Vol. 7(37), pp.

3799-3809, 7 October, 2013

DOI: 10.5897/AJBM12.741
African Journal of Business Management
ISSN 1993-8233 © 2013 Academic Journals
http://www.academicjournals.org/AJBM

Full Length Research Paper

Risk management in Islamic banking

Nico P. Swartz
Department of Law, Faculty of Social Sciences, University of Botswana, Private Bag 00705, Gaborone. E-mail:
[email protected].
Accepted 20 February, 2012

Islamic banking and finance has become a US$100 billion industry and is estimated to grow at a rate of
15% per annum. The essential feature of Islamic banking is that it is interest-free. As a result of this, the
Islamic financial system is primarily equity-based. Islamic banks therefore conducts business on a
profit-/ loss-sharing principle. Under this arrangement, the provider of capital and the entrepreneur
share in the risks and rewards of a venture.i To remain competitive, it is important for Islamic banks to
find out what their risks are, control them, and monitor them routinely.ii The objective of this paper is to
overview the guidelines for risk management in Islamic banking. Issues related to the nature of risks
arising from the use of funds of Islamic financial institutions and their implications on the banking book
of Islamic financial institutions are also to be considered in this paper.

Key words: Islamic banking, conventional bank, Liquidity risk.

INTRODUCTION

This paper opted for an exploratory study on the issue of international banks are committed to offering a wide
risk management in Islamic banking law. The data is range of Islamic banking practices and services. The
based on secondary sources in terms of qualitative practice of Islamic banking spreads from East to West,
research, but has enabled the study to forward an from Indonesia and Malaysia towards Europe and
impressionistic account of the idea of risk management in America. Due to the successes of these operations,
Islamic banking. On account of this, the article demon- Islamic banking became a viable and robust alternative to
strates knowledge of the latest research-based (empi- commercial banking practices.1
rical) literature on the topic. It is clear that the article Islamic financial markets are, however, still in the infant
present a strong and theoretical framework within which stage of development. More work is needed in order to
the inquiry is located. better account, for example, for liquidity risk exposure,
The findings of this research have larger import, and Islamic banks still have to face other challenges.2
beyond the specific case or instance under investigation.
The objectives or hypotheses of this research are aiming
at academia, economists, bankers, financial advisors, EVOLVEMENT OF RISK CONCEPT/ INTRODUCTION
etc, in order to enable them to make positive contributions
(solutions) at policy level for financial contracts. Despite the growing interest in Islamic banking and
finance, Islamic financial markets are deficient in risk
3
management tools. This may be due to the strong focus
EVOLUTION OF ISLAMIC BANKING
1
Ruma and Yolla. Challenges in implementing capital adequacy guidelines to
Islamic banks were established under heterogeneous Islamic Banks. Journal of Banking Regulation (2007: 46 to59).
2
social and economic environments. They started as a Ariss and Sarieddine (2007: 58).
3
Janice How et al. Islamic Financing and Bank Risks: The Case of Malaysia.
small rural banking experiment in a remote village in Thunderbird International Business Review, January to February (2005: 75-
Egypt and has now reached a level where both local and 94).
3800 Afr. J. Bus. Manage.

of Islamic finance on short term finance.4 But banks and chance. Ibn Taymiyyah describes gharar as things
solely with Islamic financing have lower credit and liquid- with an unknown fate. Selling such things is maysir and
dity risk than their conventional counterpart. This situation gambling.9
5
can be ascribed in part to the profit-sharing principle. Risk, as understood by today’s economic professionals,
Islamic financial instruments are structured to produce a does not belong to this prohibition as it would render
profit instead of a fixed return (on investments). The every transaction unlawful. Risk in any transaction may
shareholder of a Shariah (Islamic law) fund shares the exist due to many reasons. It can be due to natural cau-
risk and rewards of the investment. In case of a loss, ses (e.g. good weather conditions or not), time allocation
shareholders will have to bear the loss on a pro rata outcome, and market outcome. The existence of all these
basis, unless it is due to management negligence or risks is inevitable to everyday transaction. As such, the
misconduct.6 existence of risk alone does not render a contract invalid.
The paper tries to avail guidelines for risk management On the other hand, however, the existence of the
in Islamic banking. Issues related to the nature of risks elements of gharar, is de facto rendering a contract
arising from the use of funds of Islamic financial insti- invalid.10
tutions and their implications on the banking book of Risk is something that is beyond our control, while
11
Islamic financial institutions are also to be considered. gharar is within our reach and control.

