Islamic banks face the same credit, operational and liquidity risks as conventional banks although these are mitigated by the high degree of trust between most Islamic banks and their clients who adhere to the same religious values. The management of liquidity risk is complex as Islamic banks cannot hold conventional treasury bills or participate in repo operations, but in Malaysia a range of acceptable alternatives are available.
The unique risks confronting Islamic banks include ownership and Shariah risks. The former arise from Murabahah transactions and Ijarah leasing but these have not proved too troublesome. Shariah risks arise from inconsistent rulings by the Shariah board members. These can be regarded as a type of operational risk which highlights the need to carefully vet the scholars who are appointed to serve on Shariah boards.
Director of postgraduate studies, Durham University
In general, Islamic banks are largely exposed to the same risks as any other bank such as liquidity, credit, and settlement or counterparty risk. Contrary to conventional financial institutions, Islamic banks do not run an interest rate risk, but are exposed to fiduciary and displaced commercial risks.
Fiduciary risk is associated with Mudarabah contracts, and the fact that the mudarib is liable for all losses in the event of negligence. The main reason for negligence by a bank is when it has not complied with Shariah. By incorporating a solid Shariah review and auditing process as well as developing a strong working relationship with the Shariah supervisory board, this should be a manageable risk.
Displaced commercial risk is related to the practice of smoothing the returns to investment account holders from year-to-year by varying the mudarib share. This risk is largely associated with retail finance and has significantly reduced with the introduction of the profit equalization reserve and the investment risk reserve, particularly for banks that follow the AAOIFI accounting standards.
In addition, Islamic financial institutions, in particular those incorporated outside Malaysia and the Middle East, face the challenge that highly rated instruments (for the purpose of liquidity buffers) are not available. Although maintaining cash balances might provide an alternative, this is detrimental to the bank’s profitability.
DR NATALIE SCHOON
Head of product research, Bank of London and The Middle East
Two other unique aspects of good risk management for Islamic finance involve more controversial issues and demand more quality research by Shariah scholars, lawyers, and finance professionals: the Islamic banking equivalent to conventional banks’ gap risk; and the displaced commercial risk that occurs when an Islamic bank foregoes part of its own contractually-earned profit in a transaction in order to meet the expectations of its depositors (usually Mudarabah account holders), as a result of benchmark rates rising higher than the actual returns achieved by the bank.
In the first case, the relative lack of hedging instruments for Islamic finance (and some scholars’ continued resistance to hedging in Islamic finance), creates a unique challenge to reducing gap risk. In the second case, the use of reserves (including profit equalization reserves) is a controversial solution and more research and innovation needs to be undertaken to address this risk issue, as well.
PROFESSOR ANDREW WHITE
Director of International Islamic Law & Finance Center, Singapore Management University