Research Paper in Focus

An Analysis of the Normative Parameters of Reward and Risk in Islamic Finance

Paper Title: An Analysis of the Normative Parameters of Reward and Risk in Islamic Finance

Author: Mohamed Benaicha

Publisher: ISRA International Journal of Islamic Finance, 2(3), 303 -323.

This paper aims to define the parameters of the reward-risk principle in Islamic finance. The principle of reward-risk stems from the Hadith of Al-Kharāj bil-Damān (reward is justified through liability) (Source: Al-Tirmidhi, Chapter 15, Hadith No. 1286). Profit and loss sharing based investment contracts are embodiment of risk-reward principle. In contrast, Ribā (interest) is prohibited because the lender is entitled to a guaranteed return above the principal and the guaranteed principal sum in full.

One implication of the principle is that if investment deposits are taken in Islamic banking on equity investment basis, then the bank cannot give deposit insurance. If the deposits are taken as Qard or as Amānah, then the repayment of the deposited amount can be guaranteed.

In the financing operations, the primary contractual categories using Islamic banking financing products are sale, lease and partnership contracts. The author writes that reward-risk applies slightly differently to each, but the forms of risk that apply are either one or both of ownership and market risks.

The author analyses the Islamic financing contracts to see whether Islamic debt based financing products take these risks meaningfully or not. While citing other scholars as well, he cautions that it is important to ensure meaningful ownership and risk-taking.

The author writes that risk must be borne by the financier, be it in the form of ownership risk of physical assets or equity risk in the form of Māl (capital) invested into the venture of a customer.

The author elucidates that profit on Māl is justified if capital loss risk genuinely exists. Profit on a loan is Ribā, as there is no capital loss risk on a loan, i.e. it is guaranteed. In both cases, capital is advanced as a form of financing, but the distinguishing factor is the risk, which renders the profit legitimate or not.

From the investment perspective, the risk-reward or risk based reward principle is quite compatible with the notion of positive ex-ante relation between risk and return in modern portfolio theory. In developing asset pricing models for risky financial assets in Islamic finance and evaluation of investment portfolios, the standard tools can be employed with certain modifications in the choice of risk free asset (i.e. rate of return on Sukuk rather than interest rate on treasury securities). However, from the economics standpoint, it is also important to have distinctive price benchmark and meaningful observance of ownership and market risk to justify realistic distinction of Islamic finance.

The paper is a good attempt to conceptualize the Fiqh basis of risk-reward principle and to use the understanding in revisiting both Ribā-based and Islamic finance contracts.

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