Risk is an inherent force on all marketplaces. Each industry offers its own unique risks and its own unique ways of managing these risks. The art of risk management consists of identifying risks, measuring risks, and mitigating risks. This is a classroom definition of risk management. Risk simply refers to the probability of events occurring that adversely impact future expected outcomes. Risk addresses the probability of such events occurring and the impact they have on any given system. Manufacturing companies face the risks that by the time products come to the marketplace they are obsolete, unwanted, or are selling at prices lower than the cost of production. Banks confront a host of different risks that are unique to the business model of banks.
Financial intermediaries mobilize deposits from households, companies, and governments and lend these deposits back to other households, companies, and governments. At one stage banks are borrowers of funds and at another stage they are lenders of funds. The risks that impact a bank’s ability to mobilize funds at a certain cost are different from the risks they face in being able to recover moneys lent out to third parties. Islamic banks face many of the same risks that are faced by conventional banks. These risks are categorized into credit risk, market risk, and liquidity risk. Islamic banks also face Shariah risk, which is unique to Islamic financial institutions (IFIs); however, that topic is discussed in other works.
Credit risk
Credit risk is merely the risk of loss faced by a bank due to the inability of borrowers to make all the payments owed to the bank. This is risk of default, pure and simple, and can arise from changing financial circumstances of borrowers that affects their ability and willingness to return loans taken from banks.
Banks therefore have in place a risk management process by virtue of which risk is identified, measured, and mitigated. Credit risk is identified as the risk of default. It is measured by certain methods, which we discuss in detail, but what is an obvious measure of this risk is the impact on the bank’s assets, liabilities, and income if a borrower fails to make payments on the bank’s receivables.
Islamic banks experience credit risk in the same manner as conventional banks as they, too, have adopted credit financing models through credit-based sales and lease contracts. The discussion on credit risk to conventional banks is therefore applicable to Islamic banks as well.
Credit risk is mitigated at source by carefully screening borrowers for their creditworthiness and ability to repay any loan over a long period of time. The methods of credit analysis that are found in many conventional banks apply to Islamic banks as well, and by and large no matter how complex such analyses may be in their attempt to forecast a borrower’s cash flow, they remain at best educated predictions.
A variant of the credit analysis technology is simply to focus on the assets pledged as collateral to secure a loan or financing contract and to measure the ease with which that asset can be liquidated for cash. A combination of assessing a borrower’s creditworthiness and the quality of assets pledged make up the major portion of credit analysis. It is a little more complex for large corporations with various sources of revenue streams. The process becomes more complex if such companies have revenue streams in various currencies and have bank borrowings in various countries and in various currencies, where the companies’ operations face political risk, currency risk, business risk, risk of nationalization, risk of…