Islamic banking is a banking structure which is in accordance with Islamic practices and rules, known as Shari'ah. It is used with relevance to economics as explained by Islam. The Islamic law disallows the using of interest when providing or borrowing a loan. In Islam, interest is called riba or usuary. Also, it prohibits the investment of funds in those types of business activities that are inconsistent with the Islamic principles - Haraam. These principles were formally started to being applied to commercial banks in the 20th century. (Ayaz, 2009)
In order to manage risks effectively in Islamic banks, special attention is required. This is specially for the specific risks that the Islamic banks face because of the various different ways through which they make funds available - permissible Islamic modes of financing.
Risk Management in Islamic banking
In order to ensure proper banking systems, careful risk management practices are to be carried out by all banks. Since there are many different laws, the regulations for risk management in Islamic financial institutions have to be designed such that they could be implemented with harmony to the present international rules and principles and consistent with the Islamic principles of Shariah that are appropriate for Islamic Banks. (Cherrak, n.d)
The kinds of risks the Islamic Banking faces are similar to those found in the conventional banking system. These include Credit risk, Equity investment risk, Liquidity risk, operational risk, Shari'ah non compliance risk, Market risk and so on. (Beig, n.d)
Like any other risk, risks in the banking sector cause unanticipated losses which can be controlled by means of hedging. In the conventional banking system, risk is alienated from the instrument or asses, and then traded independently. This process leads to the practice of speculation and guesswork. However, in Islamic Banking, hedging is done on the basis of the assets and liabilities of the balance sheet that actually exist and are real. The transactions should not be unfair to anyone. (Alvi, 2009)
Special Risks faced by Islamic Banks
There are certain risks that are specific to Islamic banks due to the different practices that they follow. Because of the various allowed Profit and Loss sharing ways of financing, the risks are transferred to the depositors and the extent of banks's assets risk also increases. Profit and Loss sharing makes Islamic banks susceptible to unexpected losses which are then faced by the investors rather then the debtors.
The profit and loss sharing financing is difficult to administer. When funds are made available through it, there is no identifiable non-payment on the borrower's part till the term of the agreement ends. Non payment could mean the failure of the borrower's venture. Because of this, a less amount of gains or losses are shared.
Also, there is no lawfully written ways in which the borrower's actions with regard to his venture could be controlled, in case of Mudarbah agreements. In this regard, Mushariqah agreements give some control over the venture.
Where financing is not on the basis of profit and loss sharing, there are other risks involved. An example is that of Salam agreement that involve buying with the delivery delayed. This means exposure to credit risks as well as cost risks. The buyer may have to pay a higher price than the product is worth when it actually comes in his hands.
Reducing Special Risks of Islamic Banks
In order to manage the afore mentioned risks, a proper framework needs to be followed which is consistent with Shari'ah. Examples include:
Asset - as mentioned above, in Mudarbah agreements, defaults are no identifiable until the end of the agreement. To manage this risk, the banks should make an attempt to assess cautiously the profit and loss sharing assets that are likely to give lower returns prior to the end of term of agreement.
Liquidity - When compared to older banks, Islamic banking does not have many choices to get funds by lender of last resort arrangements. But Islamic banks commitment is limited to demand deposits over others. Therefore, to manage the liquidity risk, Islamic banking needs to make use of a different and broader liquidity framework. (Makiyan, n.d)
The IFSB has set some regulations that are meant to control the liquidity risk faced by Islamic banks. It requires a proper supervisory body that can categorize and assess risks accounting for the shari'ah rules and banks can be exposed only to that amount of risks which can be covered using other means which are in compliance with the Shari'ah. (Ismal, 2010)
Islamic banks have made use of the following in order to assess default risk based on its capital:
- The Standardized Approach,
The use of Basel II keeps Islamic banking in line with global banking rules, and it also introduces terms specific to Islamic banking. It asses the Banks capital sufficiency which is likely to be riskier by higher understanding of collateral and other such instruments that reduce or minimize risk. (n.a, 2008)
Basel II has similar terms for conventional as well as Islamic banks with the exception of the following:
- Shari'ah agreements on which a transaction is based determine the handling of funds and capital.
- Risk can be minimized by use of Profit sharing investment accounts
- In the case of credit risk, collaterals can be used.
- In order to reduce risks related to keeping assets, a capital requirement is called for.
By using them, banks are able to measure their risks to calculate their needed funds for investments.
- Alvi, Ijlal Ahmed. (November 2009). Risk management in Islamic Finance. Retrieved March 25, 2010 http://www.iifm.net/media/PDF/presentation-paper/Risk-Management.pdf
- Ayaz, Maryam. (2009). Overview of Islamic Banking. Retrieved March 25, 2010 http://www.apvision.com.pk/islamic_banking_finance_economics.html
- Cherrak, Houda.(n.d). Shariah Compliant Risk Management. Retrieved March 25, 2010 www.globalfinance.org/.../advrisk/Shariah%20Compliant%20Risk%20Management.p pt
- Makiyan, Seyed Nezamuddin. (n.d). Retrieved March 25, 2010 http://www.ibtra.com/pdf/article3_v4_n3.pdf
- Mujeeb, Beig. (n.d). Risk management in Islamic Finance. Retrieved March 25, 2010 www.sbp.org.pk/.../ibd/.../RISKMANAGEMENT- Mujeeb.Beig.ppt
- Ismal, Rifki. (2010). Liquidity Risk Management in Sharia Perspective. Retrieved March 25, 2010 http://www.docstoc.com/docs/24335916/Liquidity-Risk-Management-in-Islamic- Banking-%282%29
- n.a. (2008). Basel II Enhances Islamic Banks. Retrieved March 25, 2010 http://www.islamicfinanceasia.com/features1.php