shared among economic agents so that there is
no risk concentration at the systemic level. One may conclude from this that in a
risk-sharing system, there is less need for any active risk management.

2 Are the modern tools of risk management appropriate for Islamic

finance?
When we look at the risk measurement, risk analysis, and risk control tools of the
conventional system, Islamic finance can benefit from them greatly and, as the
principles and rules of quantifying risk are well established, there is no need to
reinvent the wheel. One notable difference is that as conventional markets are
dominated by fixed-income securities, risk management for them is much more
advanced than other asset classes, i.e. equities and risk-sharing asset classes. In

367
 other words, the modern tools of risk management are designed for a risk-shifting
financial system whereas the Islamic financial system is a risk-sharing system.
Therefore, there is no need to apply the risk analysis framework developed in the
conventional system to the asset classes and financial products practiced by Islamic
finance. When it comes to risk management through hedging products, Islamic
finance cannot benefit from them as derivatives are not permitted. To illustrate this
point, let's take credit risk as an example. Islamic finance can use all the techniques
of analyzing credit exposure to a counterparty, like a conventional institution, but
when it comes to using market-based credit management tools such as credit
default swaps, an Islamic institution would not be permitted to use them.

3 How about the use of derivatives as potential tools for risk

management?
As mentioned earlier, the Islamic system is risk-sharing rather than risk shifting.
Therefore the need for derivatives would be limited. At the moment, derivatives
as practiced in the conventional markets are not permitted by Islamic financial
institutions on the grounds that they encourage speculative behavior and
create leverage, neither of which are compatible with the core tenets of Islamic
finance. There is growing debate on the issue but the consensus is that derivatives
(exchange-traded or OTC) are not allowed. As we know that the concept behind
derivative pricing is based on a no-arbitrage principle and that a derivative can
be constructed synthetically, one could argue that through financial engineering
a financial instrument that is fully compliant with Islamic finance with the sole
purpose of hedging one's undesirable risk can be developed. For example, if two
financial institutions decide to exchange cash flows for their respective assets or
liabilities m different currencies, one could construct a return-sharing currency
swap (assuming that the principle of prohibition of interest is not violated).

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 ,
, LEARNING OBJECTIVE 10.1 Risk Management from an Islamic
Understand the concept
of risk management from
Perspective
the Islamic perspective, Although risk management is a general concept in modern finance, this section focuses
Nith particular reference on risk management from the Islamic perspective. That is, we shall examine the meaning
to Islamic commercial of risk and risk management, consider the affirmative evidence of risk management in
transactions.
Islam, and discuss the concept in the light of Islamic commercial transactions.

The Meaning of Risk and its Underlying Principles

Risk is exposure to the chance of imminent danger or loss. Such damage or loss may
present itself in the form of loss of life, property, or loss of investments in commercial
transactions. One thing that remains certain is the nature and effect of risk in human
endeavors. That is, risk may be harmful to human transactions because of its obscure or
uncertain nature. Therefore, any measures undertaken to reduce the effect of any form
of risk are regarded as risk management or risk mitigation techniques. Risk is associated
its origin from the with uncertainty, speculation, and obscurity in business transactions. Generally,there is
French word risque
and Italian risc(hi)o an element of risk in every walk of [Link] financial sector has its own share of [Link]
both of which mean
to the significance of financial transactions in human life, the risks encountered in this
something that has an
obscure origin. sector often have ripple effects that may eventually trigger the collapse of a country's
economy; hence, the need to evolveproper measures of risk management.
risk management
Risk management is the quantification and assessment of business risks with a view to
:.. process of identification,
'jllantification, and taking the necessary measures to control or mitigate them. Islam recognizes risk while
.mderstanding of business risks engaging in business activities. Cumming and Hirtle define risk management as "the
nth a view to undertaking overall process that a financial institution follows to define a business strategy, to
necessary measures to control
identify the risks to which it is exposed, to quantify those risks, and to understand and
er mitigate the risk or its impact
.n the overall business of a 'control the nature of the risks it faces." According to Islamic commercial principles, a
financial institution. business only grows by taking risks. One of the reasons for the prohibition of interest-
bearing (riba) transactions is the unjust enrichment associated with such transactions
Commercial risk is where the lender earns multiple returns without any risk, hence the common legal
recognized in Islamic
law. as it is considered maxim in financial transactions, al-ghunm bi al-qhurm, which means entitlement to
part of business return is related to the liability of risk. Another maxim, derived from the sayings of
activities especially in
equity-based transactions. Prophet Muhammad (PBUH), says, at-khara] bi a/-daman, meaning entitlement to the
return of an asset is associated with the risk resulting from its possession. This gives a
preliminary glimpse into the nature of commercial transactions in Islam. There is no
transaction, whether debt-based or equity-based, in Islamic finance that is not associated
with risk. What is prohibited in Islam is the excessive risk of transactions based on
aleatory transactions uncertain events known as aleatory transactions, which is completely anticipated by
These are transactions
the parties engaging in contracts such as games of chance or raffle draws.
conditioned on uncertain
events. Literally, these are
transactions that depend on Affirmative Evidence on Risk Management in Islam
chance or the throw of a die.
Islam encourages its followers to effectivelymanage risks associated with their worldly
activities. There are numerous examples in the Our'an and Prophetic precedents

369
 where instances of risk management have been reported to serve as lessons for future
generations. A narration given in the Our'an relates to the story that revolves around
the family of Prophet Yaqub (Jacob). As a precautionary measure to be taken to avoid
unnecessary risk, Prophet Yaqubtold his sons:

Qur'an [Link] "And he said: 'O my sons! Do not enter (the capital
city of Egypt) by one gate, but enter through different gates, and I
cannot avail you against Allah at all. Verily, the decision rests only by
Allah. In Him, I put my trust and let all those that trust, put their
trust in Him'."

The precautionary measures must be directed towards risk management, as clearly

underscored in the verse. In a similar vein, precautionary steps to be taken to reduce the
effect of the risk of famine that was anticipated in the city during the time of Prophet
Yusuf (Joseph)were outlined thus:

Qur'an [Link] "Yusuf said: 'For seven consecutive years, you shall
sow as usual and that (the harvest) which you reap you shall leave it
in the ears, (all) except a little of it which you may eat'."

In order to avoid the risk of rejection, the Prophet Muhammad began his call towards
Islamic faith from among the members of his immediate family and friends who were
closely associated with him. The Prophet also approached the people of Arabia, who
are known for their truthful lives and who readily accepted his sacred mission. He did
not go openly to the Sacred House of Ka'aba to preach Islam to others nor openly teach
his companions the precepts during the early days of Islam. These steps were taken to
mitigate instances of risks to life,loss of property, and persecution as a result of the mass
exodus from paganism to Islamic monotheism, which was then prevalent in Arabia.
When the instances of persecution grew by the day, in order to avoid the continuous
loss of life, the Prophet immediately advised his companions to migrate to Abyssinia
before the greater migration to Medina. For more than a thousand years, Muslims have
continued to face all sorts of risks. Riskmitigation techniques are provided in the Our'an
and Sunnah, which Muslims have continuously used to reduce the effect of such risks.
sadd al-dhari'ah In Islamicjurisprudence, a secondary source of the Shari'ah is known as sadd al-dhari'an
Preventive measures or
(blocking the legitimate means to an evil), is designed to reduce risks in commercial
precautionary principles
which are a secondary source and non-commercial transactions among people through the use of precautionary
of Islamic law that seeks to measures. All measures taken towards blocking the means to evil are steps towards risk
prevent a violation of the law. management, particularly when the risk is imminent. Scholars of Islamic jurisprudence
have developed this concept into a secondary source of Shari'ah. Therefore, blocking all
potential risks is important in the steps towards risk management. This tool is used to
block an ostensibly legitimate means when it is being used to pursue an illegitimate end.
Sadd al-dhari'ah resonates in the risk management techniques that we discuss later in
this chapter.

370
 Risk Management in Islamic Commercial Transactions
All Islamic commercial transactions, particularly those that involve profit and loss
arrangements, are prone to market risks. Since inception, risk has been at the front of
Islamic commercial transactions. Business activities have always been exposed to risks.
If a person is not ready to bear any risk,he or she does not have to undertake any business
activities within the framework of Shari'ah-based or Shari'ah-compliant transactions.
For the sake of emphasis, the general maxims in Islamic commercial transactions we
mentioned earlier are:
al-qhunm bi ai-qhurm. entitlement to return is related to the liability of risk
Risk management
is related to the
a/-kharaj bi al-daman, entitlement to the return of an asset is associated with the
mitigation of risk resulting from its possession.
commercial risks,
which are permissible These two maxims mean the same thing. Profit in commercial activities means risk
under the low. These forms
of commercial risks are with responsibility. The criterion of the legality of any return on capital investment is
different from the risks in risk. People have to bear loss if they want legitimate profits on investment. Suppose an
aleatory transactions. While
the former is permissible, entrepreneur gets capital investment from an Islamic financial institution on the basis of
the latter is prohibited in
Islamic law.
trust financing (mudarabah). Both the entrepreneur and the capital provider must agree
on terms and conditions at the inception of the contract. The underlying contract must
contain the pre-agreed ratio of capital contribution and the ratio for the distribution of
profit and loss. Ordinarily,the entrepreneur risks losing any potential reward from his
or her labor while the capital provider risks losing the capital in a mudarabah contract.
The parties must agree to mutually bear the risk of business in line with the mandatory
provisions of the Shari'ah on commercial transactions. In a musharakah (partnership)
contract, the parties make financial contributions on the basis of profit and loss sharing
(PLS). The profit and, where applicable, loss are shared at predetermined ratios, as
contained in the underlying contract. These examples give the idea of risk in commercial
transactions. Both profit and risk go together in commercial transactions and the parties
must undertake to share both. However, reasonable measures must be put in place to
mitigate the effect of any risk. This has been analyzed in the affirmative evidence given
above on risk management and risk prevention in human endeavors. Such gestures
must be extended to commercial transactions with a view to maximizing profits and

g~· Challenge minimizing instances of market-associated risks.