THE MEANING OF RIKS IN ISLAM ECONOMICS RISK AND ISLAMIC LAW

It will be useful to clarify the meaning of two terms: risk Islamic bank’s activities differ in substance and in form
and gharar (uncertainty). Obviously, there is no clear from those of conventional bank’s and they therefore face
distinction between the two. Although some writers a different risk profile. Islamic banks have to own different
translate gharar as risk, the term in Arabic that describes assets before they can sell them to clients in need of
the risk best is khatar. Risk refers to the events that can financing, in order to be compliant with the Shariah rule
be associated with given probability while uncertainty that “one cannot sell what one does not own.” 12 This
refers to the events for which probability assessment is exposes the majority of Islamic banks’ transaction to
not possible. price risk resulting from the acquisition of various assets
The Oxford Dictionary of Economics defines risk as “[the] which in turn introduces a new risk dimension to the
fact that the results of any action are not certain, but may banking book of Islamic banks.
take more than one value. Risk is usually used to Islamic banks have been more resilient to the financial
describe the form of uncertainty where, while the actual crisis than their conventional counterparts, because all
outcome of an action is not known, it is expected that it transactions have to be backed by a tangible asset,
will be determined as the result of a random drawing from which means that Islamic banks tend to have more
a set of possible outcomes whose distribution is known.”7 collateral than their conventional counterparts.13
Ibn Taymiyyah (728H-1328G) defined risk (khatar) as One aspect that is associated with the tremendous
follows: “Risk falls into two categories: commercial risk, growth of the Islamic Banking and Finance is the risk
where one would buy a commodity in order to sell it for factor where disputes are always anticipated. Whereas
profit, and rely on Allah for that. This risk is necessary for Islamic banks, as already mention, are different from
merchants […] and although one might lose sometimes conventional banks in their form of financial inter-
this is the nature of trade. The other type of risk is that of mediation, financial instruments, and structure of financial
gambling, which implies eating people’s wealth for statements. These institutions are nevertheless subject to
nothing. This is the type that Allah and His Messenger a similar framework for analyzing their risk and expo-
(pbuh) have prohibited.”8 sures. As these principles and procedures for measuring
Looking into the technical meaning of gharar we will see and controlling risk are similar, so the analytical
14
that there is a slight difference between risk and gharar. framework for assessing risk should be similar as well.
The literal meaning of gharar is danger, deception, The practice of bank supervisors continues to evolve.
illusion, and conceit that is derived from the Arabic verb This evolution is necessary in part to meet the challenges
gharra, which means to deceive, to delude, and to of innovation and new developments and in part to
mislead. In broad terms, it refers to uncertainty, hazard accommodate the broader convergence of international
supervisory standards and practices. Supervisory tools
4
How et al. (2005: 89).
5
How et al. (2005: 88).
6
Standard and Poor’s. (2010). Islamic Finance Outlook. The McGraw Hill 9
Dusuki (2009) 545..
10
Companies: 37. Dusuki (2009) 546.
7
Black, J. (Ed.) Oxford Dictionary of Economics (2 nd ed.) (2003). 11
Dusuki (2009) 546..
12
Asyraf W.D. Dusuki & Edib Smolo Islamic Hedging: Rationale, Necessity, and Ariss & Sarieddine (2007): 52.
13
Challenges (2009) at 545. Standard & Poor (2010) 40.
8 14
Dusuki (2009) 545. H. Van Greuning The World Bank (2008) at 72.
 Swartz 3801

for assessing a bank’s condition are: liquidity, adequacy bank’s ability to minimize credit risk is the source of its
of capital, quality of the investment portfolio, extent of profitability. With Islamic banks, lending is replaced with
insider and connected lending, size of exposures and an investments and partnerships. 20 But Islamic banks are
open foreign exchange positions. These measures, how- not exonerated from risks, they have special credit risks,
ever useful, are in themselves not an adequate indication such as murabaha transactions, bay’ al-salam or istisna
of the risk profile of a bank and the stability of its financial contracts and mudarabah investments.
condition, or its prospects. 15 In the case of murabaha, Islamic banks are exposed to
The central technique for analyzing financial risk is the credit risks when the banks deliver the asset to the client
detailed review of a bank’s balance sheet. It underscores but do not receive payment from the client in time. In bay’
the relevant institutional aspects, such as the quality and al-salam or istisna contracts, the bank is exposed to the
style of corporate governance and management, the ade- risk of failure to supply on time or to supply not at all.
quacy, completeness, and consistency of a bank’s poli- With mudaraba investments, Islamic banks are exposed
cies and procedures. The composition of a bank’s balance to an enhanced credit risk on the amounts advanced to
sheet is normally a result of risk management decisions.16 the mudarib (agent). The bank is not in a position to know
A profit without assuming a certain risk and/ or obli- and decide how the activities of the mudarib can be
gation is non-halal, according to the well-known legal monitored accurately. The risk is present in markets
maxim “al-kharaj bi al-daman,” and is deemed tanta- where information asymmetry is high and there is low
mount to riba. On the other hand, however, excessive transparency in financial disclosure by the mudarib.21
risk renders a contract, and therefore the profit resulting Credit risk management for Islamic banks is further
from that contract, tantamount to the sale of gharar and complicated by the fact that these institutions are
as such is prohibited.17 prohibited from charging any accrued interest or imposing
any penalty. This can be misused by clients who may
delay the payment, since they know that the bank will not
KEY RISKS EXISTING WITHIN THE ISLAMIC charge any extra charge or payment.
ECONOMY Credit risk can incur bank insolvency, which in turn may
adversely affect a bank’s growth prospects and its
A financial institution was for two to three decades, competitive ability.22 Weak credit risk management
primarily faced with credit and market risks only. Today’s practices and poor credit quality continue to be a
financial institution is exposed to a whole array of new dominant cause of bank failures and banking crises
risks. Several factors are responsible for this changed worldwide.23 Credit risk is, for example, high under
set-up. They are: increased market volatility, financial mudaraba and musharaka, because the entrepreneur
innovations, shift in banking business, increased com- (obligor) does not provide sufficient information to the
petition and the regulatory environment.18 financier on the actual profit of the bank. This is known
Risks are grouped into four broad categories: financial, as “capital impairment risk” as the entrepreneur has no
business, treasury and governance risks. contractual obligation towards the financier.24
Credit risks depend on the type of Islamic financing
structure in place. From the financing structures such as
Financial risk murabaha (markup-based), mudaraba, musharaka, ijara
and bay’al-salam, murabaha carries the lowest risk. Islam
Financial risks are the exposures that result in a direct finance is therefore associated with lower credit risk. The
financial loss to the assets or the liabilities of a bank. assets of Islamic banks are predominantly of a debt
Islamic financial institutions are also exposed to credit nature resulting from sale-based financing while their
and market risks.19 deposits are on a mudaraba (profit-sharing basis). This
enables Islamic banks to shift the risk of debt default to
investment depositors. This principle of profit-sharing
25
Credit risk offers a cushion for bankers at times of recession.

