Risk Management in Islamic Banks

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Present globalization of international trade and financial markets provide opportunities for countries and financial institutions to do cross-border deals, to increase international business and global banking. At the same time, globalization of financial markets also exposes businesses, financial institutions and investors to risks of potential losses. These risks may come from uncertainties in unexpected fluctuations in assets prices, project failures, legal liabilities, accidents, natural causes and disasters as well as deliberate attacks from an adversary.

Risk is the probability of negative outcomes which could be as a result of an unexpected event happening, either from factors within the bank such as staff negligence, mismanagement or external forces outside the bank (such as regulatory changes, economic downturn or changes in tax or interest rate structure) that have significant impact on the bank’s performance.

Definition of Risk (Conventional Perspective)

Sharpe (1997) defines risk as probability of negative outcome or potential losses that could bring an adverse impact to a bank. Risk is also defined as uncertainties of future events which might influence successful achievement of an organizations objectives and targets.  Risk is defined as exposure to uncertainty of outcome (Cade, 1997) or the possibility that the actual returns will deviate from the expected returns (Ahmad, 2003). Statistically, risk is defined as the probability of a negative outcome, variance or standard deviation around the expected return, or as a shortfall probability (Fisher & Jordan, 1983; Sharpe et al., 1995).

Definition of Risk (Islamic Perspective)

Elgari, (2003) explains that risk in Arabic word is Mukatharah, which is defined as the situation that involves the probability of deviation from the path that leads to the unexpected or usual result. Risk is sometimes associated with Mukhatarah and Gharar. However Gruining & Iqbal (2008) provide a more definite distinction between Mukhatarah and Gharar where Mukhatarah is risk and Gharar is uncertainty. Gharar could also be referred as a situation in which either party to a contract has information regarding some elements of the subject of the contract that is withheld from the other party or in which neither party has control over the subject of the contract. Prohibition of Gharar is therefore seen as a way mitigating risk by avoiding contracts with high information asymmetry. (Elgari, 2003)

Types of Risk in Islamic Banks

Risks in Islamic banks are categorised into the following but may not be exhaustive.

Credit Risk, Liquidity risk, Funding risk, Market risk, Rate of return risk, Withdrawal risk, Solvency risk, operational risk,  commodity price risk, reputation risk and Shariah /legal risk.

Concept of Risk Management in Islam

Risk management is a process of managing the risk by risk identification, risk assessment and measurement, risk control and mitigation, monitoring and review of the risk exposure and risk reporting. In spite of the safe net, sound risk management is still needed for Islamic banking, more so for the following reasons. Firstly, rapid developments in conventional banking have influenced Islamic banks’ operations to be more price-competitive and to take greater risks. Secondly, dynamic changes in external and internal factors equally expose Islamic banks to many types of risk as the conventional banks. Thirdly, Islamic banking products and financing contracts are different in nature from loan and financing contracts in conventional banking. For example, the profit-loss sharing concept poses specific risks such as counter party risk that require different risk management approach since this concept is not used in conventional banking.

There are many evidences from the Quran and the Hadith which describe the concept of risk management. For instance, (i) Surah Yusuf verses 46-48 (ii) Surah Yusuf verse 67 and (iii) Hadith about a person who had left his camel untied.

  • Risk management by anticipating foreseeable negative event (story of Prophet Yusuf (as)). Prophet Yusuf (as) interpreted the dream of the King and based on his interpretation, he recommended a plan to face a drought. He proposed to the people of Egypt to actively plant crops during the first 7 years and store as much as they could. This is to prepare them to face the 7 years of drought as foreseen by Prophet Yusuf.
  • Risk Mitigation by Diversification

Allah said:

Further he said: “O my children! Do not enter the capital of Egypt by one gate but go into it by different gates. However know it well that I cannot ward off you. Allah’s will for none other than He has any authority whatsoever. In him I put my trust and all who want to rely upon anyone should put their trust in Him alone” (Yusuf 67).

  • Precaution and Calculated Risk

In the following Hadith, Prophet Muhammad (saw) taught on not leaving to chance but taking calculated risk.

“Why do not tie your camel?” the Bedouin answered, “I put my trust in God”. The prophet then said, “Tie up your camel first then put your trust in God”.

Risk Management Tools Practiced by Islamic Banks

The Islamic financial institutions have different orientations towards risks. In addition to credit, market and operational risks, they are exposed to equity investment risks which depend on the type of contracts structured between the binding parties (Akkizidis & Khandelwal, 2008). These risks are specific to the contract type namely Musharakah and Mudarabah. Islamic Banks are also exposed to performance risk in Salam, Istisna and Ijarah Islamic product and compliance risk in Murabahah contract. Among the risk management tools include net Income simulation, scenario analysis, risk thresholds, trading limits, counterparty limits, potential loss limits, stress test, credit rating system

REFERENCES

  1. Ahmad, A,. (1993) Contemporary of Islamic Financing Techniques. Research Paper No 20. Jeddah Islamic Development Bank-Islamic Research and Training Institute
  2. Elgari, M., M., (2003) Credit Risk in Islamic Bank and Finance Islamic Economic Studies Vol. 10, No. 2; 1-25
  3. Khan, T. & H. Ahmed (2001) “Risk Management: An Analysis of Issues in Islamic Financial Industry “, Islamic Research and Training Institute, Jeddah, available at http://www.irti.org/publications/publications_english6.htm
  4. Meor, A. (2007). Risk Associated with Islamic Financial Contracts, Islamic Finance Bulletin, (16, 17 and 19) RAM & IBFIM. March 2008
  5. Othman, A. (2007) Risk Management in Islamic Bank. Paper presented INCEIF-LOFSA Workshop at Labuan November 15, 2007 available at http://www.labuanfsa.gov.my/pdf/IslamicFinanceLectureSeries2007/Risk%20Management%20in%20Islamic%20Bank%20by%20En%20Arop.pdf

The views expressed in this article are the author’s own and do not necessarily reflect Saray Consultancy’s editorial stance.

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