The risks faced by the Islamic banking industry are more than the normal risks of
Why do you think risk the banking industry. This is because of the requirement for Shari'ah compliance in
is generally inherent
Islamic banking business and the nature of Islamic financial products. Risk in Islamic
in Islamic financial
products? commercial transactions is not evil in itself, but its effect on the parties' contributions
and situations is what brings about any problem. Therefore, avoiding risk with zero
wadi'ah yad damanah profit in business activities is allowed in Islam This is being applied in Islamic banking
A guaranteedbank deposit through a product known as a wadi'ah yad damanah (savings only) deposit. This is a
wherethe bank is the contractual arrangement on the basis of trust where the parties agree that the customer
guarantorand undertakesto
deposits their money into the custody of the bank or financial institution and the latter
pay the wholeor part of the
depositwhen requestedby the acts as the guarantor of the funds. The safe custody of the funds deposited is guaranteed
depositor. and the customer can withdraw part or the whole of the funds at anytime. The bank

371
 guarantees the repayment of the funds. Note, avoiding risk with a positive profit is not
allowed because this is the same as interest (riba) from loans.
Remember, there cannot be any profit without risk. An attempt to obtain profit from
a business without bearing any risk may result in transactions involving unjust
enrichment, such as interest-bearing business activities. This is why avoidance of risk
if it injures the counterparty is considered an evil action under the Shari'ah when it
involves business activities. This is only realizable through interest from loans, which is
categorically prohibited in the Shari'ah, In risk management for Islamic finance products,
Islamic law has its own framework, which precludes the replication of conventional
techniques of risk management.
The wide range of possibilities offered by Islam to manage risks is part of the main
discourse of this chapter, as clearly described in Box 10.1. Every Islamic financial
The first guiding
principles issued by institution is required to put in place a good framework for risk management. As a
IFSB, Guiding Principles
prelude to other sections of this chapter, it is important to bear in mind that the IFSB's
of Risk Management
for Institutions (other than Guiding Principles of Risk Management for Institutions (Other than Insurance Institutions)
insurance institutions)
offering only Islamic
Offering Only Islamic Financial Services (!IFS) will be the major source of reference on risk
Financial Services, generally management. Throughout this chapter, direct references to the IFSB guiding principles
called IFSB-1, will be used
throughout this chapter. will be made in appropriate places to explain some of the key mechanisms inherent in
the Islamic traditions.

The IFSB's Guiding Principles of Risk Management for Institutions {Other than Insurance
Institutions) Offering Only Islamic Financial Services (!IFS) provides for the need for every
Islamic financial institution to have a comprehensive risk management framework. The
guiding principles, popularly known as IFSB-1, expressly prohibit the making of profit
without necessarily bearing the corresponding business risks.
The general spirit of the underlying objective of!FSB-1 is given in Principle 1.0 which reads:
!IFS shall have in place a comprehensive risk management and reporting process,
including appropriate board and senior management oversight, to identify, measure,
monitor, report, and control relevant categories of risks and, where appropriate,
to hold adequate capital against these risks. The process shall take into account
appropriate steps to comply with Shariah rules and principles and to ensure the
adequacy of relevant risk reporting to the supervisory authority.
The above principle connects risk management with the role of corporate governance
and Shari'ah governance in properly managing risks in order to protect the interest of
all stakeholders, particularly investors who are likely to lose their money in the case of
losses. Thus, it becomes imperative for every !IFS to put in place a formidable framework
for risk management to protect the funds of depositors and investors.
Source: IFSB. (2005). Guiding Principles of Risk Management for Institutions (Other than
Insurance Institutions) Offering Only Islamic Financial Services. Kuala Lumpur: IFSB: p. l.

372
I
LEARNING OBJECTIVE 10.2 Types of Risk Exposure
Be familiar with the Islamic banks are exposed to a number of risks in the course of business transactions
types and characteristics with customers. In this section, we will examine the types and characteristics of
of risk exposure and the
risk exposure and the specific Islamic banking risks enumerated in the IFSB guiding
Islamic banking risks
under the IFSB guiding principles,which are unique to institutions offering Islamic financial services other than
principles. insurance companies. As Table 10.1 shows, financial institutions are exposed to a number
of risks that can be broadly classified into financial and non-financial [Link] financial
risks include market risk, credit risk, liquidity risk, displaced commercial risk, and rate
of return risk. Non-financial risks comprise operational risk, regulatory risk, and legal
or Shari'ah risk. These are presented in the first two columns below. The third column
enumerates the risks that have some features are exclusive to Islamic banking business.
Islamicfinancial institutions face a number of risks,some of which are specificto Shari'ah-
compliant businesses. We shall focus on the risks that are associated with the Islamic
banking industry as a whole because within the global financial system, the Islamic
finance industry has a unique risk profile due to the requirement of Shari'ah compliance.
The requirement to have in place a Shari'ah board is one of the major ways of preventing
operational [Link] discussing the Islamic banking risks,we shall rely on the IFSB's Guiding
Principles of Risk Management for Institutions (Other than Insurance Institutions) Offering
Only Islamic Financial Services. As shown in Figure 10.1, IFSB-1 identifies the following six
risks that have some features unique to the Islamic banking business:
credit risk
equity investment risk
Name any other type of market risk
risk that is not unique
liquidity risk
to the Islamic banking
business. rate of return risk
operational risk.
The IFSB guiding principles require Islamic banks and financial institutions to have in
place comprehensive risk management and reporting processes. As shown in the Global
Islamic Finance box on page 375, the framework for risk management introduced by
the IFSB is not so different from the framework introduced by the Basel Committee on
Banking Supervision (BCBS), which is used [Link] box sheds some light on the
relationship between the IFSB guiding principles and the BCBS guidelines.

TABLE 10.1:Risks in Business Transactions

• market risk • operational risk • credit risk

• credit risk • regulatory risk • market risk
• liquidity risk • legal or Shari'ah risk • liquidity risk
• displaced commercial risk • operational risk
• rate of return risk • displaced commercial risk
• Shari'ah risk
• rate of return risk

373
 FIGURE 10.1 !1vPisoF 1sLAMicJaANK1~~rii~is~L.J
ACCORDING~''/° .. . :·~·_:"'1
/
I
,
J.r,
-.·- .
.~.

Credit Risk
credit risk
Credit risk is the risk encountered in business transactions when there is the potential
Risk encountered in business for default on the part of the counterparty in meeting its obligations as agreed in an
transactions when there is underlying contract. This is a common risk in Islamic banks. Whenever there is a default
potential for default on the
in the repayment of a debt or loan obligations in accordance with the agreed terms in
part of a party in meeting its
obligations as agreed in an the contract, the problem of credit risk arises. While using Islamic financial techniques
underlying contract. such as murababah (mark-up cost contract), musharakah mutanaqisah (diminishing
counterparty partnership) and ijarar.i (lease contract), which contractually involve receivables and
An opposite party in a financial leases, there is the potential that the counterparty may fail to meet its obligations
transaction or contract. under the contractual terms. This is also true of contracts that involve credit facilities for
working capital financing projects.
Islamic banks and financial institutions also lend funds, which exposes them to credit

credit exposure
risks. Exposure is a loose word to describe a transaction that generates some risk. Credit
The amount of risk, or amount exposure refers to the amount of risk, or amount subject to loss of value, or the size of
subject to loss of value, or the the commitment. For example, when a bank takes a position such as deciding to lend or
size of the commitment.
extend financing facilities, it has an exposure. Different stages of the financing contracts
in Islamic finance have different credit exposures. These potential credit exposures
must be recognized and closely examined, using appropriate measures and strategies to
effectively manage the resultant risks.

374
• GLOBAL ISLAMIC FINANCE
Risk Management: IFSB Guidelines and
Basel II Framework
Beforethe modern Shari'ah-onented framework for risk them to exercise due diligence in the management
management in Islamic banks and financial institutions, of investment funds. To this end, they are required
these institutions used conventional risk management to put in place all necessary Shari'ah-compliant risk
techniques while still trying to remain on the Shari'ah- mitigation techniques. Pairing risk and profit in Islamic
compliance track. In December 2005, the IFSB issued commercial transactions does not in any way imply the
Guiding Principles of Risk Management for Institutions mismanagement of funds.
(Other than Insurance Institutions) Offering Only Islamic The approach adopted by IFSB in crafting its guidelines
Financial Services (Guiding Principles). Thiswas not meant is commendable. Not every technique or mechanism
to replace the existing framework of Basel Committee that originates from the conventional banking industry
on Banking Supervision {BCBS) [Link] new IFSB is non-Shari'ah-compliant. All the sound practices
guiding principles were meant to complement the BCBS's and principles that relate to risk management in the
guidelines, which are used in all banks and financial BCBS guidelines are considered in Islamic finance and
institutions around the world. While certain issues are are adapted to suit the needs of the industry to the
of equal importance to all financial institutions, some extent of their consistency with the general spirit of
exclusive issues need to be addressed as they affect the Islamic economic theory. This is carried out without
Islamic finance industry. The IFSB guiding principles compromising the principles of Islamic finance.
specifically cater for the needs and unique nature of The internal mechanism in the principles of Islamic
institutions offering Islamic financial services. jurisprudence, which allows for the adaptation of such
One of the major features of Islamic finance is the standards from whatever models that are not contrary
consideration of both profit a:1d risk together that must to the Shari'ah, remains the driving force that makes
be present in every joint venture. One is not allowed Islamic finance Shari'ah-compliant and, at the same
to generate profit without bearing risk. This does not time, [Link] harmonization
imply that the Islamic financial institutions should of regulations, guiding principles, and laws should be
be carefree in their dealings with their customers. encouraged in a global village where the rate of financial
The fiduciary duty they owe their customers requires intercourse has reached an unprecedented level.

Nature. of Credit Risk

The potential default of a bank's customer to meet their obligations on agreed terms
constitute a credit risk for the bank. Credit risk is a type of banking risk that relates to
the repayment of a debt at the appointed time in accordance with the terms of the loan.
Failure to repay the debt within the time stipulated in the contract and in line with the
terms of the contract will result in a loss and therefore constitute a risk for the bank. This
is considered the most important type of risk faced by banks and financial institutions
in their relationship with the owners of wealth, the reason being that default is not
uncommon. Bank customers will always have one reason or the other to default on
repayments, which ultimately results in a credit risk for the bank. Outright default in

375
 Principle 2.1: IIFS shall have in place a strategy for financing, using various instruments
in compliance with Shari'ah, whereby it recognizes the potential credit
exposures that may arise at different stages of the various financing
agreements.

Principle 2.2: IIFS shall carry out a due diligence review in respect of counterparties
prior to deciding on the choice of an appropriate Islamic financing
instrument.

Principle 2.3: IIFS shall have in place appropriate methodologies for measuring and
reporting the credit risk exposures arising under each Islamic financing
instrument.
Principle 2.4: IIFS shall have in place Shari'ah-compliant, credit risk mitigating
techniques appropriate for each Islamic financing instrument.

Source: IFSB. (2005). Guiding Principles of Risk Management for Institutions (Other than
Insurance Institutions) Offering Only Islamic Financial Services. Kuala Lumpur: IFSB: p. 6.

debt repayment results in loss and the bank bears the credit risk. As credit risk is inherent
in any business involved in lending funds, there is a need for credit risk management in
order to minimize such risks. IFSB-1 provides guiding principles for the management of
credit risk for Islamic banks and financial institutions, outlined in Box 10.2.

Operational Consider-ationsin Credit Risk Management

The operational considerations for risk management in !FI place credit risk management
at the core of the integrated approach to the management of financial risks. A holistic
approach is required to tackle the problems of credit risk arising from transactions
involving Islamic financial instruments. In order to cushion and effectively mitigate
such risks, IIFS are required to put in place proper framework towards the identification,
measurement, monitoring, reporting, and control of credit risks. According to IFSB-1, the
proposed framework for IIFS should include:
an appropriate credit strategy, including pricing and tolerance for undertaking
various credit risks
a risk management structure with effective oversight of credit risk management-
credit policies and operational procedures including credit criteria and credit review
processes, acceptable forms of risk mitigation, and limit setting
an appropriate measurement and careful analysis of exposures, including market-
and liquidity-sensitive exposures
a system to (a) monitor the condition of ongoing individual credits to ensure the
financings are made in accordance with the IIFS' policies and procedures, (b)
manage problem credit situations according to an established remedial process, and
(c) ensure adequate provisions are allocated.2

376
 These tools for credit risk management are meant to reduce the potential exposure of
!IFS to risks. The boards of directors (BoDs) of the !IFS should be proactive in this regard
to lay down a workable strategy for risk management. A good understanding of the
credit risks associated with each of the Islamic financial instruments would assist in
this regard.