Under credit risk a counter party will fail to make pay-

ments on its obligations in accordance with the agreed Market risk
terms. Conventional banking business based on lending
operations is considered a credit risk business since the Market risk arises from unfavorable price movements

15 20
Van Greuning (2008) 73. Iqbal & Mirakhor (2007) 229-231.
16 21
Van Greuning (2008) 82. Iqbal & Mirakhor (2007) 231.
17 22
Dusuki (2009) 546. How et al (2005) 78.
18 23
Iqbal, Zamir & Mirakhor Abbas. 2007. An Introduction to Islamic Finance: Ariffin (2009) 160.
24
Theory and Practice: 227-8 Ariffin (2009) 155.
19 25
Iqbal & Mirakhor (2007) 229. How et al (2005) 79.
3802 Afr. J. Bus. Manage.

such as yields (rate of return risk), benchmark rates Conventional commercial banks operate on interest-
(interest rate risk), foreign exchange risk (FX risk), equity based fixed income securities on the assets side, there is
and commodity prices (price risk). Islamic banks are less uncertainty in the rate of return earned on their
exposed to market risk because of the volatility in the investments, while Islamic banks have a mix of mark-up
values of tradable, marketable or leasable assets. based and equity-based investments, which have a
Market risk encompasses different risk factors such as higher uncertainty. Furthermore, the return on deposits in
mark-up risk, price risk, leased asset value risk and conventional banks is pre-determined, whereas the
equity investment risk. Under mark-up risk, Islamic returns on deposits in Islamic banks are expected but not
28
banks, murabaha and other trade-financing instruments pre-agreed.
are fixed for the duration of the contract while the Two sub-categories of the rate of return risks are
benchmark rate may change. With regard to price risk (in displaced by commercial risk and withdrawal risk. The
the case of bay’ al-salam) Islamic banks are exposed to former is the risk when an Islamic bank is under pressure
commodity price volatility during the period between the for paying its investment depositors a rate of return
delivery of the commodity and the sale of the commodity higher than what should be payable under the “actual”
at prevailing market price. terms of the investment contract.
In the case of an operating ijara, the bank is exposed to To mitigate the displaced commercial risk, Islamic
market risk due to a reduction in the residual value of the banks may decide to waive their portion of profits in order
leased asset at the expiry of the lease term or in the case to retain their deposits and thus dissuade the depositors
of early termination due to default, over the life of the from withdrawing their funds. With regard to the second,
contract. With an increasing market for Islamic bonds Islamic banks could be exposed to the risk of withdrawals
(sukuk), Islamic banks invest a portion of their assets in by its depositors as a result of a lower rate of return.
marketable securities (sukuk). However, the prices of Such competition may come from other Islamic banks or
such marketable securities are exposed to current yields. from conventional banks with Islamic windows.29
Similar to a fixed-income security, the prices go down
as yields go up and vice-versa. Islamic banks holding
such securities will be exposed to volatility in yields, Treasury risks
unless they hold the security till maturity. The secondary
market for such securities may not be very liquid and Treasury risks arise from the management of the financial
therefore Islamic banks are exposed to distorted prices in resources of the financial institutions in terms of cash
an illiquid market. management, equity management, short-term liquidity
Equity investment risk includes partnership-based management and asset liabilities management. They
mudaraba and musharaka investments. This risk is (treasury risks) are liquidity, assets and liability manage-
somewhat unique to Islamic financial institutions, consi- ment and hedging risks.30 In terms of liquidity risk (as it
dering that conventional commercial banks do not invest applies to Islamic banks), a lack of liquidity constrains the
on the basis of equity-based assets. Equity investments financial institutions by illiquid assets and it unable the
can lead to volatility in the financial institution’s earnings institution to meets its liabilities and financial obligations.
due to liquidity, credit, and market risks associated with Unlike conventional banks, Islamic banks do not have
equity holdings.26 access to borrow or raise funds at reasonable cost, when
needed.
Lack of liquidity adversely affects the bank’s ability to
Business risks manage portfolios. The prohibition by Shariah law from
borrowing on the basis of interest has restricted Islamic
Business risks are associated with a bank’s business bank’s options to efficiently manage their liquidity
environment, including macro-economic and policy positions. Access to short-term borrowing, it is vital for
concerns, legal and regulatory factors and the overall meeting a financial institutions short-term cash flow
financial sector infrastructure such as payment systems needs. The previous factors have raised Islamic bank’s
and the auditing profession. While Islamic financial exposure to liquidity risk, and have adversely affected
institutions are exposed to the regular business environ- their profitability by limiting their ability to invest their
ment, for example solvency and financial sector infra- capital in long-term and illiquid but more profitable
structure risks, they are particularly exposed to one assets. 31
specific business risk, namely the rate of return risk. The Assets liabilities management risk results from the
rate of return risk stems from the uncertainty in the difference in maturity terms and the conditions of a
returns earned by Islamic banks on their assets. This bank’s portfolio on its assets and liabilities sides. Islamic
uncertainty can cause a divergence from the expectations
investment account holders have on the liabilities side.27 28
Iqbal & Mirakhor (2007) 236.
29
Iqbal & Mirakhor (2007) 236-8.
26 30
Iqbal & Mirakhor (2007) 233-4. Iqbal & Mirakhor (2007) 238.
27 31
Iqbal & Mirakhor (2007) 235-6. Iqbal & Mirakhor (2007) 240.
 Swartz 3803

