Salman Ahmed Shaikh
In this article, we discuss the major risks that Islamic banks face in their commercial operations and the tools with which they mitigate these risks.
Credit Risk
Credit risk is generally defined as the risk that the counterparty fails to meet its obligations in accordance with agreed terms. Credit risk includes the risk arising in the settlement and clearing of transactions.
But, since clean borrowing is not possible in Islamic banking, Islamic financing is asset backed and adequately collateralized. Furthermore, the title of ownership rests with the bank in Ijarah and Murabaha until the actual sale transaction is made. Therefore, an Islamic bank has the option of foreclosing the asset in the case of default.
Tools to Manage Credit Risks
- Pledge of Assets as Collateral
Any asset owned by the client could be taken as collateral. The client may not be able to sell that asset without bank’s permission. However, the ownership of the asset will remain with the client.
- Third Party Guarantee
If the client’s own guarantee is not completely reliable, then the bank can ask for third party guarantee, especially when the client is an associated company or a subsidiary company or when the majority owner is a conglomerate.
- First and Second Charge on Assets
First and second charge rank the order in which the proceeds of the liquidated asset(s) are used to pay off liabilities. If a financier has a secondary charge, then his turn to be paid back from the client’s liquidation of asset(s) will come second or later than the first. All else equal, financiers will prefer to have first charge.
- Takaful
Takaful is used to insure a tangible movable or immovable asset. The insurance cost is added back in sale price or rentals.
- Hamish Jiddiyah
As an alternative to down payment or security deposit, some advance rental is taken which is adjusted for future rental payments. It could also be used as partial settlement price for the sale of asset. However, any amount received in this case at the beginning of the contract cannot be taken as income for that period.
Market Risk
It refers to the risk arising from adverse movements in interest rates, commodity prices and FX rates. Commodity risk is also present in Murabaha, Ijarah and Salam.
Tools to Manage Market Risks
- Parallel Contract (if permissible)
To mitigate the storage risk and avoid inventory cost, parallel contract can be done for the same date in the case of Salam.
- Binding Promise
Binding promise which is unilateral (one-sided) can be taken to ensure contract enforcement and to guarantee seriousness of purpose on client’s end before the bank invests depositors’ funds to provide financing to the clients.
- Takaful for Asset Risk
Takaful is used to insure a tangible movable or immovable asset. The insurance cost is added back in the sale price or rentals.
Equity Risk
It refers to adverse changes in market value (and liquidity) of equity held for investment purposes. It covers all equity instruments including Mudarabah and Musharakah.
Tools to Manage Equity Risks
- Seek diversification of capital contribution.
- Use restricted Mudarabah.
- Use Musharakah than Mudarabah where possible.
- Limiting period of contract.
- Plan exit strategies.
Liquidity Risk
Liquidity risk is the potential loss to the Islamic banks arising from their inability to meet their obligations as they fall due without incurring unacceptable costs or losses.
Tools to Manage Liquidity Risks
- Diversify Sources of Funds
Increase in non-remunerative deposits can reduce the cost of raising funds from the public. Reliance on few big deposits is risky. It is better to have a widespread deposit base.
- Reduce Concentration of Funding Base
It is better to have efficient liability mix with adequate availability of short term and long term deposits. Maturity matching on both sides of balance sheet can solve much of the problem systematically.
- Rely on Marketable Assets
It is better to finance those assets on priority basis that have secondary market and that are somewhat standardized and widely used in the real sector of the economy.
Legal Risk
It refers to inadequate legal framework, conflict of conventional and Islamic laws and conflict between Shariah rulings and legal decisions.
Tools to Manage Legal Risks
- Documenting agreements to make them enforceable.
- Binding undertakings.
- Covering contingencies in design of agreements.
- Documenting the details of rights/duties in agreements.
- Strong internal compliance, due diligence and audit.
Displaced Commercial Risk
It refers to the risk that the Islamic banks may confront commercial pressure to pay returns that exceed the rate that has been earned on its assets.
Tools to Manage Displaced Commercial Risks
- Floating rentals so that increase in benchmark rate is absorbed effectively on both sides of the balance sheet.
- Using profit equalization reserves.
- Using Hibah.
Categories: Articles on Islamic Finance
Islamic Economics Project 
Dear Salman Sb,
The risks and their mitigating tools defined in this article are exactly the same as in conventional except with use of some Arabic terms. The article has unnecessarily been titled as Islamic Banking tools.
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Thanks a lot Khan Saheb for the feedback.
The article was meant to describe the current practice as is rather than suggest new risk mitigation tools. However, a detailed look at Islamic banking will reveal that their risk mitigation strategies use different tools since they can not engage in Forwards, Futures, Options, Swaps, Forward Rate Agreements, Asset-less Securitization and they also can not access Central bank’s lender of the last resort facility as is and offer products like credit cards, conventional bill discounting, REPOs and overnight rollover loans. However, some of the alternatives devised are pretty much similar in economic effects and implications. That serves the short term narrow purpose. Some thinkers also suggest that in the long run, we need to devise our own and unique set of products which effectively contribute towards realizing the vision and aspirations of Islamic economics to foster distributive justice, egalitarian and equitable distribution of income and be more inclusive than the current financial system.
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Sir, as investors, I want to assess the risk profile of the bank. Then, should the bank disclose all this information and do the investors’ expected return will be lower if the bank discloses such risk management? TQ sir.
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Banks have to disclose information as directed by their respective central bank (regulators) and auditors. Expected return is a function of so many fundamental variables. Yes, if a bank’s NPL, operating expenses to income ratio rises more than industry average, then, the expected return may increase as investors bidding lower price for such banks’ stocks.
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Yes, the asset is transferred in ownership of the customer when Murabaha sale is executed. But, when the customer buys the asset as an agent of the bank, he takes constructive possession, but ownership and risk remains with the bank until second leg transaction (Murabaha sale) is executed. After that, the asset is in ownership and at the risk of the customer. If the customer defaults, the bank can be compensated by means of collateral which could be the same asset pledged or a third party guarantee or other forms of recourse.
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It is an alternative to down payment or security deposit. It can be treated as advance rental which will be adjusted in future settlement. It could also be used as partial settlement price for the sale of asset. However, the difference is that any amount received in this case at the beginning of the contract cannot be taken as income for that period.
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