There is also the requirement for due diligence reviews of the counterparties of the !IFS,
who generally include retail/consumer, corporate, or sovereign clients. This will enable
them decide on the appropriate Islamic financial instruments to be used in each case.
Each case is treated on its own merit while dealing with the counterparties. A due
diligence review includes the ascertainment of the eligible counterparties through a
comprehensive assessment of their individual risk profiles. This process must precede
the granting of any type of financing for the counterparties. The creditworthiness of the
counterparties as well as the Shari'ah compliance of newly proposed business projects
should be properly reviewed and ascertained through the assistance of Shari'ah advisors
or the standing Shari' ah advisory committee and, in some cases, the services of technical
experts should be employed to determine the feasibility of certain projects.

Credit risk exposure must be properly measured and reported through standardized
methodologies that are relevant to Islamic financial instruments. The !IFS are also
required to manage their counterparty risks at different stages of the implementation of
the contract. While carrying out risk measurement and reporting, price volatilities of the
underlying asset must be taken into consideration. Furthermore, each financial instrument
must have its unique credit risk mitigating technique that is Shari'ah-compliant.

Equity Investment Risk

equity investment Equity investment is the buying and holding of shares by individuals or firms of a listed
The money invested in a
company on the stock exchange in anticipation of income from dividends and capital
company by its owners or
holders of ordinary shares gains. When the value of the stock rises on the stock market, the value of the investment
in a company, which though increases. For unlisted companies, equity investment is defined as the acquisition
not necessarily returned in of equity (or ownership) participation in a joint venture company or a start-up. This
the course of the business,
arrangement is otherwise called venture capital investing, which is considered to be of
can only be recouped when
they decide to liquidate the higher risk than that for listed companies.
assets of the company or sell
Therefore, according to IFSB-1, equity investment risk can be defined as "the risk arising
their shareholdings to other
investors. from entering into a partnership for the purpose of undertaking or participating in a
particular financing or general business activity as described in the contract, and in
equity investment risk
A risk that arises from a which the provider of finance shares in the business risk."3 Remember that the most
partnership investment popular Islamic finance instruments are equity-based products such as mudarabah
contract whereby the capital and musharakah. These financial products are based on a joint venture through the
providers share in the business
risk. partnership of the capital provider and the entrepreneur in the case of mudarabah, and
joint partnership in the provision of both capital and management of the venture in the
case of musharakah. Much as the parties hope to make a profit and share it in accordance
with predetermined ratios, they also undertake to share the business risk such as a loss.
It is this kind of risk that is known as equity investment risk.

377
 Nature of Equity Investment Risk
The nature of equity investment risk is a combination of risks connected to the
entrepreneur (mudarib) or a partner in a musharakah arrangement. the underlying
business activity for the partnership, and operational issues. Preventive measures must
be put in place such as the consideration of the risk profiles of potential partners. This
element of due diligence is significant, as the !IFS is in a fiduciary relationship with the
investment account investment account holders (IAH). Investing the IAH funds in profit-sharing and loss-
holders (IAH) bearing investments with third parties requires the utmost due diligence to uphold
Bank customers who opt the fiduciary relationship between the IIFS and IAH. The !IFS will have to review the
for an investment account
risk profiles of the potential partner or entrepreneur through a careful examination
at an Islamic bank, which
yields legitimate returns of of its past records, the quality of the business plan, the proposed business activity, and
predetermined share of profits. the human resources involved. These preventive measures are necessary to forestall
The funds are especially instances of loss. which would take its toll on the funds of IAH. The risk evaluation
used in Shari'ah-compliant
should also include factors relating to the legal and regulatory environment that may
investments.
affect the viability of the investment within a particular jurisdiction.

Operational Considerations in Equity Investment Risk

Management
There are three IFSB guiding principles on equity investment risk management,
summarized in Box 10-3. The first principle relates to appropriate strategies for risk
management and adequate reporting processes. The second principle focuses on
appropriate valuation methodologies for the purpose of profit allocation. The third
principle provides for exit strategies in respect of the equity investment activities of the
contracting parties.

Principle 3.1: IIFS shall have in place appropriate strategies, risk management and
reporting processes in respect of the risk characteristics of equity
investments, including mudarabah and musharakah investments.

Principle 3_2: IIFS shall ensure that their valuation methodologies are appropriate and
consistent, and shall assess the potential impacts of their methods on
profit calculations and allocations. The methods shall be mutually agreed
between the !IFS and the mudarib and/or musharakah partners.

Principle 3.3: IIFS shall define and establish the exit strategies in respect of their equity
investment activities, including extension and redemption conditions for
mudarabah and musharakah investments, subject to the approval of the
institution's Shari' ah board.

Source: IFSB. (2005). Guiding Principles of Risk Management for Institutions (Other than
Insurance Institutions) Offering Only Islamic Financial Services. Kuala Lumpur: IFSB: p. 12.

378
 There is a need for the proper stipulation of objectives for profit-sharing instruments
such as mudarabah and musharakah, and the criteria for each of them should be properly
structured. The applicable risks in the acquisition of. holding, and exiting from profit-
sharing investments should be evaluated and managed appropriately. An appropriate
management structure is required, which must include a Shari'ah compliance body for
the proper evaluation of investment activities. Adequate financial reporting standards
must also be agreed upon for the purpose of transparency and accountability. The risk
mitigating techniques must be Shari'ah-compliant.
Valuation methodologies must be appropriate and consistent for the purpose of profit
allocation. The IIFS is required to agree mutually on the valuation methodologies with
the partner/entrepreneurto ensure the quality of the equity investment. The parties
must agree on the procedure to be adopted to determine the profit of the investment. It
can either be agreed that the profit should be a percentage of the gross or net profit of
the underlying business, or as mutually agreed by the parties.
Risk associated with the possible manipulation of reported profit, which may manifest
itself as overstatement, or understatement, of the profit should be properly addressed
through adequate measures to nip this potential problem in the bud. The services of
independent bodies or parties should be engaged to carry out audits and valuation of the
business investments for the overall interest of the parties, including the !AH.
Finally,the parties must agree on the exit strategies and their criteria, and the period of
the joint venture and the timing of the exit. The IIFS and the investing partner must also
agree on the treatment of retained profits. All the agreements, contracts, and processes
must be reviewed and approved by the Shari'ah board of the IIFS to ensure the utmost
Shari'ah compliance.

Market Risk
market risk Market risk is also known as systematic risk, or generally called systematic
The risk arisingfromthe market risk. The market risk can be defined as the risk arising from the potential of
potentialof investorsto
investors to experience losses occasioned by market price fluctuations. IFSB-1 defines
experiencelosses occasioned by
movementsin marketprices. market risk as "the risk of losses in on- and off-balance-sheet positions arising from
movements in _market prices, i.e. fluctuations in values in tradable, marketable, or
leasable assets (including sukuk) and in off-balance-sheet individual portfolios (for
restricted investment accounts example restricted investment accounts)."4Restricted investment accounts are account
These are accountportfolios portfolios where the account holders authorize the Islamic bank to invest their funds
wherethe accountholders
authorizethe Islamic bankto in Shari'ah-cornpliant business ventures with certain restrictions as to where, how,
investtheir funds in Shari'ah- and for what purpose the funds are to be invested. The volatility of market values of
compliantbusinessventures assets results in market risk, particularly in transactions that involve future delivery or
with certainrestrictionsas deferred payment such as a sa/am contract or murabahah contract. Foreign exchange
to where,how,and for what
purposethe funds are to be rates are also not fixed. The foreign exchange market fluctuates from time to time and
invested. this volatility leads to market risk. In other words, market risk is the impact of volatility
on income as a result of the changes in market [Link] income of IIFS is greatly affected
in this regard.

379
 Nature of Market Risk
The nature of market risk as it appears in some of the Islamic financial instruments is
explained here. It is important to note that other types of risks are also applicable to the
financial instruments discussed here but our focus here is market risk.

Salam Contract
This is a commodity sale involving an advance payment where the delivery of the
commodity is deferred. Risk exposure in a salam contract manifests in different ways.
salam contract When the price expectation reverses after the bank has earlier concluded a salam contract
A commodity sale contract for future delivery of the commodity, a market risk arises. The bank may have to pay
involving an advance payment
more to obtain the commodity on or before the maturity date to fulfill the contractual
where the delivery of the
commodity is deferred. terms. This commodity risk adversely affects the income of the bank. According to
IFSB-1, IIFS are exposed to commodity price fluctuations on a long position after entering
into a contract and while holding the subject matter until it is disposed of. "In the case
of parallel salam, there is also the risk that the failure of delivery of the subject matter
would leave the !Bis [Islamic Banking Institution] exposed to commodity price risk as a
result of the need to purchase a similar asset in the spot market in order to honor the
parallel salam contract.">

ljarah Contract
ijarah contract An ijarah contract is a typical lease contract where the owner (lessor) of an asset
A contract where the owner of leases it to a customer (lessee) at an agreed rental fee, which is a consideration for the
an asset leases it to a client at beneficial use of the underlying asset. In a lease arrangement, when there is a default
an agreed rental fee, which is a
consideration for the beneficial of payment on the part of the lessee because of a price variation, the resultant effect is
use of the underlying asset. market risk. The bank/lessor faces market risk, which in turn may lead to credit risk and
ultimately losses for the bank/lessor. In some cases, market risk in a lease contract may
ijarah muntahia bittamlik arise from the default on the asset delivery by the bank/lessor. If the lessee terminates
(also known as ijarati wa iqtina) the lease earlier than the contractual term, either through default in payment or some
A form of lease contract that
other factor, the lessor is exposed to market risk on the residual value of the leased asset.
offers the lessee an option to
own the asset at the end of the The risk exposure is more in a lease contract that offers the lessee an option to own the
lease period either by purchase asset at the end of the lease period, known as ijarah muntahia bittamlik, because in the
of the asset through a token event of any form of default on the part of the lessee on the lease obligations, the lessor
consideration or payment of
will be exposed to market risk on the carrying value of the leased asset. This commodity
the market value, or by means
of a gift contract. risk may have an adverse affect on the lessor.

Foreign Exchange Contract

foreign exchange contract The nature of market risk in foreign exchange contract (bay a/-sarj) is related to
A contract of exchange of fluctuations in currency exchange rates. Foreign exchange rate risk is the risk arising
money for money, closely from changes experienced in the currency exchange rates. This may affect the value
regulated and restricted by
relevant Shari'ah rules. of investment by the IIFS. An adverse movement in exchange rates will always result
in currency risk or exchange rate risk. IIFS that engage in export and import business
activities are usually affected by any sudden changes in exchange rates. IIFS that engage
in international investments are also exposed to exchange rate risks. According to IFSB-1,
IIFS are also exposed to foreign-exchange fluctuations arising from general FX spot-rate
changes in both cross-border transactions and the resultant foreign currency receivables

380
 BOX 10.4: , ltFSB~UIDING P' IN<:._IPLES ON( ;~;;· .. ~~-,_
MARKET RISK h, _... .. . · ,

,, , .• . . . . .;~- ..