banks are less exposed to assets and liabilities mis- With regard to transparency risk, a lack of transparency
matches. This advantage is rooted in the “pass-through” creates the risk of incurring losses due to bad decisions
nature of Islamic banks which act as agents for investors/ based on incomplete or inaccurate information. Islamic
depositors and all profits and losses are passed through banks are exposed to transparency risk due to the
to the investors/depositors. Depositors in the conven- practice of non-standard accounting and financial repor-
tional system have a fixed claim on the returns to the ting of Islamic financial instruments, which are different
bank’s assets as they get paid, a pre-determined interest from conventional instruments and therefore require
rate in addition to guaranteed principal irrespective of the different conventions of reporting to truly reflect the
bank’s profitability on its assets side. Holders of profit- financial picture.37 Shariah risk is of two types: the first is
sharing investments accounts in the Islamic system share due to non-standard practices in respect of different
in the bank’s profits and losses alongside the share- contracts in different jurisdictions and the second is due
holders and hence are exposed to the risk of losing all or to failure to comply with Shariah rules. Different adoption
part of their initial investment. The risk-sharing and pass- of Shariah rules sometimes result in differences in finan-
through features are not fully followed, which in turn cial reporting. For instance, while some Shariah scholars
creates unwanted assets and liabilities mismatch risks. consider the terms of a murabaha or istisna contract to
The practice of distributions of profits even if there are no be binding on the buyer, others argue that the buyer has
or low profits creates distortions and put strains on the the option to decline even after placing an order and
equity shareholders (capital providers).32 Under hedging paying the commitment fee. The nature of the relation-
risk, the bank’s overall risk exposure is enhanced by the ship between the bank and the investors/depositors is not
failure to mitigate and management different types of only of an agent and principal, but it is also based on an
risks.33 implicit trust between the two that the agent will respect
the desires of the principal to fully comply with the
Shariah.
Governance risks Breaching the trust and confidence of investors/
depositors can lead to dire consequences, including
Governance risk refers to the risk arising from a failure in withdrawal and insolvency risk. The bank should there-
governing the institution. Banks are unable to enforce fore, give high priority to ensuring transparency in com-
their contracts. Types of governance risks are operational pliance with the Shariah and take necessary actions to
risk, fiduciary risk, transparency risk, Shariah risk and avoid any non-compliance.38
reputation risk.34 Operational risk is the risk of loss Although fiduciary and Shariah risks stems from
resulting from the inadequacy or failure of internal negligence and non-compliance, reputation risk is a
processes. It includes the risk of failure of technology and reflection of irresponsible behavior by a single institution
systems and analytical models. People risk is another which can taint the reputation of other Islamic banks in
type of operational risk arising from incompetence or the industry. Negative publicity can have a significant
fraud, which exposes Islamic banks to potential losses. 35 impact on an institution’s market share, profitability and
Fiduciary risk is the risk that arises from an institution’s liquidity.
failure to perform in accordance with explicit and implicit The Islamic financial services industry is a relatively
standards applicable to its fiduciary responsibilities. young industry and a single case of failed institution can
Fiduciary risk leads to the risk of facing legal recourse have a bad name to all others who may not be engaged
action in a situation where the bank breaches its fiduciary in any such irresponsible behavior.39
responsibility toward depositors and shareholders.
Fiduciary risk can lead to dire consequences for a bank.
First, it can cause reputation risk creating panic among RISK MANAGEMENT FRAMEWORK
depositors, who may decide to withdraw their funds.
Secondly, legal recourse may lead to charging the bank a Risk management practices
penalty or compensation which can result in a financial
loss. Thirdly, it can impact negatively on the market price Good corporate governance
of shareholder’s equity. Fourthly, it may lead to insol-
vency if the bank is unable to meet the demands of the The activities of Islamic banks and banking may affect
current and investment account holders.36 the welfare of more than 20% of the world’s population,
mostly concentrated in developing countries, and their
32
Iqbal & Mirakhor (2007): 242.
corporate governance arrangements matter for economic
33
Iqbal & Mirakhor (2007) 242. development. Sound corporate governance can create an
34
Iqbal & Mirakhor (2007) 243-6. enabling environment, which rewards banking efficiency,
35
Iqbal & Mirakhor (2007) 243. An internal control problem cost the Dubai
Islamic Bank US$50 million in 1998 when a bank official did not conform to
the bank’s credit terms. This also resulted in a run on its deposits of US$138 37
Iqbal & Mirakhor (2007) 244-5.
million, representing 7% of the bank’s total deposits, in just one day. 38
Iqbal & Mirakhor (2007) 245.
36 39
Iqbal & Mirakhor (2007) 244. Iqbal & Mirakhor (2007) 246.
3804 Afr. J. Bus. Manage.

