74 • december 09 islamic finance evolution www.islamica-net.

com • december 09 • 75

Crucial Key By Ahsan Ali

Risk Management Integral to the Islamic finance has

weathered the current crises
much better than the

Future of Islamic Finance conventional finance sector,

and with 25% of the world
population as Muslims,
Islamic finance is likely to
maintain its strong growth
trajectory.

Since the advent of the first Is-

lamic bank in 1963, Islamic fi-
nance has evolved rapidly and
today is gradually progressing towards
standardisation across geographies. The
Middle East, Southeast Asia and
Malaysia have typically been the strong-
holds of Islamic finance. However, in the
last five years, Islamic finance has made
significant inroads into the developed
markets and is now seriously considered
as an alternative to conventional financ-
ing.
The last decade has seen product com-
plexity within Islamic finance increase
dramatically, with an Islamic variant for
most of the conventional offerings. This
has led to complicated product struc-
tures and the need for documentation
and specialised expertise within the Is-
lamic finance world.

Unfortunately, risk
management within
Islamic finance has
not kept pace with its
conventional
counterpart.
76 • december 09 islamic finance evolution www.islamica-net.com • december 09 • 77

Over the years the complexity of the products has increased. disasters, terrorism, vandalism.
• Business disruption and systems fail-
ures: Utility disruptions, software failures,
hardware failures.
• Execution, delivery and process man-
agement: Data entry errors, accounting
errors, failed mandatory reporting, negli-
gent loss of client assets.
For IFIs, the risk universe is wider than
that of conventional finance. It includes:

Source: Kuala Lumpur Islamic Finance Forum
Unfortunately, risk management within
Islamic finance has not kept pace with its
conventional counterpart. The existing
gap between conventional and Islamic
risk management techniques can be at-
tributed to:
• Lack of standardised product descrip-
tions and attributes within Islamic fi-
nance.
• Lack of understanding of Islamic struc-
tures and therefore, weak regulatory
frameworks within countries to manage
Islamic financial institutions (IFIs).
• Limited data on Islamic transactions
and low technological adaptability for
technology-based risk management
models.
• Concentration of Islamic finance insti-
tutions in emerging markets, where the
risk management techniques for both
conventional and Islamic modes of fi-
On the regulatory
front, confusion
reigns, with
conventional
requirements
adapted to Islamic
finance.
nancing lag the developed markets.
In the wake of the credit crises, Islamic fi-
nance is being heralded as a superior al-
ternative to conventional finance. This
argument is based on the following:
• Islamic finance is based on tangible as-
sets.
• Structured products and derivatives in
Islamic finance are limited and linked to
tangible assets.
• The element of speculation is banned
within Islamic finance.
• There is a strong element of “morality”
through an additional level of independ-
ent oversight (Shari’ah boards).
While the outlined reasons carry some
weight, in reality, IFIs are inherently
riskier propositions than their conven-
tional counterparts.
Different Risks
Within conventional finance, risks are
grouped into:
1. Credit risk: The risk of loss due to a
debtor's non-payment (default) of a loan
or other line of credit (either the principal
or interest or both).
2. Market Risk: The risk that the value of
a portfolio, either an investment portfolio
or a trading portfolio, will decrease due
to the change in value of the market risk
factors. The four standard market risk
factors are stock prices, interest rates,
foreign exchange rates and commodity
prices. The associated market risks are:
• Equity risk: The risk that stock prices
and/or the implied volatility will change.
• Interest rate risk: The risk that interest
rates and/or the implied volatility will
change.
• Currency risk: The risk that foreign ex-
change rates and/or the implied volatility
will change.
• Commodity risk: The risk that com-
modity prices and/or implied volatility will
change.
3. Operational Risk: The risk of loss re-
sulting from inadequate or failed internal
processes, people and systems or from
external events. This specifically covers:
• Internal fraud: Misappropriation of as-
sets, tax evasion, intentional mismarking
of positions, bribery.
• External fraud: Theft of information,
hacking damage, third-party theft and
forgery.
• Employment practices and workplace
safety: Discrimination, workers’ compen-
sation, employee health and safety.
• Clients, products and business prac-
tices: Market manipulation, antitrust, im-
proper trade, product defects, fiduciary
breaches, account churning.
• Damage to physical assets: Natural
1. Credit Risk
• Foreclosure on certain types of assets
(particularly residential real estate) is dif-
ficult because of the potential conflict
with the IFI’s “social responsibility” to-
wards its customers.
• Certain transactions carried out by IFIs
carry above-average credit risk. Exam-
ples can be musharaka and mudaraba,
where the IFI participates in the profit and
loss of the transaction, instead of receiv-
ing interest, as in the case of a conven-
tional financial institution.
• Focus on “asset financing” through
murabaha and ijara can cause IFIs to be
less vigilant on the credit-worthiness as-
sessment.
• Exposure to real estate is higher than
for conventional banks.
2. Market Risk
• Hedging using derivatives is not al-
lowed for IFIs. This leads to margin risk,
i.e., a mismatch earned on the bank’s as-
sets and what is paid out on its deposits.
The fact that most IFIs’ balance sheets
are weighted towards fixed margins
(murabaha) can lead to fluctuating mar-
gins. Generally, IFIs try to raise non-re-
munerative deposits or floating margin
assets (ijara) to hedge this risk.
• IFIs lack comparable opportunities for
investment in terms of both instruments
and their respective market depth. Due
to the restrictions on speculative activi-
ties and Shari’ah non-compliance of
complicated structured products, the av-
enues of investment are concentrated in
few asset classes and instruments. This
leads to both “crowding out” (investment
values being driven up because of a
large number chasing limited opportuni-
ties) as well as longer holding periods
(limited secondary markets for instru-
ments).
• IFIs run a much higher foreign ex-
change risk on their balance sheets com-
pared with their conventional
counterparts. This is due to the limited in-
struments available to hedge foreign ex-
change risk.
3. Operational Risk
• IFIs run a unique risk in terms of docu-
mentation and processes. While this ex-
ists in conventional financial institutions
as well, the severity for IFIs is much
higher. For example, not following cor-
rect process or sequential documenta-
tion invalidates all Islamic transactions,
with any profit arising on the transaction
required to be donated to charity.
• There is an acute shortage of qualified
resources within the Islamic finance
arena. The problem has been com-
pounded because of the explosive
growth within IFIs recently.
Specific Islamic Finance Risks
Liquidity Risk
Liquidity is one of the most critical issues
for IFIs. This stems from the fact that the
Islamic money market is quite limited (a
small number of IFIs or conventional
funds with segregated funds for Islamic
investment) and assets held cannot be
converted to cash easily. Finally, IFIs can-
not invest in most of the fixed income in-
struments for treasury management.
Therefore IFIs, because of their inherent
structures, run a much higher degree of
liquidity risk.
Most IFIs accept deposits under the mu-
daraba structure, whereby the deposit
holders are treated as investment ac-
count holders (IAH), liable for all the prof-
its as well as all losses. The IFI gets a
share of the profit as fees for its services.
These IFIs hold profit equalisation re-
serves (used to smooth returns in case
of reduced distributable cash flows), as
well as investment risk reserves (used to
cover future unexpected losses for IAHs).
These complicate liquidity requirements,
increasing the need for holding addi-
tional liquidity and reducing profitability.
IFIs have a disadvantage in terms of ac-
cess to a lender of last resort. Most of
these facilities available with the central
banks are non-Islamic in nature, pre-
senting IFIs with a catch-22 situation. To
avail of such a facility could save the in-
stitution from distress, but this would not
be acceptable to the Shari’ah board and
would be against Islamic principles.
Reputational Risk
IFIs also carry the risk of Shari’ah non-
compliance. Any activity related to the in-
stitution that is deemed in violation of
Shari’ah principles carries harsh penal-
ties and would be a major blow to the
brand of the IFI. This risk is further exac-
erbated because Shari’ah decisions are
not standardised and are completely de-
pendent on the respective Shari’ah
78 • december 09 islamic finance evolution