Principle 4.1: !IFS shall have in place an appropriate framework for market risk
management (including reporting) in respect of all assets held, including
those that do not have a ready market and/or are exposed to high price
volatility.
Source: IFSB. (2005). Guiding Principles of Risk Management for Institutions (Other than
Insurance Institutions) Offering Only Islamic Financial Services. Kuala Lumpur: IFSB: p. 16.

and payables. These exposures may be hedged using Shari'ah-cornpliant methods.6

There is only one IFSB guiding principle on market risk, shown in Box 10-4.

Operational Considerations in Market Risk Management

In order to mitigate or properly manage instances of market risk in financial transactions
between the !IFS and a client, an appropriate framework is required. Note that these
risk management policies are also applicable to the assets held on behalf of restricted
IAH, based on the fiduciary relationship between the !IFS and the !AH. This framework
comprises a number of strategies summarized in Figure 10.2.
These strategies for market risk management in Islamic financial institutions are
explained in Box 10.5 where they are reproduced verbatim from IFSB-1.

Liquidity Risk
liquidity risk
Liquidity risk can be defined as the potential loss anticipated by an Islamic financial
The potential loss anticipated
by an Islamic financial institution that arises as a result of insufficient liquidity to meet its normal operating
institution that arises as a result
of insufficient liquidity to meet
its normal operating obligations
and operating needs.

Sound and
Appropriate market comprehensive market
risk strategy risk management
process and
information system

Appropriate definition
of risk appetite for the Detailed approach to Allocate funds to cover
tradable assets with valuing the market risks resulting from
adequate capital risk positions illiquidity, new assets
support and uncertainty
-""~~. ~

Source: Based on IFSB. (2005). Guiding Principles of Risk Management for Institutions
(Other than Insurance Institutions) Offering Only Islamic Financial Services (p. 17).
Kuala Lumpur: IFSB.

381
 WR.1,~l~-,,,:t!II
Accordingto IFSB-1, the framework to be implemented for the operational considerations in market risk
management consists of the following strategies.
1. Appropriate market risk strategy. IIFS shall develop a market risk strategy including the level of
acceptable market risk appetite taking into account contractual agreements with fund providers,
types of risk-taking activities, and target markets in order to maximize returns while keeping
exposures at or below the predetermined levels. The strategy should be reviewed periodically by
IIFS, communicated to relevant staff and disclosed to fund providers.
2. Sound and comprehensive market risk management process and information system. IIFS shall
establish a sound and comprehensive market risk management process and information system,
which includes:
a) a conceptual framework to assist in identifying underlying market risks
b) guidelines governing risk-taking activities in different portfolios of restricted IAH and their
market risk limits
c) appropriate frameworks for pricing, valuation, and income recognition
d) a strong MIS for controlling, monitoring and reporting market risk exposure and performance
to appropriate levels of senior management.
Given that all the required measures are in place (e.g. pricing, valuation, and income recognition
frameworks, strong management information system for managing exposures, etc.), the applicability
of any market risk management framework that has been developed should be assessed, taking
into account consequential business and reputation risks.
3. Quantification of market risk exposure. IIFS should be able to quantify market risk exposure and
assess exposure to the probability of future losses in their net open asset positions.
4. Appropriate definition of risk appetite for the tradable assets with adequate capital support.
The risk exposures in investment securities are similar to the risks faced by conventional financial
intermediaries, namely market price, liquidity, and foreign exchange rates. In this regard, IIFS shall
ensure that their strategy includes the definition of their risk appetite for these tradable assets and
that this risk appetite is adequately supported by capital held for that purpose.
5. Detailed approach to valuing the market risk positions. In the valuation of assets where no direct
market prices are available, IIFS shall incorporate in their own product program a detailed approach
to valuing their market risk positions. IIFS may employ appropriate forecasting techniques to assess
the potential value of these assets.
6. Allocate funds to cover risks resulting from illiquidity, new assets and uncertainty. Where
available valuation methodologies are deficient, IIFS shall assess the need to (a) allocate funds
to cover risks resulting from illiquidity, new assets, and uncertainty in assumptions underlying
valuation and realization; and (b) establish a contractual agreement with the counterparty
specifying the methods to be used in valuing the assets.
Source: IFSB. (2005). Guiding Principles of Risk Management for Institutions (Other than Insurance
Institutions) Offering Only Islamic Financial Services. Kuala Lumpur: IFSB: p. 17.

382
 obligations and operating needs. The implication of liquidity risk is that the Islamic
financial institution may find it difficult to meet its liabilities by selling assets whose
market value has fallen. Liquidity risk is sometimes considered to be part of market
risk but for the purpose of IIFS, liquidity risk is regarded as a separate risk. Liquidity risk
involves a kind of systemic failure on the part of the financial institution where it fails
to meet expected and unexpected cash flow needs as they emerge from time to time.
Such cash flows include the financial institution's portfolio of assets. The inability to fund
those assets at appropriate maturity and rates results in liquidity risk. Liquidity risk can
be caused by incorrect judgment and complacency, unanticipated change in cost capital,
abnormal behavior of financial markets, range of assumptions used, risk activation
by secondary sources, breakdown of payment systems, macroeconomic imbalances,
financial infrastructure deficiency, and contractual forms. In Islamic financial institutions,
liquidity risk is linked with displaced commercial and Shari'ah compliance risks.

Nature of Equity Liquidity Risk

IIFS manage two major funds directly:
current account holders
unrestricted investment account holders {!AH).
The funds of these two account holders require proper management through a
stable level of liquidity that regulates the cash flow process. The IIFS must meet the
requirements for withdrawals of the two types of account holders through a healthy
degree of liquidity. The current account holders only make cash withdrawals. They do
not participate in the sharing of profits realized in investment activities. To this end,
the !IFS must make readily available funds for cash withdrawal at every point in time.
This requires enough liquidity in the cash flow of the financial institution. All cash
withdrawal requests of the current account holders must be adequately met through a
sound repayment capacity. Such repayments are guaranteed at any point in time when
requests are made because the current account holders do not share in the profit or the
risk of the business activities of the IIFS. However, unlike the current account holders,
the !AH have a share in the profits and risk of the business of IIFS as investors. IFSB-1
provides that "apart from general withdrawal needs, the withdrawals made by IAH may
be the result of (a) lower than expected or acceptable rates of return; {b) concerns about
the financial condition of the IIFS; and ( c) non-compliance by the IIFS with Shari'ah rules
and principles in various contracts and activities."7There are two IFSB guiding principles
on liquidity risk, shown in Box 10.6.

Operational Considerations in Liquidity Risk Management

The IIFS must put in place a liquidity management framework, which addresses the
liquidity exposures of the financial institution with particular regards to the two types
of account holders - current account holders and !AH. This involves measuring and
monitoring the risk exposures at every point in time and coming up with strategies for
liquidity risk mitigation. First and foremost, the IIFS are required to maintain adequate
liquidity at all times to meet all their obligations.

383
 BOX 10.6: ·JilFSB GUIDIN
•"
, - C PLESJ~.
y
. LIQUIDITY~ .-..,r-_.· ~~- . ~

Principle 5,1: IIFS shall have in place a liquidity management framework (including
reporting), taking into account separately and on an overall basis their
liquidity exposures in respect of each category of current accounts and
unrestricted investment accounts.

Principle 5.2: IIFS shall assume liquidity risk commensurate with their ability to have
sufficient recourse to Shari'ah-compliant funds to mitigate such risk.

Source: IFSB. (2005). Guiding Principles of Risk Management for Institutions (Other than
Insurance Institutions) Offering Only Islamic Financial Services. Kuala Lumpur: IFSB: p. 19

The oversight functions of the BoD cannot be overemphasized in a corporate entity,

especially when it comes to the challenges of liquidity risk. The failure of effective
oversight functions through proper policy formulation and monitoring will lead to
solvency issues in the IIFS. In order to mitigate instances of liquidity risk effectively, the
IIFS should have a liquidity contingency plan.

Rate of Return Risk

rate of return risk Rate of return risk is defined as the risk associated with the potential impact of the
Risk associated with the returns of an Islamic financial institution, arising from unexpected change in the rate
potential impact of the
of returns in business transactions undertaken by such institutions. This happens when
returns of an Islamic financial
institution, arising from the IIFS balance sheet is exposed to unexpected change in the rate of returns, which
unexpected change in the ca1;1ses an inconsistency between the assets and balances of the capital providers. To
rate of returns in business fulfill its fiduciary duty to the IAHs on one part and the current account holders on the
transactions undertaken by
other, the IIFS must put in place a sound framework for balance-sheet risk management.
such institutions.
There is a difference between the rate of return risk and the interest rate risk, which is
prevalent in the conventional banking industry. While the rate of return risk is based on
the return on investments anticipated by the IIFS at the end of the investment cycle, the
interest rate risk relates to a predetermined interest rate that is fixed at the beginning of
the investment cycle.

Nature of" Rate of Return Risk

The rate of return risk may lead to displaced commercial risk. This refers to the risk
arising from the assets managed on behalf of the IAH that is in due course transferred
to the Islamic financial institution's own capital, where the IIFS foregoes part or all of
its portion of profits on a profit-sharing investment account (PSIA), in order to increase
the rate of return that would otherwise be payable to the IAH.8 The prevailing market
pressure at a particular point in time may push the IIFS to pay a return that exceeds the
rate that has been earned on assets financed by IAH in situations where the return on
assets is underperforming compared with competitors' rates. It is strategic for the !IFS to

384
 retain their fund providers to avoid insolvency and an ultimate liquidation. Therefore,
it may be ready to waive some of its rights by parting with its share of profits in the
mudarabah arrangement with the !AH to avoid a situation where they withdraw their
funds from the IIFS. Investors, who are fund providers, must be retained at all costs as a
result of market competitive pressures.
Two important terminologies that are related to rate of return risk management
are profit equalization reserve (PER) and investment risk reserve (IRR). The PER is
the amount of funds set aside by the Islamic financial institution out of its gross
income prior to the appropriation of the relevant amount due to the investment
manager (mudarib). This step is taken to protect the interest of the investors who,
in this case, are the !AH. Apart from maintaining a certain level of return on
investment for the !AH, PER also increases the equity of the owners of the financial
institutions.
The IRR is the reverse of PER in that it is the amount appropriated from the
income of the !AH after the share of the investment manager (mudarib) has been
allocated. This is carried out to prevent any future risk of investment losses on the
part of the !AH. As a means of cushioning the effects of future losses on the part of the
!AH, the IRR is very appropriate for mudarabah arrangements in deposit accounts at
Islamic banks.
PER and IRR are important reserves maintained by IIFS to cater for situations where
market pressures may result in displaced commercial risk. The IIFS maintains these
reserves as part of its risk management strategy. There are two IFSB guiding principles
on rate of return risk, shown in Box 10-7.