mitigates financial risks, and increases systemic stability. accorded the necessary visibility and leverage within the
Good corporate governance tends to lower the cost of bank and relevant risk management concerns and
capital, as it conveys a sense of lower risk that translates parameters for decision making on the operational level
into shareholder’s readiness to accept lower returns. should be incorporated for all relevant businesses and
43
Good corporate governance reduces the risks of conta- functional processes.
gion from financial distress. 40 Traditionally, banks have seen the management of
Corporate governance relates to the manner in which credit risk as their most important task. Awareness has
the business of the bank is governed, including setting developed of the critical need to manage exposure to
corporate objectives and the bank’s risk profile, aligning other operational and financial risks as well. In order to
corporate activities and behaviors with the expectation survive in a market-oriented environment, banks must be
that the management will operate in a safe and sound able to manage financial risk. Supervisory authorities
manner, running day-to-day operations within an esta- assess whether the bank is viable, meets its regulatory
blished risk profile, while protecting the interests of requirements, and is capable of fulfilling its financial
depositors and other stakeholders. commitments to depositors and other creditors. They also
While Islamic scholars argue that Islamic corporate verify whether or not the bank’s operations are likely to
governance induces ethical behavior and is immune to jeopardize the safety of the banking system as a whole.44
the flaws of conventional banking, Islamic banks and The bank’s risk management processes involves the
banking are no less prone than conventional banks to assessment and management of credit, market and
suffer breaches of fiduciary responsibility or the conse- operational risks. The basic principles of the bank’s risk
quences of asymmetric information.41 management policies are to: ensure risk assessment and
monitoring are strictly independent from the business
lines; adhere to a strict definition of limits/restrictions on
Bank supervision balance sheet items and ensure risks are continually
monitored.45
On the one hand, in the context of recession, volatile The primary role of bank regulators and supervisors is
interest rates and inflation during the late 1970’s and to facilitate the process of risk management and to
early 1980’s, the management of both assets and liabi- enhance and monitor the statutory framework in which it
lities became necessary in order to maintain satisfactory is undertaken. Bank supervision is sometimes applied
margin performance. Balance-sheet management be- incorrectly as a legal or administrative function focused
came more complex as a result of deregulation in the largely on regulations related to the business of banking.
1980’s. On the other hand, in the 1990’s an increase in Such regulations are often prescriptive in nature and
and engagement of liabilities underscored the need for impose onerous requirements on banks, which seek to
competitive pricing in a manner that maximizes spreads circumvent them by developing innovative products.46
between costs and yields on investment and controls Central banks have a mission to maintain a stable
exposure to related risks. Due to the inverse relationship currency and economy. Three interrelated functions are
of these two goals, a balancing act between maximizing critical to monetary stability: the implementation of
the spreads and controlling risk exposures has become a monetary policy, the supervision of banks, and the
focal point in the financial management, regulation and monitoring of the payment system. All three functions
42
supervision of banks. must take place to ensure stability. For this reason
In the case of Islamic banks, attention must be paid to banking supervision cannot be divorced from the wider
the contractual role of the bank concerned, when mission of monetary authorities. Although the attention of
analyzing the risks inherent in the bank’s assets and central banking policy focuses on the macro-economic
liabilities. Decisions must be made regarding the aspect of general equilibrium and price stability, micro
acceptable degree of risk exposure. The responsibility of considerations regarding the liquidity and solvency of
47
various aspects of risk management must be assigned, individual banks are key to attaining stability.
the effectiveness of risk management process must be
assessed and the execution of responsibilities must be
ensured. Effective risk management requires a formal Supervisory authorities
process. In developing economies, especially those in
transition, unstable, economically volatile, and shallow Supervisory authorities assess whether the bank is
market environments significantly expand the range and viable, meets its regulatory requirements, and is capable
magnitude of exposure to financial risk. Effective risk of fulfilling its financial commitments to depositors and
management includes: the risk management function
should be on par with other major functions and be
43
Van Greuning (2008: 66 to 67).
44
Van Greuning (2008: 68).
40 45
Van Greuning (2008) 31. Prospectus (2009: 70).
41 46
Van Greuning (2008) 31. Van Greuning (2008: 32).
42 47
Van Greuning (2008) 89. Van Greuning (2008: 70).
 Swartz 3805