board; thus, even with a change of board

Islamic finance risks
are poorly members, the IFI runs the risk of invali-
understood and the dating certain product lines (tawaruk is a
art of risk key example, which is acceptable to cer-
management is tain scholars and is considered non-ac-
behind global best ceptable by others).
practices
Measurement and Monitoring
Exposure to comparatively more com-
plex and severe risks requires a much
Are regional banks in full control of risks associated with Islamic finance? better risk monitoring framework for IFIs.
As a Mckinsey 2007 GCC risk survey
points out, Islamic finance risks are
poorly understood and the art of risk
management is behind global best prac-
tices. The risk is further compounded be-
cause there is no universal body defining
the mandatory product standards, ac-
counting norms and disclosure require-
ments – despite attempts to do so on a
“voluntary basis” by IFSB, AAOIFI, etc.
On the regulatory front, confusion reigns,
with conventional requirements adapted
to Islamic finance. No country has pro-
gressed to looking at the Islamic bank-
ing financial sector on its own (Iran being
Source: McKinsey Risk Summit, November 2007 an exception, with its curious banking
setup). In almost all places, Islamic fi-
nance is a segmented offering which, at
the end of the day, plugs into the con-
Where do you see risk management practises among Islamic Banks in the GCC? ventional financial setup and is regulated
by very similar rules.

Containing Risk
Islamic finance is fast developing into a
viable alternative for commercial finance.
However, before this can happen, the
risks inherent in Islamic finance need to
be clearly identified, globally acceptable
standards for risk measurement and dis-
closure need to be put in place and reg-
ulatory best practices for IFIs need to be
defined and implemented. Without these
measures in place, Islamic finance might
just prove to be a systemic risk to the fi-
nancial ecosystem in the years ahead.

Source: McKinsey Risk Summit, November 2007

IFIs run a unique risk

in terms of
Ahsan Ali is the Director − Credit for the Khalifa Fund for Enterprises Development, a documentation and
sovereign fund focussed on SME development in the UAE. His previous work experience processes. While this
of over 12 years in banking spans across eight countries and multiple disciplines. His exists in conventional
areas of interest include economic development, risk management, Islamic banking and financial institutions
SME development. He holds an MBA from the Institute of Business Administration, as well, the severity
Karachi University, as well an MS in financial economics from the School of Oriental and for IFIs is much
African Studies, London. Ali is a CFA Charter Holder, an FRM certified risk manager and a higher.
member of the Securities and Investment Institute (SII), UK.