Operational Considerations in Rate of Return Risk

~anagement
The operational considerations in rate of return risk management relate to the necessary
steps the IIFS needs to take in assessing the potential impact of market factors that affect
the rates of return on assets. When these are compared with the expected rates of return

Principle 6.1: IIFS shall establish a comprehensive risk management and reporting
process to assess the potential impact of market factors affecting rates
of return on assets in comparison with the expected rates of return for
investment account holders (!AH).
Principle 6.2: IIFS shall have in place an appropriate framework for managing displaced
commercial risk,where applicable.
Source: IFSB. (2005). Guiding Principles of Risk Management for Institutions (Other than
Insurance Institutions) Offering Only Islamic Financial Services. Kuala Lumpur: IFSB: p. 23.

385
 for IAHs, necessary steps are taken to mitigate any mismatch between the assets and
balances from the funds of the investors.
Islamic banks must have in place appropriate management processes that cater for the
identification, measurement, monitoring, reporting, and control of the rate of return
risk. The factors that give rise to this kind of risk must be identified in order to put in
place a proper strategy to mitigate such risk. Apart from other techniques, IIFS are
encouraged to use balance-sheet techniques to minimize exposure to risks. In addition,
displaced commercial risk must be properly managed through an appropriate policy
and framework. The IIFS must identify their shareholders' and IAH expectations, and put
in place an appropriate policy and framework to meet those expectations through the
proper management of the displaced commercial risk.

Operational Risk
operational risk Operational risk can be defined as a risk that arises from the execution of the business
Risk that arises from the functions of an Islamic bank. These are risks arising from failures in the internal controls
execution of the business
of a financial institution involving processes, people, and systems. Operational risk also
functions of an Islamic bank.
includes risk arising from non-compliance with the Shari'ah requirements and any
failure in the fiduciary responsibilities of the financial institution towards the IAH and
current account holders. This risk may lead to withdrawal of funds by the fund providers
and the ultimate closure of accounts, resulting in loss of income, diminished reputation,
and limited business opportunities.

Nature of Operational Risk

Operational matters are important in the life of an Islamic bank. When the internal
controls of a financial institution are not functioning well and there is exposure to risks
coupled with non-compliance with the Shari' ah, a systemic failure has occurred that may
lead to eventual insolvency. Thus, operational risk must be properly handled to ensure
the sustained confidence of fund providers. Relevant governance bodies are required to
play their roles in properly mitigating operational risk. For instance, the Shari'ah board
must play its supervisory role to ensure total compliance with the rules and principles of
Shari' ah, as compliance is critical to the continued existence of the IIFS.

The other form of operation risk relates to fiduciary risk. Remember that every financial
institution has a fiduciary relationship with its clients, which must be performed in
accordance with standard practices in the industry. In managing the investments of the
IAH, the financial institution must act with the utmost due care in terms of calculation of
expenses and allocation of profits. Failure to uphold the fiduciary relationship may result
in loss of investments. If the financial institution becomes insolvent, it is impossible to
meet the frequent demands of the current account holders and protect the interest of
the IAH.
There are two IFSB guiding principles on rate of return risk, shown in Box 10.8.

386
 There are two IFSB guiding principles on rate of return risk.

Principle 7.1: IIFS shall have in place adequate systems and controls, including a
Shari'ah board/advisor, to ensure compliance with Shari'ah rules and
principles.

Principle 7.2: IIFS shall have in place appropriate mechanisms to safeguard the
interests of all fund providers. Where !AH funds are commingled with the
IIFS' own funds, the IIFS shall ensure that the bases for assets, revenues,
expenses, and profit allocations are established, applied, and reported in
a manner consistent with its fiduciary responsibilities.
Source: IFSB. (2005). Guiding Principles of Risk Management for Institutions (Other than
Insurance Institutions) Offering Only Islamic Financial Services. Kuala Lumpur: IFSB: p. 26.

Operational Considerations in Operational Risk

Management
The IIFS must have an adequate system for the management of operational risks arising
from its business activities. This operational risk relates to Shari'ah non-compliance risk
and fiduciary risk.

With regards to Shari'ah non-compliance risk, the IIFS must ensure that total compliance
is maintained in all contracts, procedures, processes, and services in accordance with the
rulings of the Shari'ah board or advisor or as determined by the appropriate body in
' the jurisdiction within which they operate. Shari'ah compliance begins with contract
documentation and, after the implementation of contracts, there should be a Shari'ah
compliance review. This should be in the form of a Shari'ah audit to periodically
determine the level of compliance of the IIFS' activities with the Shari' ah.

Fiduciary risk can be more destructive, considering the relationship of an IIFS with its
fund providers. The interest of the fund providers must be protected at all times in all
business policies and investments. The fiduciary responsibilities of the IIFS towards the
fund providers must be reflected in the due diligence it applies in the management of
the investment funds.

~~ t~
LEARNING OBJECTIVE 10.3 Risk Management Mechanisms in
Examine the risk
management techniques
Islamic Banks
in Islamic banks and The risk management mechanisms or systems for Islamic banks and financial
how they can be avoided,
institutions are meant to mitigate, transfer, avoid, or absorb the risk in a particular
absorbed, or transferred.
business undertaking. Hence, the terms risk mitigation, risk transfer, risk avoidance/

387

---:-_~_-_~~~~~~- ~~~-~::'.;;;::---:::--~~~~~~~iiiiiiiiiii~~
risk-adjusted return on capital elimination, and risk absorption/management. There are two general mechanisms for
(RAROC) risk identification and management for Islamic banks and financial institutions. The
An adjustment to the return of
first mechanism is based on certain standard techniques that are consistent with the
an investment, which accounts
for the element of risk. This Shari'ah. These include techniques such as risk reporting, internal and external audits,
gives decision-makers the risk-adjusted return on capital (RAROC), and internal rating. One important technique,
ability to compare the returns known as gap analysis, determines the steps to be taken in moving from a current state
from different projects with
varying risk levels. to a desired future state. This tool helps companies compare actual performance with
potential performance. It is also called need-gap analysis, needs analysis, and needs
gap analysis
An accounting term that assessment.
means a technique for
The second mechanism comprises techniques that require adaptation and further
determining the steps to be
taken in moving from a current development to suit the requirements of Shari'ah compliance. The discussion here
state to a desired future state. focuses on the risk management techniques available for Islamic banks and financial
institutions. Figure 10,3 gives a graphic example of how the key risks in musharakah
mutanaqisah (diminishing partnership contract) are effectively managed.

Do you remember the

meaning and application Risk Avoidance
of musharakah
mutanaqisah? Risk avoidance is also known as risk elimination. It is a technique of risk management
that involves pre-emptive steps to remove moral hazards or risk-prone activities
risk avoidance through alternative activities. In financial businesses, it is most appropriate to set up
A technique of risk management strategic frameworks for risk avoidance. This is the best technique for risk mitigation.
which involvespre-emptive Most contractual terms in Islamic commercial transactions were legislated to avoid
steps to remove moral hazards
or risk-prone activities through instances of risks. Therefore, measures that promote risk avoidance start from the
alternative activities. contractual stage. All business-related documents must be standardized in line with the
requirements of the Shari'ah and endorsed by the Shari'ah board of an Tslamic bank. All
processes, procedures, and services rendered by the financial institution should also be
subject to the same approval to ensure that no stone is left unturned in the process of
standardizing the activities of the corporate entity. There are also some risks the bank
can reduce or totally eliminate through transfer or sale.

Risk avoidance or elimination techniques in Islamic banks include contractual risk

mitigation, where appropriate documentation of products and proper construction of
contractual terms are made. All elements of uncertainty (g hara r) and undue enrichment
through interest (riba) are excluded from the contract. When the counterparties bear
these in .rnind and prepare proper documentation in compliance with the Islamic
modes of finance, potential risks are avoided or totally eliminated at the contract stage.
A typical example of a risk control technique in an Islamic mode of finance contract
is the case of istisna' (manufacturing contract). The enforceability of qualitative
specifications stipulated by a party is always a problem. Muslim jurists have allowed
the counterparties to stipulate in the underlying contract that in the event of any
default in fulfilling the qualitative specifications, a penalty fee (band a/-jaza'a) will be
imposed. This penalty fee is meant to eliminate the risk associated with non-fulfillment
of the qualitative specifications in the istisna' contract and enhances the contract's
credit quality.

388
 TM: Full transfer T 0: Aquisition of
of Banking property by the
Institution's bank and customer
ownership to
customer Risk management
1 . Ensure comprehensive
agreement to cover the rights and
Risk management obligations under joint ownership
Provide appropriate
mechanism to 2. Proper assessment of customer
compensate the bank's credit profile and valuation of
loss of future income the property
arising from early
settlement Rate of Legal risk
return risk Enforceability of
Potential loss in contract and
future income recognition of
arising from early beneficial ownership
settlement under the law

Credit risk Market risk

Tn: Customer default T 0-T M: Lease rental
Non-payment Arising from the and transfer of
of rental by the fluctuation of market bank's ownership
customer price (in the case of
Risk management
transactions without
1. Incorporation of
wa'd)
purchase undertaking
(wa'd) as risk mitigant
(exit strategy) in the event
of default
Risk management
Pre-agreed rental price
2. Use of security instruments
based on financial
(charg~ on the underlying property)
market indicators
against the non-payment of rental

Source: IFSB, IDB, IRTI. (2010). Islamic Finance and Global Financial Stability. A report of the Task Force on Islamic
Finance and Global Financial Stability. Available at [Link]/ docs/[Link].

Risk Absorption
risk absorption
Risks that can neither be There are some risks that cannot be eliminated or transferred. Instead they must be
eliminated nor transferred absorbed or effectively managed by the financial institution. This is known as risk
but can be absorbed and absorption. Some risks are so complex that they cannot be easily separated from the
effectively managed by the
financial institution due to
assets of the bank and its investors. The financial institutions must accept such risks
their centrality in its business because they are central to their business. Remember the legal maxim on profit and
operations. risk given earlier in this chapter: entitlement to return is related to the liability of risk.

389
 Relating this maxim to risk absorption, the financial institution must decide from
inception to bear some risks while hoping to maximize profits. Credit risk and market
risk are the most prominent in this regard. In order to effectively absorb or manage
these risks, the financial institution should adopt the following techniques: collateral
(security against credit risk). guarantees (supplements collateral to avoid absorbing
credit risk), loan loss reserves, and allocating capital. We discuss these in the next
section of this chapter.

Risk Transfer
hedging Risk transfer involves the use of derivatives for hedging (a measure of investment to
A proactive measure of reduce instances of future risk arising from adverse price movements in the value of
investment purposefully
an asset). This also includes changing the borrowing terms and selling or buying of
directed at reducing instances
of future risk arising from financial claims. Although most conventional derivative instruments are not Shari'ah-
adverse price movements in the compliant, experts have developed alternatives that conform to the precepts of Shari'ah,
value of an asset.
These alternatives are discussed in the next section under Islamic swaps. In addition,
bay al-arbun forwards and futures include salam and commodity futures, currency forwards and
The deposit the buyer gives the
futures. Options include parallel contracts, such as bay al-arbun, which is the money
seller, on the understanding
that it will be part of the buying that the buyer gives the seller on the understanding that it will be part of the buying
price once the sale is finalized. price once the sale is finalized. In the event that the sale falls through the seller keeps this
bay al-tawrid initial amount. Another parallel contract is a continuous supply-purchase relationship
A continuous supply-purchase with a known but deferred price and object of sale, known as bay al-tawrid, with khiyar
relationship with a known but al-shart (an optional condition in a contract), or embedded options. These risk mitigation
deferred price and object of sale.
techniques will be discussed in the next section of this chapter.