creditors. They also verify whether or not the bank’s ope- traditional instruments, which do not satisfy the needs of
rations are likely to jeopardize the safety of the banking the market fully in terms of liquidity as well as risk and
system as a whole. Financial statements provide a true portfolio management. With regard to the absence of
and fair view of the bank’s actual condition. liquidity, Islamic financial institutions cannot easily ex-
Banks are normally required to undergo an external pand portfolios across capital markets and are restricted
audit that involves at least year-and financial statements in opportunities for portfolio diversification.50
and that is considered satisfactory to supervisory autho- Risk can effectively be managed by the application of
rities. The financial viability and institutional weaknesses financial engineering. Financial engineering dictates that
of a bank are also evaluated through financial assess- firms in the Islamic financial markets will lose their
ments, extended portfolio reviews, or limited assurance business competitiveness due to its inability to handle
reviews. Such evaluations often occur when a third-party variability in cost, revenues and profitability. A firm
evaluates credit risk that the bank poses, for example in without active risk management will be perceived as a
the context of the following: high risk firm and will be exposed to a higher risk during a
system-wide financial crisis.51
1. Participation in a credit-line operation of an Currency swaps are popular applications of financial
international lending agency or receipt of a credit line or engineering. It entails the raising of capital at favorable
loan from a foreign bank; rates and then the agreement with another party to ex-
2. Establishment of correspondent banking relationships change cash flows according to a pre-determined sche-
or access to international markets; dule for cash flows in another currency. A currency swap
3. Equity investment by an international lending agency, can help an institution reduce its exposure to a particular
private investors or foreign banks; currency by allowing it to swap existing assets or
4. Inclusion in a bank rehabilitation program.48 liabilities for more desirable ones. With currency swaps,
financial institutions can manage currency exposure and
In addition to effective management and supervision, also achieve better asset/liability management, which can
sound and sustainable macroeconomic policies and a reduce financial risk.
well-developed and consistent legal framework are Currency swaps are currently not practiced in Islamic
needed. Adequate financial sector infrastructure, effective financial markets. To construct a currency swap, which
market discipline, and sufficient banking sector safety may be acceptable in the Islamic financial market, two
nets are crucial.49 methods need to be involve, a partnership with a financial
The goal of financial risk management is to maximize intermediary and an exchange of sukuk proceeds. 52 With
the value of a bank. Since risk is inherent in banking and regard to the former, the financial intermediary becomes
unavoidable, the task of the risk manager is to manage a partner in the assets of each financial institution and the
the different types of risk at acceptable levels and cash flows are fully backed by the cash flows on each
sustainable profitability. Doing so requires the continual underlying asset. The financial intermediary backs each
identification, quantification, and monitoring of risk ex- agreement with a real asset in addition to underwriting
posures, which in turn demands sound policies, adequate the credit risk. With respect to the latter, Islamic bonds
organization, efficient processes, skilled analysts, and an (sukuk) are similar to conventional bonds in terms of
elaborate computerized information system. In addition, payoffs, and a currency swap can therefore be con-
53
risk management requires the capacity to anticipate structed by utilizing the structure of sukuk.
change and to act in such a way that a bank’s business Considering the importance of financial engineering,
can be structured and restructured to profit from the Islamic financial institutions should think about making
changes or at least to minimize losses. joint efforts to develop the basic infrastructure for intro-
Regulatory authorities should not prescribe how ducing new products. A good example of such collective
businesses are conducted; instead they should maintain effort could be to sponsor research in the area of the
prudent oversight of a bank by evaluating the risk development of analytical models, computer systems and
composition of its assets and by insisting that an tools to analyze the risk and return on different Shariah-
adequate amount of capital and reserves is available to compatible instruments. Islamic financial institutions can
safeguard solvency. benefit from more experienced western institutions in
terms of the engineering and marketing of products to the
clients. Conventional banks can work for or with Islamic
Financial engineering financial institutions to develop products according to the
requirements specified by Islamic financial institutions.
Financial engineering is critical for Islamic risk manage- Once a financial engineering shop is set, it can be used
ment practices. According to Zamir Iqbal and Abbas
Mirakhor Islamic financial institutions are operating on 50
Iqbal and Mirakhor (2007: 204).
51
Iqbal and Mirakhor (2007: 205).
48 52
Van Greuning (2008) 68. Iqbal and Mirakhor (2007: 215).
49 53
Van Greuning (2008) 71. Iqbal and Mirakhor (2007: 217).
3806 Afr. J. Bus. Manage.

to develop different products of different risk and return management in Islamic financial institutions. The docu-
profiles. Islamic institutions must on the basis of this, try ment represents an important milestone in harmonizing
to develop synergies and make collaborative efforts with and standardizing the risk exposure of Islamic financial
59
conventional institutions. institutions.

Islamic financial services board RISK MITIGATING FACTORS

The Accounting and Auditing Organization for Islamic Banks must take action to mitigate risks. The division of
Financial Institutions (AAOIFI) was the first initiative to responsibilities for these actions between the public and
address the risks faced by Islamic banks. Followed by the private sectors will depend on the nature of the risk
Islamic Financial Services Board (IFSB) in 2002; these and the capacity of firms individually, to improve their risk
two entities serve also as a regulatory framework for preparedness. One important action that might arise from
Islamic banks.54 the risk assessment approach is: the further exploration
The general objective of the IFSB is “promoting, sprea- of gabs in understanding the significance of different
ding and harmonizing best practices in the regulation and risks. Actions to address gaps might involve exploration
supervision of the Islamic financial services industry.”55 or gathering of new data. Risk can be mitigated by
The IFSB serves as an international standard setting engaging in discussions with market participants and
body of regulatory and supervisory agencies that have an research must be done to improve modeling techniques.
interest in ensuring the reliability and stability of the Another risk mitigating action, is stress testing. It is
Islamic financial services industry. It also aims at standar- difficult for individual firms to judge how financial market
dizing Islamic banking practices in identifying risks in liquidity might behave in times of stress, since that
Shariah-compliant products and services and in assigning requires an understanding of the behavioral response to
risk weights that meet internationally acceptable pru- other firms. A third potential action lies in the field of
dential standards. The IFSB like the AAOIFI serves to prudential policy, for example, in the design of standards
complement the Basel Committee on Banking Super- for capital and liquidity requirements. Typically, these
vision’s guidelines in order to cater to the specificities of standards are not targeted at specific vulnerabilities, but
Islamic financial institutions. While the AAOIFI focuses rather at ensuring that individual firms hold adequate
on the sources of funds of an Islamic bank, the IFSB buffers to cushion the effects of a range of potential
goes a step further by considering the uses of funds and disturbances. These regulatory rules are the respon-
assigning appropriate risk weights to each asset item.56 sibility of the Financial Stability Report, but the bank has
In the risk-sharing scheme of AAIOFI investment a role in advising on regulatory design when this has
account holders share part of the risk with shareholders. systemic risk implications.
The rationale is that investment depositors can withdraw Finally, the mapping of vulnerability channels can help
their funds upon maturity and reduce the sources of in devising effective crisis management plans. Under-
funds available to the bank, but the equity base remains standing the potential shape of future crisis can help in
unchanged when shareholders “withdraw their funds” by the identification of data required to assess the systemic
selling their shares to other investors.57 impact of such crisis and in the formulation and testing of
60
Proposals for risk management of Islamic banks procedures for their management.
suggested by Ariss and Sarieddine are: to treat Islamic These four elements; detection of key vulnerabilities,
banks for regulatory purposes as mutual funds; the mapping of risk transmission channels, quantification of
second proposal is to structure liabilities and assets along impact and probability, and identification of priority risk
different objectives following the risk appetite of account mitigation policies, comprise the new approach to
holders; third approach is to involve the structuring of financial stability risk assessment. The hallmarks of this
liabilities according to a scheme of subordination of the approach are intended to be greater clarity, analytical
rights of different categories of accountholders. This coherence, and consistency in risk assessment.
would lead to an appropriate categorization of risk on the The discussion is divided into three categories: cross-
asset side. According to these proposals, one can sectional risk diversification, inter-temporal risk sharing
account for the risk exposure of Islamic banks and be and liquidity risk. The financial system’s ability to provide
able to develop a reliable capital adequacy framework.58 risk diversification services can affect long-run economic
In 2005, the IFSB published a set of best practices growth by altering resource allocation and savings rates.
guidelines for establishing and implementing effective risk Although savers do not like risk, high-return projects tend
to be riskier than low-return projects. Thus, financial
markets that make it easier for people to diversify risks
54
Ariss and Sarieddine (2007): 47.
55
Ariss and Sarieddine (2007: 51).
56 59
Ariss and Sarieddine (2007: 51). Ariss and Sarieddine (2007: 53).
57 60
Ariss and Sarieddine (2007: 50). A. Haldane A New Approach to assessing risks to financial stability (2007) at
58
Ariss and Sarieddine (2007: 51). 7.
 Swartz 3807

