From articles 94–97, readers may have gathered that, contrary to conventional finance, the risks are not considered alien in Islamic finance, and that accommodating them in a transaction actually acts as a balancing factor between the rights and obligations of the parties over each other.
Moreover, the spectacle of not eliminating the risks from Islamic financing transactions allows distributing the odds evenly between the parties, as opposed to conventional financing transactions where the odds are always heavily staked against one party, ie the borrower (or the obligor as commonly regarded in the loan documentation).
Also note that the substantial amounts spent on staff training by conventional financial institutions on the so-called ‘risk management techniques’ do not always pay off to safeguard them from colossal losses, as has been seen many times. Ironically, it turns out to be a zero sum game in the end when the same risks they have been running away from finally catch up with them.
So my question is: what is the point in trying so hard to always ‘eliminate’ the risks from a financial transaction and not getting the desired result? Isn’t it a good point to ponder, readers?
The aforementioned opening paragraphs are not at all trying to emphasize that you must go an extra mile to fetch unnecessary risks just to make a transaction look Shariah compliant with all those borrowed fancy risks. As already discussed in this space, every Islamic financing contract is relevant to a particular situation and holds certain inherent risks. The risks found in an investment contract may not necessarily be available in a sale contract and vice versa.
Without going into too much detail, the primary risk in a Murabahah contract is categorized as the credit risk. The credit risk encompasses all the sub-risks within itself such as the insolvency risk, cross-default risk and risk due to any change in circumstances — known as the material adverse effect — and allied. To the contrary, a Mudarabah contract does not hold the credit risk but it certainly has the performance risk of the Mudarib, market risk of the Mudarabah assets and of course, the (de facto) ownership risk of the Mudarabah capital. So you see the ‘one size fits all’ phenomenon of conventional lending cannot be applied on an Islamic financing transaction.
I hope this important perspective is fairly clear to readers which enables me to proceed to discussing the mitigation of risks in a Mudarabah transaction based on the seven parameters enumerated in last week’s article. While doing so, I will not go back to the risky points already explained in the 16 articles I have penned before this one on the subject of Mudarabah. I just checked and found that the word ‘risk’ appeared 115 times in those 16 articles — as such a lot of risk explanation has already gone into them. Let us now try to understand the other risks and how they are mitigated.
When a depositor of an Islamic bank makes a Mudarabah term deposit, he or she (or ‘it’) immediately gets exposed to the performance risk of the bank. What if the Islamic bank is held back from performing normally (ie as per depositors’ expectations) due to any extraordinary situation, such as the current COVID-19?
Please note that the term deposit agreement provides for sharing the actual profit with the depositor during the deposit period based on a distribution ratio. It means whatever actual Mudarabah profit is earned by the Islamic bank during the fiscal periods of the validity of the deposit, the customer will benefit from it.
However, in order to ward off any unfavorable situation, the Islamic banks maintain profit reserve accounts where a certain portion of the annual profit is retained for rainy days before distribution. The reserve accounts are dipped in for distribution to depositors and shareholders when the going gets tough and the Islamic bank is finding it difficult to continue to maintain earnings it used to make during the normal market conditions. By utilizing the profit reserve accounts, the Islamic bank is still able to pay near-normal returns by filling the gap between the actual result and the expected one.
The question is why does an Islamic bank need to undertake such an effort when it is adequately protected by the deposit contract which does not guarantee any specific return in percentage terms or the amount, and is simply required to distribute whatever it actually earns?
Bankers reading this article know how difficult it gets to retain deposits during a crisis situation where the customers who have obtained financing are genuinely unable to pay back to the Islamic bank due to market disruption whereas the Islamic bank has to maintain the regulatory ‘finance to deposit ratio’. In such circumstances, every deposit counts and the profit reserve accounts come in handy to keep the depositors and shareholders content until the economy is able to weather the storm.
So, therefore, by adopting the profit reserve account policy, the Islamic bank is able to mitigate the risk of losing the depositors. On the other hand, the depositors’ risk of receiving mediocre returns in difficult market conditions is also taken care of.
Nothing could be more realistic in understanding this point better than the prevalent global economic situation due to the coronavirus.
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].