LEARNING OBJECTIVE 10.4 Risk Mitigation Techniques in

Understand risk
management techniques
Islamic Finance
such as hedging through Risk mitigation techniques are, as we saw earlier, geared towards effectively managing
the use of the following the risks encountered in the business activities of the bank. Risk mitigation generally
derivatives: forwards,
includes risk absorption/management, risk transfer, and risk avoidance/elimination.
futures, and swaps based
on Shari'ah-compliant A number of techniques, which we identified in the previous section, are essential in
risk mitigation the risk mitigation strategy of Islamic banks. However, in this section, let us focus on
frameworks. risk mitigation techniques through hedging. Risks may be hedged through the use of
the following derivatives, forwards, futures, and swaps, subject to the restrictions of
the Shariah. A brief overview of each of these techniques with relevant examples will
give you an insight into how you can effectively mitigate risks in an Islamic bank. But
before addressing these techniques, it is important to understand the meaning of some
fundamental concepts used in risk mitigation within the framework of conventional
banking.

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 The Basics: Defining Derivatives
Derivatives are financial instruments or securities whose value or price depends upon
or is derived from the value of one or more underlying assets, or from the value of a
rate or index of asset value. Derivatives are generally used specifically as an instrument
to hedge risks. This is why they are considered to be financial instruments for trading
risks. They are also used for speculative purposes within the secondary market (a
•. Challenge financial market where previously issued securities such as bonds are bought and
sold). The most common types of derivatives are futures contracts, forward contracts,
Why are conventional
options, and swaps. These derivatives are contracts and can be structured in a way to
derivatives considered
to be non-Shari'ah- serve as underlying assets. A good understanding of derivatives is necessary for better
compliant? comprehension of the Islamic paradigm for risk mitigation using such derivatives that
are Shari'ah-compliant.

Forwards and Futures

forward contract
Forward contracts are derivatives involving a cash market transaction where the delivery
An informal contractual
transaction involving of the underlying asset is deferred to a future date. This is a non-standardized contract
derivatives where the delivery between counterparties. The parties agree on the price on the spot but the underlying
of the underlying asset is asset is delivered at a specified future time. The parties agree on the delivery price,which
deferred to a future date.
is the forward price at the time of entering into the contract. The parties agree the price
at the time of the contract and not at the future date of [Link] is why a forward
contract is generally regarded as a contract where the parties 'lock in' the price when
entering into the contract to avoid future fluctuations in the market. In essence, the price
is paid before delivery. For example, it is possible for a farmer to enter into a forward
contract with a bank where he locks in a price for his grain from the upcoming harvest.
Forward contracts can be used as derivative securities to hedge risks, especially those
associated with currency or exchange rate risks, as a means of speculation on future
fluctuations in the market value.
futures contract Futures contracts are similar to forward contracts but there are some differences
A standardized contractual
agreement between two parties
between the two. While forward contracts are non-standardized contracts, futures
to exchange a specified asset contracts are defined on standardization. Forward contracts are not exchange-traded,
with a known standardized while futures are exchange-traded derivatives. To this end, a futures contract is defined
quantity and quality at a price as a standardized contractual agreement between two parties to exchange a specified
agreed upon by the parties on
the spot while delivery is made asset with a known standardized quantity and quality at a price agreed upon by the
at a specifiedfuture date. parties on the spot while delivery is made at a specified future date. The price may be
known as the futures price or the strike price. The futures contract is traded on the floor
of a futures exchange, which is a centralized financial market where contracting parties
can trade standardized futures contracts.
For instance, a farmer who produces wheat in commercial quantity and who supplies a
biscuit factory with tonnes of wheat every season intends to secure the selling price of
wheat for the next crop season. At the same time, the biscuit company seeks to secure
its buying price of wheat for the next financial year to determine the exact quantity
of biscuits it can produce and the corresponding realizable profits. With these similar

391
Farmers can enter into a
forward contract with a
bank where the price for
grain is fixed for the season
prior to harvest.

objectives,the wheat farmer and the biscuit company may decide to enter into a futures
contract providing that in the next six months, 100 tonnes of wheat will be delivered to
the biscuit company at a price of US$3,500 per tonne. This futures contract secures the
price of wheat regardless of market fluctuations. This futures contract between the two
parties can be bought or sold in the futures market. That is, it is the contract instrument
that can be sold or bought and not the wheat. By entering into the futures contract,
the parties have hedged or prevented future market risks. Remember, just like forward
contracts, futures are used primarily by buyers and sellers in the futures market to
option hedge risk or speculate. A futures contract is more about hedging risks than exchanging
A financial derivative sold by the
option writer to an option holder physical commodities. This is why there are standardized contracts that may be traded
where there is the opportunity on the floor of the futures exchange.
to buy or sell a security at an
agreed price within a specified Options .
period of time.
An option is a financial derivative sold by the option writer to an option holder. That is,
call ( call option)
A financial contract between a
it is a contract whereby the buyer is given a right to buy (call) or sell (put) a security at an
buyer and the seller where the agreed price within a specified period of time. The buyer is only given the right and not
former is given the right but not an obligation, nor does the right constitute an obligation.
the obligation to buy an agreed
quantity of an underlying A call or call option is a financial contract between a buyer and the seller where the
commodity or financial former is given the right but not the obligation to buy an agreed quantity of an underlying
instrument from the seller of
commodity or financial instrument from the seller of the option at a particular time
the option at a particular time
and at a fixed price. and at a fixed price. The option remains with the buyer. Once they decide to buy the

392
 underlying asset through the exercise of the right, the seller is obligated to sell it at the
agreed price and within the specified period of time. However, for the buyer to be able to
exercise their right, they must pay a fee called a premium. For example, if an individual
has a call option that gives them the right to purchase the stock of ABC Company at a
price of US$8o in four months' time, they pay the premium of US$10 for the call to secure
the price. If, per chance, the price of the stock increases to US$100 on the maturity date,
the buyer has therefore recorded a net gain of US$10 on the investment of the initial
US$10. The net gain realized by the buyer is a loss on the part of the seller. The risk of the
buyer is only limited to the premium paid (in this example, US$10 ). In this case, the buyer
would want the stock to go up so that they can benefit from the price rise.
put (put option) A put or put option is a financial contract between a buyer and the seller where the
A financial contract between
holder has the right to sell, but not an obligation, at a specified period of time and at a
a buyer and the seller where
the buyer has the right to sell,
certain price. In this case, the buyer would want the stock to go down so that they can
but not an obligation, at a exercise the right. In relation to risk mitigation, put can be used to limit the risk of the
specified period of time and at seller's (writer's) portfolio. For example, the shares of ABC Company are trading at US$8o
a certain price.
at present. The price at which the put option can be exercised (the strike price) is US$5.
Stephen expects the shares of ABC Company to depreciate so he bought a contract of put
options of 100 shares from a seller. The premium Stephen paid is US$500 (a strike price of
US$5 x 100 shares). During the expiration of the put options, the shares of ABC Company
fell to US$70. Therefore, Stephen made US$1,ooo ([US$8o - US$70] x 100). The total net
profit made by Stephen in the put transaction is US$500 (US$1,ooo - US$500), so his risk
is only limited to the premium he paid.

Swaps
The term swap is derived from its lexical meaning, i.e. to exchange certain items. In
swap business terms, a swap can be defined as the exchange of one security for another for
A derivative contract where the mutual benefit of the parties. The counterparties exchange each other's financial
two parties exchange one
financial instrument for
instrument in order to enjoy the benefits of the other. This is a derivative where the parties
another for the mutual benefit swap the financial instruments. The benefits in question depend on the type of financial
of the parties. instruments swapped by the parties. In a case involving two firms seeking to engage in
swaps involving two bonds, they may agree on the periodic interest payments on those
bonds as the benefits being exchanged. The parties may swap currency, interest rates,
bonds, etc. Firms may engage in swaps to change the quality of issues, either as bonds
or stocks. They also engage in swaps because of a sudden change in their investment
objectives. This affords them the opportunity to benefit from each other's vantage point.
This may be in form of cash flow, where each of the parties exchanges their individual
cash flow streams for the other in order to mutually benefit from the exchange. The cash
flow streams are otherwise called the legs of swap. When they exchange the legs of
swap, the swap contract is concluded and they both stand to mutually benefit from each
other's stream of cash flows.

When counterparties enter into a swap agreement, the agreement must clearly stipulate
the way the cash flows are calculated and the dates they will be paid. The different types
of swaps include interest rate swaps, currency swaps, commodity swaps, equity swaps,

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 and credit default swaps. When pricing a swap, the 'fair fixed rate' is used. This means
the calculation of a fixed rate whereby the parties are indifferent whether the fixed rate
is fixed over time or fluctuates over time. In order to realize this, the value of the swap
is set at zero at inception. The value of the two expected cash flow streams must be
equal to each other to achieve this. Swaps are used to hedge certain risks. This includes
interest rate risk where the counterparties agree to exchange interest payments based
on a certain notional amount.
For example, ABC Bank and DEF Bank conclude a contract for an interest rate swap for
LIB OR one year based on a nominal value of US$100million. In exchange for a rate of LIBOR
(Londoninterbank offered rate) {Londoninterbank offered rate) plus 2 percent, ABC Bank offers DEF a fixed annual rate
The basic interest rate used in
of 5 percent. While the interest rate of ABC Bank is fixed, that of DEF Bank is floating
interbank lending, which is
common among the banks on and both parties intend to swap their respective interest rates. Meanwhile, it is assumed
the London market. that both parties have speculated the rate at which LIBOR will be trading at maturity
to be 4 percent. If, per chance, the LIBOR rate is trading at 5 percent by the end of the
year, DEF Bank is expected to pay 7 percent {5% + 2% of US$100million) to ABC Bank,
which is US$7 million. On the other hand, ABC Bank will pay 5 percent of US$100million,
which is US$5 million to DEF [Link] will notice a difference of US$2 million, which is
considered as the value of the swap transaction. Both parties initially speculated on the
rate of LIBOR. As the LIBOR rate was higher than initially contemplated by the parties,
ABC Bank has gained US$2 million while DEF Bank lost US$2 million. In this case, DEF
Bank only needs to pay the difference {US$2 million) to ABC Bank, and rather than both
banks paying the full amounts of US$5 million and US$7 million respectively.

Hedging
The concept of hedging in business investments is meant to reduce exposure to various
ris~s within the market environment. In simple terms, hedging may be likened to
insurance where a person protects themselves or their property from unexpected
death or destruction to the property as the case may be. In order to reduce the impact of
such a loss, they purchase an insurance [Link] same thing applies to the financial
investments. Portfolio managers, investors, and corporations use hedging to reduce
the potential effects of business risks on them. To this end, hedging can be defined as a
proactive measure of investment purposefully directed at reducing instances of future
risk arising from adverse price movements in the value of an asset. In the literal sense,
this is like insuring oneself against loss. The concept is best understood through this
comparison with the notion of insurance.