tend to induce a portfolio shift toward projects with higher time and labour. It is argued prima facie or on face value
61
expected returns. that mudaraba offers functions comparable to interest. It
Cross-sectional risk diversification can stimulate offers the opportunity of pure finance in the sense that
innovative activity, but engaging in innovation is risky. the owner of the capital can invest without having to
The ability to hold a diversified portfolio of innovative pro- personally manage the capital investment and without
jects reduces risk and promotes investment. Thus finan- having to be exposed to infinite liabilities. However,
cial systems that ease risk diversification can accelerate mudaraba (and musharaka) are distinct from interest in
62
technological change and economic growth. that they maintain a fair balance between the owner of
A third type of risk is liquidity risk. Liquidity reflects the the capital and the entrepreneur who implements it.
cost and speed with which agents can convert financial Distribution of profits is agreed according to a pre-
instruments into purchasing power at agreed prices. determined proportion of the total and each party loses
Liquidity risk arises due to the uncertainties associated what they put into the investment, be it capital or
64
with converting assets into a medium of exchange. Infor- manpower.
mational asymmetries and transaction costs may inhibit A musharaka contract is similar to the conventional
liquidity and intensify liquidity risk. These frictions create sense of partnership arrangement where each party
incentives for the emergence of financial markets and contributes capital in their specific capacity and each
institutions that augment liquidity. Savers do not like to partner has management rights in proportion to their
relinquish control of their savings for long-periods. If the investment. However, the share of profit for each partner
financial system does not augment the liquidity of long- is determined as a proportion of the final total profit rather
term investments, less investment is likely to occur in the than a ratio of capital invested. In the event of a loss,
high-return projects. With liquid capital markets, savers each partner is obliged to lose only the amount invested
can hold liquid assets like equity, bonds, or demand in the project.65
deposits that they can quickly and easily sell if they seek Mudaraba and musharaka are non-debt creating
access to their savings. Simultaneously, capital-markets modes of financing. The principal amount of finance is
transform these liquid financial instruments into long-term not guaranteed. Therefore, the entrepreneur is not re-
capital investments. quired to pay back the total amount of financing, nor is
Banks can offer liquid deposits to savers and undertake he/she required to pay a fixed amount of profit. However,
a mixture of liquid, low-return investments to satisfy de- he/she rather agrees to pay a pre-determined proportion
mands on deposits and illiquid, high-return investments. of total profits. It is argued that mudaraba and musharaka
By providing demand deposits and choosing an appro- are appropriate financial tools for the banking system with
priate mixture of liquid and illiquid investments, banks two major advantages. Firstly, they are consistent with
provide complete insurance to savers against liquidity the bank’s roles as financial intermediaries. Secondly,
risk, while simultaneously, facilitating long-run invest- these tools can be employed for different periods of
ments in high-return projects. By eliminating liquidity risk, investment and with a diversity of entrepreneurs.
banks can increase investment in the high-return, illiquid However, in practice the mudaraba arrangements have a
asset and therefore accelerate growth.63 drawback in that moral hazard and asymmetric
information become serious in the arrangement.
A trustworthy entrepreneur is the cornerstone of the
Islamic products: Mudaraba and Musharaka as risk mudaraba arrangement. The fact that the bank or investor
mitigating tools/factors bears all the loss of the investment in the event of failure
may encourage the entrepreneur to behave against the
In tolerating profits as opposed to interest, Islamic finance interests of the investor. As a result, investors may be
allows partnership contracts. There are two principal averted from making large investments with a single
contracts in Islamic finance that employ the principles of entrepreneur. The musharaka arrangement may help off-
profit/loss sharing. These are mudaraba and musharaka. set these disadvantages of information because of the
66
The mudaraba contract is structured between the sup- provision for management control to the investors.
plier of capital and the entrepreneur who services it. One
party supplies the capital to a second entrepreneurial
party (mudarib) for the procession of some trade on the CHALLENGES FOR ISLAMIC FINANCE
condition that the resulting profits are distributed in
mutually agreed proportions while all capital loss is borne A major problem challenging the growth of Islamic ban-
on the provider of the capital. In the case of loss, the king was the absence of recognized guidelines on
entrepreneur bears the brunt of the opportunity cost of prudential, supervisory, accounting, auditing and other
corporate regulatory practices. This resulted in ineffective
61
Demirgüç-Kunt Finance, Financial Sector, Policies, and Long-Run Growth
64
(2008: 7). A. Tariq Managing Financial Risks of Sukuk Structures (2004) at 13.
62 65
Ibid. Tariq (2004: 14).
63 66
Idem at 8. Tariq (2004: 14 to 15).
3808 Afr. J. Bus. Manage.

