Financial Risk Management for Islamic Banking and Finance

Efficient financial systems are one of the pre-requisites for a developing and growing economy. Resilient and responsive financial systems enable the government to implement monetary policies effectively, which is used to control and manage several macro-economic parameters. Banking is a major component of the financial system and hence has far-reaching impact on the overall financial health and stability of an economy. Any disruption in the banking system has serious implications for the economic conditions of a country. Banking and financial system in a country connects individual economic units, thereby creating a national network of financial claims, and helps in the creation of national financial market. Essentially, banking system routes the financial transactions, plays the role of financial intermediation and helps in the creation of wealth. The intermediation process in financial market creates a series of interconnected contractual obligations and relations which alters the values of the variables in the risk equation. Intermediation helps in rationalising the decision to save and invest by surplus units and to borrow and invest by deficit units. The intermediation is generally a very long chain involving several financial entities and processes, each of which is aimed at reducing cost, improving the match between the needs and availability of funds, creation of tailor-made financial products based on the market needs, and provision of timely funds.

Risks are part and parcel of financial intermediation. The survival and success of a financial organisation depends on the efficiency with which it can manage its risks. Risk management is one of the critical factors in providing better returns to the shareholders. It is also a necessity for stability of the overall financial system. This chapter is an attempt to understand various risks associated with Islamic finance in general and Islamic banking products in particular. Increasing complexity and convergence of financial activities has resulted in multiplicity of risks. The three most common forms of risks — credit, market and operational, which occupy the maximum attention of the financial community — are explained in brief in this chapter. The Islamic financial industry has a different orientation towards risks. The risks are more aligned on the basis of contract types as a result of the special structuring of the contracts in Islamic banking. Profit and loss sharing is the nature of some of the Islamic financial contracts, along with the changing relationships of parties during the lifetime of the contract. These expose them to specific types of risks. These risks are specific to the contract types. This chapter thus presents and explains the different types of risks arising from the Mushãrakah, Murãbaha, Murãbaha, Salam, Istisnã, and Ijãrah Islamic financial products, elaborated with the help of graphs and examples. Furthermore, it highlights how financial institutions that provide such Islamic financial contracts are exposed to these corresponding underlying risks, as well as how they can manage them.

Financial liberalisation, which was a part of globalisation, was keenly followed by developing countries in the 1990s. Several restrictions were eased, paving the way for easy entry of financial institutions. Multinational financial institutions from developed countries entered developing economies. Relaxing governance was considered as an essential part of this liberalisation. Self-regulation was considered to be the motivating factor. But everything did not work well. There were several instances of malpractice, financial frauds and, finally, some failures. A study by Demirgüç-Kunt and Detragiache found that there was strong correlation between financial liberalisation and banking crisis.1 Governing bodies started looking at the existing set of standards and ways to overcome the issue of balancing control and freedom. It was realised that the existing standards were not sufficient and hence revision and additions were needed for bringing in sound financial risk-management practices. From simple capital provisions for risky assets to a comprehensive framework for risk management, practice of risk management has undergone wholesale transformation over the past several years. To protect financial systems from failure, special regulatory provisions are created on a regular basis. Each country has its own set of regulations based on several parameters. The most common among them is the requirement to hold some minimum capital indexed to the activities of the bank.

Credit risk appears when a financial institution is expecting a payment that has been contractually agreed between the institution and the counterparty and the obligors are unable — or in other words defaults — to fulfill their obligations. Credit risk also initiated also when there is a change or underestimation in the rating of the counterparty. Financial institutions that provide Islamic financial products are also exposed to credit risk because of the emphasis on lending in the Murãbaha, leasing in the Ijãrah, promising to deliver or to buy in Istisnã and Salam, and investing on business performance in the Mushãrakah and Murãbaha contracts. Financial problems related to either the individual counterparties (i.e. health problems) or to more general economic situations (i.e. market recession) may be some of the reasons for the obligors to default.

The notion of market risk management and hedging is of recent origin in Islamic financial markets. Importers and exporters, for example, would often adopt a ‘do nothing until you need to’ approach to hedging against adverse exchange rate fluctuations. This was partly due to a culture that, for many years, encouraged the view that risk was something to be accepted, rather than to be reduced. It was also an attitude promoted by the fixed exchange rate to the US dollar ($) which was powerful in most Middle Eastern countries, particularly because the most important export for most of these economies — oil — was priced in dollars, where nowadays it is also exchanged in Euros (€).

According to the guidelines of the Islamic Financial Services Board (IFSB),1 financial institutions are exposed to operational risks when losses occur due to failures in their internal controls involving processes, people, and systems. In addition, institutions should also incorporate possible causes of losses resulting from Shariah non-compliance and the failure in their fiduciary responsibilities. A special characteristic in applying Islamic financial contracts is the strong engagement between the institution and the counterparties. In addition, when applying partnership agreements (i.e. in Mushãrakah and Murãbaha), both sides may share profits and losses. There is, therefore, an involvement from all parties (banks, buyers, renters, business partners, etc.) in the cause of the operational risk.

Wealth maximisation has been an important goal of the financial institutions for many decades. The quest for generating better revenues is ongoing. Conventional financial institutions have been playing the role of financial intermediation for several years. However, the finer details of this role have changed dramatically. From simple borrowing and lending institutions, they have emerged as giants who provide a wide range of financial services and have grown to a such a proportion that the stability of entire financial markets depends on the stability of these financial institutions. For efficient financial intermediation, several factors are critical for the organisation. First, the availability of a basic infrastructure which includes local payment networks, local money markets, a deep and wide financial market, and an adequate legal framework. Second, it requires products, people, systems, and processes. Third, organisation requires an integration of all its activities from a risk perspective. Finally, it needs a sound economy with vigilant supervision. The management of risks in financial institutions can be decisive for the efficient performance of the entire economy. The Islamic financial institutions re-emerged in the last three decades. They were informally existent in history. The structured Islamic financial industry started with the setting-up of IDB and DIB. The prime reasons for this were: disenchantment of the Muslim population with the conventional form of financing, a quest for a religious form of financing, the rapid economic growth of countries with significantly higher Muslim populations, changing political, legal, and economical situations all over the world, and improved wealth among the Muslims.