Approaches to Hedging
There are three approaches to hedging:
economic hedging
cooperative hedging
contractual hedging.
Economic hedging involves a strategic arrangement by the decision-makers in a
corporate entity to achieve the aim of hedging. This does not involve dealing with third

394
 parties or agents to achieve their purpose. It basically involves the diversification of the
investment of the corporate entity. This is a very important investment strategy, which
can be independent of or complementary to other hedging strategies.

Cooperative hedging involves a strategic partnership among market players to overcome

economic problems. This requires social interaction among the market players through
a partnership in investment activities. Economic problems are better solved through
cooperation and partnership rather than using for-profit business. Cooperative hedging
is similar to cooperative insurance, which involves risk-sharing and proper management
of the risk.

Contractual hedging involves contractual financial instruments, which are, in most cases,
for-profit instruments. The same financial instruments can be modified to accommodate
finance, risk management, and ownership together.

How to Hedge
Investors make use of complicated financial instruments otherwise known as derivatives
in order to hedge. In hedging, two prominent derivatives are used-options and futures.
These investment strategies allow the investor to offset a loss in one investment through
a gain in a [Link] makes it a risk mitigation technique for investors, particularly
those who have invested in the secondary market. Here is a simple example:
Jane owns shares in Immaculate Computer Corporation. In order to protect her
investment from likely short-term losses in the industry, Jane may buy a derivative
on the company in the form of a put option at a specified price (the strike price). This
gives her the right to sell her shares in the corporation at a specific price. If Jane's stock
price dips below the strike price, she can offset the losses by gains in the put option. The
strategy adopted by Jane to mitigate future risk is known as married put.
Th~ Islamic Perspective on Hedging
Hedging can be modified to suit the requirements of the Shari'ah. When the speculative
and gambling elements are removed from the process of hedging in conventional
practice, it may be adopted within the Shari'ah framework of investments. The majority
of Islamic finance experts have agreed that hedging is allowed in order to reduce risk
and protect investments provided the fundamental prohibitions in Islamic commercial
transactions are excluded. This is applicable if the sole purpose of hedging is to protect
against loss of value as a result of various factors such as currency fluctuation, etc. in the
transaction involving an underlying real asset. Market speculators are not allowed to
deliberately expose themselves to risk in order to gain profit from currency fluctuations.
That is tantamount to gambling because speculations that involveany type of derivative
have elements of gharar (uncertainty) and maysir (gambling), which invalidate them
totally from the Shari'ah perspective. Any futures, forwards, swaps, or options contracts
involving market speculation are not Shari'ah-cornpliant,
It should be borne in mind that in conventional hedging, speculation in derivatives is
often carried out to maximize profit rather than to facilitate business activity. This is
why it is not common to see the actual delivery of the underlying asset in the contract.
The speculative elements gradually creep in, which are prohibited in the Shariah.

395
 Forwards, Futures, Options, Swaps and Other Derivatives
from the Islamic Perspective
As the concept of hedging involvesthe use of the different types of derivatives to reduce
potential risks, this section examines the Islamic perspectives on the main derivatives
we discussed earlier.

Islamic Promissory Forward Contract

Islamic promissory forward An Islamic promissory forward contract (IPFC) is also used as a tool for risk management
contract {!PFC) in Islamic financial transactions where a binding promise (wa'ad) in Islamic law is used
A tool for risk management
where binding promise (wa'ad)
in structuring forward contracts for the purpose of hedging risks. !PFC is structured in a
in Islamic law is used in manner that reflects the concept of wa'ad (promise) in forward contracts. The concept
structuring forward contracts of wa'ad plays an important role in the evolution of derivatives in Islamic finance. Its
for the purpose of hedging risks. binding nature has been extended from murabahah transactions to other Islamic
finance structures. AAOIFI allows the extension of the enforceability of wa 'ad in currency
exchange transactions within the Islamic framework. As demonstrated in the Islamic
Finance in the News box, Shari'ah scholars have adapted the dynamics of conventional
derivatives in Shari'ah-compatible terms through the use of relevant Islamic finance
instruments.
When the Islamic forward contracts such as salam or murabahah are backed with a
promise, an !PFC is established. This is used for hedging risks associated with contracts
such as commodity murabahah. It is important to emphasize that conventional futures
in which payment and delivery of goods are postponed are not allowed under the
Shari'ah due to the presence of elements of qharar and riba.

Islamic Swap
Islamic swap Islamic swaps are different from the conventional swaps. An Islamic swap is a
A derivative contract where derivative contract where two parties exchange one financial instrument for another
two parties exchange one
financial instrument for
backed with an underlying asset and excluding all prohibitive elements under the
another backed with an Shari'ah for the mutual benefit of the parties. Apart from the exclusionary rules on all
underlying asset and excluding prohibited elements such as riba, qharar, and jahl (ignorance), the Islamic swaps are
all prohibitive elements under linked to asset-backed transactions such as ijarah, murabahah, bay' bithaman ajil, etc.
the Shari'ah for the mutual
benefit of the parties. The three main instruments of a Islamic swap have been structured in a manner that
complies with the precepts of the Shari'ah, They are FX swap, cross currency swap, and
profit rate swap.

Islamic FX swap Islamic Foreign Exchange Swap (Islamic FX Swap)

A contract that has been
designed as an Islamic hedging An Islamic FX swap is a contract that has been designed as an Islamichedging mechanism
mechanism to minimize to minimize the exposure of market participants to the volatile and fluctuating market
the exposure of market currency exchange rate. The Islamic FX swap functions like its conventional counterpart
participants to the volatile and
but there is a great deal of effort to maintain absolute Shari'ah compliance in the contract.
fluctuating market currency
exchange rate. The FX swap generally involvesthe exchange and re-exchange of foreign currency.

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 ...............................................................................................................................................................................................................................................

ISLAMIC FINANCE IN THE NEWS

...............................................................................................................................................................................................................................................

Islamic finance embraces derivatives

May4,2010

"J:'ew took notice outside certain coteries of specialist against an array of risks, Islamic banks have often been
C bankers and lawyers, but the launch of a 42-page prevented from doing the same, due to the reluctance
master documentation for derivatives that comply with of clerics to approve derivatives that could contravene
Muslim religious principles could have a far-reaching religious bans on interest, gambling, and unnecessary risk.
impact on the Islamic finance industry.
Many Shan'ah scholars have moderated their position in
The International Islamic Financial Market (IIFM), a recent years. While using Islamic derivatives to 'speculate'
Bahrain-based Islamic capital markets body, and the or enhance returns is forbidden, Shari'ah-compliant
International Swaps and Derivatives Association (ISDA) financial institutions are now allowed to hedge against
have for the past four years been working on standardized currency moves, credit exposures, interest rate movements,
documentation for derivative instruments that comply and even sukuk bonds through 'Islamic credit default
with Shari'ah, or Islamic law. swaps'.
On March 1 the two industry bodies finally presented their 'Blending Islamic principles with derivatives only started
'Tahawwut Master Agreement' and are now embarking four to five years ago, but a lot is going on now,' says
upon a series of workshops to encourage Islamic banks to Ms Uberoi. 'The recent turmoil has made many people
adopt its standardized documentation. in Islamic finance realize the value of risk management
If widely adopted, the new standards could encourage more tools. For the industry to develop further we need these
Islamic banks to hedge more of their risk, and thereby help products.'
the Islamic finance industry meet its potential, bankers say. Islamic investors are already able to mimic the effects of
Islamic institutions that operate across country borders- conventional derivatives by using a complex combination
such as Saudi Arabia's Al Rajhi Bank, which also operates of existing Islamic contracts and concepts.
in Malaysia-will benefit from easier currency hedging The most common products used are uia'ad, a type of
and all could gain from better risk management on credit unilateral promise, and murababab, comparable to a
exposures and interest rate movements. conventional 'sale and deferred payment' structure. But
The Tahawwut documentation has been drafted to products such as arbun and bay salam can also be used.
closely resemble existing standardized documentation for Arbun is similar to a conventional option, and bay salam
derivatives used widely in western markets, which was resembles forward contracts.
drafted by ISDA in 1992, according to Priya Uberoi, head However, the development of such instruments has been
oflslamic derivatives at Clifford Chance, who worked on piecemeal and fragmented, and each bank often uses its
the Islamic version for ISDA.
own structures and documentation, hampering their usage
The new SharI'ah-compliant master agreement should by increasing the complexity and cost. The potential for
therefore appeal to conventional banks with Islamic arms, Islamic derivatives is significant, particularly in the Middle
such as HSBC, Citigroup, and Standard Chartered. The East, where Islamic finance is relatively less developed
launch of the Shari'ah-compliant master agreement is than in Malaysia.
timely. The Islamic finance industry has continued to grow
'In theory, the potential market size is several billion
despite the financial crisis-to about US$950bn last year
dollars per annum of structured investment products
according to Moody's-but its increasing size and maturity
and hedging instruments, but we're barely scratching the
means that risk management is becoming more pressing.
surface today,' says Harris Irfan, head of Islamic products
While conventional banks can easily hedge themselves at Barclays Capital.

Source: Robin Wigglesworth,"Islamic finance embraces derivatives", Financial Times,May 4, 2010.

397
 There are two stages in the PX swaps. At the beginning, there is the foreign exchange
of monetary currencies and, at the expiry date, there is another exchange. This may be
differentiated from a PX forward contract, which is only a one-stage contract, i.e. it only
requires the initial exchange and that concludes the contract. For instance, suppose
that Bank Istithmar, a British bank intends to invest in Saudi Arabia, which results in an
initial conversion of £50 million to SAR 307.5 million in accordance with the current spot
price. One important step the parties would take at the beginning of the contract is to
agree on a future exchange rate, which is the exchange rate fixed by the parties for the
second stage of the contract regardless of market volatility or fluctuations in the value
of the currency. To this end, at the maturity date, the parties would convert the SAR back
to GBP based on the future exchange rate mutually agreed at the initial stage of the
contract, and not at the prevailing market rates. This swap is meant to avoid the effects
of market volatility with regard to currency fluctuations in the future.

Islamic cross currency swap

Islamic cross currency The Islamic cross currency swap (ICCS) is a bilateral contractual arrangement between
swap (ICSS) two parties to exchange a series of profit and/or principal payments denominated in one
A bilateralcontractual currency for another series of profit and/or payments denominated in another currency,
arrangementbetweentwo
partiesto exchangea series based on a notional principal amount, over an agreed period of time. This allows the
of profitand/or principal Islamic banks to hedge the interest and currency exchange risks of their investments in
paymentsdenominatedin one foreign-denominated assets. Through this arrangement, the parties are able to exchange
currencyfor anotherseries a series of profit-principled payments in one currency for another denominated in a
of profitand/or payments
denominatedin another different currency based on a notional principal amount over an agreed period of time.
currency, basedon a notional The underlying asset for these transactions is commodity murabahah. A mutually
principalamount,over an agreed commodity is used as the underlying asset to legitimize the transactions. The
agreedperiodof time. ICCS performs many functions, just like conventional cross currency swaps. It serves
as a tool for risk management, reduces the cost of raising resources, and helps identify
appropriate investment opportunities. Better asset-liability management is also derived
from ICCS when properly implemented.