accounting standards and created considerable difficu- Globalization is also likely to narrow differences in the
lties when it came to comparing financial statements yields of Islamic financial instruments between countries,
issued by Islamic financial institutions and those of due to a freer flow of funds. On the other hand, the
conventional financial institutions. absence of a truly global Islamic financial system based
Despite the fact that most involved in Islamic finance on Shariah principles, means that the continued growth
claim the immunity of this sector against the financial and development of Islamic banking and finance is
crisis, the sources of the current crisis will demonstrate somewhat haphazard. In this last respect, governments
that Islamic finance can potentially encounter with the could assume a more active role in promoting the
similar fate (despite its relative stability). development of Islamic financial systems. In particular,
The rationalizing of those areas of Islamic law which they need to provide the necessary infrastructure that will
relate to commerce and other financial activities is not favour the growth of Islamic banking in their respective
that simple, because Islamic jurisprudence lacks some- countries and this means putting in place a compre-
thing of the consistency and predictability of a more hensive, Shariah-compliant, legal and regulatory frame-
codified system of laws and edicts. Further complications work. Compliance with Shariah principles is not, however,
inevitably arise when it comes to accommodating Shariah in itself sufficient to guarantee the future success of
law to the existing legal system of a particular country, Islamic banking and finance. In the long run, the sus-
which more often than not is based on an European tainability of Islamic banking rests on satisfying the
model, chiefly French or English. Lastly, there are demand for quality in the products and services that
problems relating to proper accounting standards as well Islamic finance can offer.
as regulatory challenges to ensure proper halal banking.67 The ultimate challenge for Islamic banking and finance
Islamic countries are facing barriers in restructuring its is to provide a comprehensive range of Islamic financial
current financial and economic system. A total replace- products and services that are not only Shariah-compliant,
ment of the system from conventional to an Islamic but also innovative and competitive with conventional
system seems impossible, since many Islamic countries financial instruments.
prefer a dual financial system due to its competitiveness
and effectiveness. 68
Legal challenges exist in Islamic finance. They relate to CONCLUSION
the management of investment risks, consumer protect-
tion laws, the lack of legal precedents, situations involving This paper addressed the objective stated in the abstract.
uncertainty, integrating Shariah rulings within a conven- It enabled the reader to know what the risks are for the
tional framework. In order to provide proper legal Islamic economic model. With this knowledge to his/her
foundations for the supervision of Islamic banks, it is disposal, the reader will be able to control the risks which
necessary that the nature of these banks and their hindered the Islamic finance model. As a result thereof,
specific operating relationship in relation to a particular monitoring the Islamic model becomes much easier so
country’s central bank and other conventional banks, if that guidelines for risk management can be effective. It
applicable, be defined in detail by that country’s banking must though be Shariah-compliant, in order for the profit
laws. Such a legal framework should contain provisions and loss sharing principle, which underlies the Islamic
relating to licensing and permissible modes of financing, model, to materialize.
and state, clearly, legislative powers to address com- Under the profit and loss sharing principle, the Islamic
pliance with laws and regulations. Moreover, it should be system redistributes the consequences of uncertainty
clearly established that the central bank has the authority over all parties to a business. Debt-financing of the
and all necessary powers to supervise Islamic banks as conventional system, in contrast, relieves the financier
well as conventional banks, if applicable.69 from uncertainty by shifting it on the real investor, who
Another challenge for the implementation of Shariah then alone bears the entire risk of the enterprise. By
and muamalah in the world’s economic globalization is spreading the same risk over more heads, the Islamic
the commitment from the government as well as the economic system would promote stability.
wants of the country’s citizens or the community. The From the standpoint of financial stability, it appears that
wants of the citizens alone are not enough unless the Islamic interest-free system does have merit and
accompanied by the commitment of the government who deserves more serious attention from academics and
is responsible to carry out the implementation. Policy policymakers alike, especially in view of the recent crisis
statements from the government are also needed to and rampant bank failures in contemporary economics.
move the system to a more remarkable level by providing On the strength of its stability, Islamic banking is in fact
facilities.70 less risky in terms of external shocks, liquidity risks and
insolvency risks than conventional banks. These charac-
67
teristics made Islam banks less vulnerable to risk than
Venardos (2005: 101 to 102). conventional banks. Due to its conservative charac-
68
Tahir (2004: 14).
69
Venardos (2005: 110 to 111). teristic, Islamic banks have limited access to liquidity, so
70
Venardos (2005) 15. that it enables investors stable and competitive returns.
 Swartz 3809

On these grounds, investors are given a greater incentive How Janice C, Abdul Karim M, Verhoeven P (2005). Islamic Financing
and Bank Risks: The Case of Malaysia. Thunderbird Int. Bus. Rev.
to exercise tight oversight over bank management, since 47(1):75-94.
they share risks. Iqbal Z, Mirakhor A (2007). An Introduction to Islamic Finance: Theory
and Practice. John Wiley & Sons (Asia), Singapore. Prospectus
(2009).
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i
How et al. (2005: 77) cited in Iqbal and Mirakhor, (1999).
ii
How et al (2005: 91).