Risk management for Islamic banking financial products and services is one of the greatest challenges that many westernized, as well as Islamic banks, are facing today.
As a result of this market growth in Islamic financial products there is a high demand to understand how to assess and manage the risks arising from applying these products and services. Credit, operational, market and liquidity risks together with the risk of non compliance with the Shariah are becoming very hot issues for financial institutions.
Risk traditionally means possibility of meeting danger or suffering, harm or loss. Risk is an element of life in this world for being ignorant of the future. It is also factor of investing that one should take time to understand prior to selecting any specific investment instruments or any new adventures.
The Holy Quran has presented stories of the previous prophets so that Muslims can take the lessons from their experiences. The story of Prophet Ya'qub as, tells us about the management of risks as Prophet Ya’qub as commanded his sons to enter Egypt from different gates. The Holy Quran states, "Further he said: "O my sons! Enter not all by one gate: enter ye by different gates. Not that I can profit you aught against God (with my advice): None can command except God: On Him do I put my trust: and let all that trust put their trust on Him" (Quran 12:67).
There are three basic types of Islamic risk management products and mechanisms:
a) those that are formally being standardized. There is a global trend towards the unification or de facto standardization of risk management products, which can be currently observed in the market
b) risk management methods directly based on the well-recognized Islamic financing modes and rules
c) the possibility to use formally Shariah compliant mechanisms to replicate conventional risk management products and risk profiles. Conventional financial instruments have been developed to solve "conventional" problems and needs, and it may well be that the needs of the Islamic industry differ from those faced by its conventional counterpart. Islamic banks must manage risks specific to themselves, which cannot be encountered in the same way and extent in non-Islamic institutions. This holds true both at the product-specific / individual level and on the portfolio / balance-sheet level for Islamic banks.
According to Siddiqui in his article “Risk Management in an Islamic Framework”, risk management in Islamic framework should ensure that :
a) debt proliferation is minimized. This implies that corporations raise additional funds via equity, not by issuing bonds
b) interest on debt is not practiced. This will in effect kill the bond market
c) debt is not traded
d) risks are shared between financiers and producers/businessmen
e) regulators should not allow purchase of business or financial risks by outsiders not involved in the business or supply of investible funds for the business but only taking chances on the outcome
We all know that the rating agencies (e.g. S&P, Moody’s, Fitch) do the ratings for Islamic financial institutions, however, as rightly (and timely) put by Amit Khandelwal in his article titled “ Risk Management in Islamic Finance”, Islamic financial institutions need to be rated by specific Islamic rating agency due to :
a) rigorous and consistent analysis of quantitative and qualitative factors
b) assessment of risk profile of institution or product
c) removal of asymmetry in information on the variety of business operations
d) investors in Islamic countries desire to know the credit worthiness of the institutions and products and the legitimacy, in terms of Shariah compliance, of institutions and products
Some of the conditions/guidelines of Basel II are deemed not appropriate/compatible for Islamic financial institutions and IFSB has tried to provide additional guides/principles to assist and streamline the risk management concerns, however, more needs to be done in view of the evolving nature of the Islamic products and contracts and the dynamic spur to innovate more Islamic products in the market.