Islamic profit rate swap

Islamic profit rate swap {IPRS) The Islamic profit rate swap (IPRS) is a bilateral contract to exchange profit rates
A bilateralcontractto between a fixed rate party and a floating rate party or vice versa. It is implemented
exchangeprofitrates between through a number of underlying contracts to trade certain assets based on the Islamic
a fixed rate party and a floating
rate party or vice versa. modes of contract. IPRS can be defined as a contract to exchange profit rates between
a fixed· rate party and a floating rate party or vice versa, implemented through the
fixed rate party
execution of a series of underlying contracts to trade certain assets under the Shari'ah
A party who intendsto swap
its fixed rate profitsin the principles of bay' and bay' bit ha man ajil. A fixed rate party is a party who intends to swap
profitswaparrangement. its fixed rate profits with a floating rate in the profit swap arrangement, while a floating
floating rate party rate party is a party who intends to swap its floating rate profits with a fixed rate in the
A party who intendsto swap profit swap arrangement.
its floatingrate profitsin the
profitswaparrangement. Funding rates are matched with the return rates of investment to have a healthy profit
rate swap. This provides a risk control mechanism for the Islamic :financialinstitutions,
which are also protected from fluctuating borrowing rates through the implementation

398
 of IPRS. This is a Shari'ah-compliant version of the interest rate swap. As Islamic financial
institutions cannot deal in transactions involving interest, IPRS serves as an appropriate
Shari'ah-compliant mechanism to reduce risk exposures.

A good example ofIPRS in practice is the Commerce International Merchant Bank (CIMB)
in Malaysia's Islamic profit rate swap, outlined in the Islamic Finance in Practice box.

CIMB Islamic Profit Rate Swap

CIMB Islamic entered into an agreement that owed by both CIMB and Islamic swap
allowed it to swap its profit rate obligation from counterparty to each other is offset.
fixed rate to floating rate. In order to legitimize the
4. The net difference,i.e. the fixed profit rate in Step 2,
transaction, the profit rate swapped must be of
is paid to Islamic swap counterparty by CIMB at
the same currency. In this case, the currency was
the agreed interval payment date of six months.
the Malaysian ringgit (RM). The transaction was
carried out in three distinct but related stages. The
transaction must have a tenor or what is generally Stage 2: Floating Profit Rate
called the maturity date. While the first two stages 1. CIMB sells asset to Islamic swap counterparty at
of the IPRS transaction involved a swap of fixed the notional principal of RM500,ooo + floating
profit rate between CIMB and the counterparty, profit rate.
the second stage involved the swap of the floating
2. Islamic swap counterparty sells asset to CIMB at
profit rate, respectively. The third stage involved
the notional principal of RM500,ooo.
the repetition of the floating profit rate swap every
six months to mitigate risks until the contractual 3. The notional principal amount of RM500,ooo
maturity date. owed by both CIMB and Islamic swap
counterparty to each other is offset.
There were three stages in CIMB's IPRS.
4. The net difference, i.e. the floating rate profit
Stage 1 : Fixed Profit Rate in Step 1, is paid to CIMB by the Islamic swap
counterparty at the agreed interval payment
1. CIMB sells asset to Islamic swap counterparty at
date of six months.
the notional principal of RM500,ooo.
2. Islamic swap counterparty sells asset to CIMB Stage 3: Determination of
at the notional principal of RM500,ooo + profit Subsequent Floating Rate
based on fixed profit rate.
The floating profit rate (Stage 2) is repeated every six
3. The notional principal amount of RM500,ooo months until maturity.
Source: Badlisyah Abdul Ghani. (24 June 2004). Islamic Profit Rate Swap-its Mechanics and Objectives. Seminar
on Derivatives in Islamic Finance. Kuala Lumpur, Malaysia.

399
A good example of
IPRS in practice is the
CIMB Islamic Profit Rate
Swap, which gave it the
opportunity to swap its
profit rate obligation from
fixed rate to floating rate.

Islamic Options
Islamic option Islamic option is a contract of promise to buy or sell an asset at a predetermined price
A contract of promise to buy or within a stipulated period of time. Within the framework of Islamic finance, these
sell an asset at a predetermined
price within a stipulated period
promises cannot be traded and no premium should be charged for such options. In
of time with the condition that Islamic jurisprudence, there is a reference to options in commercial transactions under
such options cannot be traded the doctrine of contractual stipulations (al-khiyarat). Reference to options is also found
in the financial market. in bay al-arbun, which is a transaction in which a buyer pays a deposit to secure the
underlying asset as well as the price at the time of concluding the contract. This is a kind
of risk management technique where the buyer tries to avoid or eliminates future market
volatility. However,it should be borne in mind that bay al-arbun is only permitted by the
Hanbali jurists (one of the four major schools of Islamic jurisprudence). The three other
doctrines do not allow it as they consider it a void contract. This influenced the ruling
of the ore International Islamic Fiqh Academy in 1992 when it held: "Option contracts
as currently applied in the world financial markets are a new type of contract which do
not come under any of Shari'ah denominated contracts. Sincethe subject of the contract
is neither a sum of money nor a utility nor a financial right, which may be waived, the
contract is not permissible in Shari'ah."?Therefore, Muslim scholars are not unanimous
with regards to the validity of options as a derivative for the purpose of hedging within
the Islamic financial market. As trading in options is prohibited by the resolution of the
ore Fiqh Academy, it therefore has a limited scope of utility in Islamic banks as a risk
management technique.

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 Review
Key Terms and Concepts
aleatory transactions (p. 369) Islamic profit rate swap (IPRS) (p. 398)
bay al-tawrid (p. 390) Islamic promissory forward contract
bay al-arbun (p. 390) (!PFC) (p. 396)
call (call option) (p. 392) Islamic swap (p. 396)
counterparty (p. 374) LIBOR (p. 394)
credit exposure (p. 374) liquidity risk (p. 381)
credit risk (p. 374) market risk (p. 379)
equity investment (p. 377) operational risk (p. 386)
equity investment risk (p. 377) option (p. 392)
fixed rate party (p. 398) put (put option) (p. 393)
floating rate party (p. 398) rate of return risk (p. 384)
foreign exchange contract (p. 380) restricted investment accounts (p. 379)
forward contract (p. 391) risk absorption (p. 389)
futures contract (p. 391) risk-adjusted return on capital
gap analysis (p. 388) (RAROC) (p. 388)
hedging (p. 390) risk avoidance (p. 388)
ijarah contract (p. 380) risk management (p. 369)
ijarah muntahia bittamlik (p. 380) sadd al-dhari'an (p. 370)
investment account holders (IAH) (p. 378) salam contract (p. 380)
Islamic cross currency swap (ICSS) (p. 398) swap (p. 393)
Islamic FX swap (p. 396) wadi'ah yad damanah (p. 371)
Islamic option (p. 400)

Summary
Learning Objective 10.1 1. The concept of risk management in Islamic finance is different from the conventional
practice of risk management. The unique characteristics of the Islamic framework
include the prohibition of gharar (uncertainties) and speculation, riba (interest) and )ah/
(ignorance) in risk mitigation techniques. Once these elements have been successfully
isolated from the conventional risk management framework, it becomes Shariah-
compliant and has the potential to be replicated in the Islamic finance industry.

Learning Objective 10.2 2. The basis of the IFSB guiding principles on risk management is to standardize the
Shariah risk mitigation techniques while considering adaptable guidelines of the Basel
Committee on Banking Supervision (BCBS). The IFSB guiding principles provide the
Shari' ah mitigation techniques to cater for the specificities of the Islamic finance industry.

Learning Objective 10.3 3. The most common risks in the Islamic banking industry as identified by IFSB-1 include
credit risk, equity investment risk, market risk, liquidity risk, rate of return risk, and
operational risk. These risks have specific features in the Islamic finance industry given
its unique nature. They can be measured and controlled through Sharl'ah-cornpliant risk
mitigation techniques.

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 4. Risk transferring techniques such as hedging through the use of derivatives have been
Learning Objective 10.4
adapted to suit the fundamental requirements of the Islamic finance industry. Forwards,
futures, and swaps that are based on Islamic modes of financing are now considered as
Shari'ah-compliant and can be used as tools for risk mitigation in the Islamic finance
industry.

Practice Questions and Activities

Practice Questions
1. Define risk and risk management. How are the two concepts related?
2. How can you distinguish between the main features of risk management in Islamic
finance from the conventional practice of risk management?
3. What is the relevance of the IFSB guiding principles on risk management for Islamic
financial institutions?
4. Are the guidelines of the Basel Committee on Banking Supervision on risk management
unsuitable for Islamic financial institutions?
5. Explain the six major risks faced by Islamic banks and financial institutions.
6. What are the appropriate risk mitigation strategies for the six major risks faced by
Islamic banks and financial institutions?
7. Explain the risk transferring techniques in the Islamic finance industry with special
reference to the use of derivatives as a tool for hedging risks?
8. What do you understand as the Islamic profit rate swap (IPRS)?

Activities
1. Prepare a io-minute presentation on the Islamic framework of risk management and its
relevance to the 2007-2009 global financial crisis.
2. Prepare a short summary for presentation on the six major risks faced by Islamic
financial institutions as given in the IFSB Guiding Principles of Risk Management for
Institutions (Other than Insurance Institutions) Offering Only Islamic Financial Services.
3. Identify an Islamic financial institution within your city and explain its framework for
risk management.

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Further Reading
Ahmed, H. and Khan, T. (2007). Risk Management in Islamic Banking. In M. Kabir Hassan
and Mervyn K. Lewis. Handbook of Islamic Banking (pp. 144-158). Cheltenham, United
Kingdom: Edward Elgar Publishing Limited.

Al-Amine, M.A. (2008). Risk Management in Islamic Finance: An analysis of derivatives

instruments in commodity markets (Brill's Arab and Islamic Laws series). Leiden & Boston:
Brill Academic Publishers.

Al-Suwailem, S. (2006). Hedging in Islamic Finance. Occasional Paper No. 10. Jeddah:
Islamic Development Bank.

Greuning, H. V. and Iqbal, Z. (2008). Risk Analysis for Islamic Banks. Washington, DC: The
International Bank for Reconstruction and Development/The World Bank.

IFSB. (2005). Guiding Principles of Risk Management for Institutions (Other than Insurance
Institutions) Offering only Islamic Financial Services. Kuala Lumpur: IFSB.

IFSB, IDB, IRTI. (2010). Islamic Finance and Global Financial Stability. A report of the Task
Force on Islamic Finance and Global Financial Stability. Available at [Link]/docs/
[Link].

Khan, T. and Ahmed, H. (2001). Risk Management: An Analysis of Issues in the Islamic
Financial Industry. Occasional Paper No. 5. Jeddah. IRTHDB.

Mahlknecht, M. (2009). Islamic Capital Markets and Risk Management Global Market
Trends and Issues. London: Risk Books.

Obaidullah, M. (2002). Islamic Risk Management: Towards Greater Ethics and Efficiency.
International Journal of Islamic Financial Services. Vol. 3, no. 4: 1-18.

Vogel, F. and Hayes, S. (1998). Islamic Law and Finance: Religion, Risk, and Return.
Netherlands: Kluwer Law International.

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