In article 94, I had explained the essential and prohibited risks to be considered by parties while contemplating to enter into an Islamic finance transaction. Is there a third category of risks? Yes, it is ‘permissible risks’.
These are those risks which do not fall in the two extremes, ie essential and prohibited risks, and therefore, can either be taken or avoided. If such risks are opted to be undertaken, at times it becomes necessary to hedge against them by using Shariah compliant mechanisms, modes and contracts which can loosely be termed as Islamic derivatives.
An example of permissible risk is the exposure to currency exchange fluctuations in trade transactions — either import- or export-based. Here, the trader can avail of the Islamic alternative to the conventional currency hedge or swap.
Since Islamic financial institutions offer a wide variety of products and services to customers, which are either based on a financing (sale) contract, an investment contract (which includes the Mudarabah contract — the subject of the current discussion) or a hybrid one, it becomes important to understand the clear line of distinction between Islamic finance and conventional lending in relation to risk management and mitigation techniques.
This is all the more important because conventional finance centers around only one core product to be studied for risk assessment, risk management and risk elimination. What is that one product? The practice of lending on interest, no matter which product you examine — be it in the retail, corporate or capital market.
On the contrary, as described previously, Islamic finance has a range of contracts, each of them situation-based and different from the others and involving risks which are not the same. Therefore, there are varying methods and techniques to measure and mitigate risks in each of these contracts. I hope while reading this article, readers continue to be mindful of the essential risks I explained in the last article (94).
Financing or sale contracts are those in which an institution transfers its ownership risk to its customer through a sale transaction by creating a debt payable by the customer in installments (for example in Murabahah), or acquires the ownership by paying the full purchase price of a commodity to be delivered to the institution on an agreed future date by the customer (as in Salam).
In these transactions, more relevant for the institution is the credit risk in Murabahah since the ownership to the goods sold stands transferred to the customer who in turn gets indebted to the institution. As for Salam, it needs a little bit of explanation. You see when the institution enters into a Salam contract and pays the 100% purchase price as downpayment, it immediately gets exposed to credit risk since the payment made to the customer shall continue to be considered as debt on the customer until it successfully delivers the commodity contracted under the Salam contract.
However, as soon as the customer delivers the goods under a Salam contract, the credit risk gets automatically transformed into the ownership risk and market risk for the institution. These risks usually remain short-lived since the institution makes the arrangement in advance for the sale of the Salam commodity immediately on receipt.
However, interestingly, if the Salam commodity received by the institution is sold by it on a deferred basis, the ownership and market risks get transformed into credit risk — ie from where the Salam transaction had started. Investment contracts are those where the institution forms a partnership either by investing through a customer (as in Mudarabah and investment agency or Wakalah) or with the customer (as in Musharakah or joint venture). In these transactions, the institution does not transfer the risk of ownership and there is no debt obligation on the customer and therefore it continues to bear all the risks which an owner endures. The same will be applicable on investment Sukuk which are issued by using any of the investment contracts.
Since in investment contracts, an Islamic financial institution in its capacity as the Rab Al Maal, partner or principal does not lend money to the customer but invests capital (equity), the risk is not shifted from the institution to the customer and therefore, the customer does not carry a debt obligation — as it does in financing contracts.
Nonetheless, if the customer violates any of the investment contract terms, it ceases to be a trustee and at once becomes liable to fully compensate the institution. This is based on the Shariah principles that in the case of negligence or default by the customer, the institution’s capital gets converted into a debt on the customer payable immediately, or as per the arrangement agreed between the institution and the customer. In such a situation, the equity risk shall transform into credit risk, similar to the modes of financing.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the senior advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected]
Next week: We need to complete the risk discussion before we conclude the Mudarabah topic, so see you next week.