RISK MANAGEMENT IN ISLAMIC FINANCIAL INSTITUTIONS

Risk management is at the heart of banks' financial intermediation process, and has assumed utmost importance at a time when complexity and volatility in financial markets have become both differentiating factors building competitive advantages and sources of risk entanglement. Basel II and widespread write-downs have highlighted the importance of sufficient capital adequacy and, more importantly, set a framework for improving the overall risk management architecture in banks.

Compared to conventional financial institutions, Islamic financial institutions face many challenges in adequately defining, identifying, measuring, selecting, pricing and mitigating risks across business lines and asset classes.

Risk issues at Islamic financial institutions include:

a) The range of asset classes found in Islamic banks;
b) The relatively weak position of investment account holders;
c) The importance of the Shariah supervisory board and the bank's ability to provide the board with adequate information as well as abide by its rulings;
d) Rate-of-return risk;
e) New operational risks.

Islamic finance is a growing subset of the global financial system, and is increasingly becoming a mainstream industry. Notwithstanding a series of specific features that somewhat distinguish IFIs from a number of their conventional peers, the building blocks are very similar for every banking institution. If fully adhering to the core principles of financial Islam, Sukuk in particular should really be equity based, as should risk-sharing securities. Indeed, venture capital and equity are the most common, and the most Halal forms of ethical finance, as all parties share risk and reward.

However, for the majority of existing institutional financing, in the form of Sukuk, investors ask for, and indeed receive, debt securities. Equity is expensive, hence the structural engineering of asset-backed, risk-sharing securities. Securitization is the debt structure that best satisfies the underlying profit-sharing principles of Shariah compliant investment.

In a large number of contracts, risk categories of a different nature are entangled. For example, in an Ijarah contract, the IFI buys an asset that is subsequently leased or rented to a customer against periodic rental payments.The management of leased assets' residual value is a feature that differs materially from credit risk management and assumes access to robust and reliable market data as to asset-price volatility and behaviour across economic cycles and business conditions, all the more so as IFIs tend to run a portfolio of asset inventories that they buy and then sell or lease.

Inventory management is another aspect that separates IFIs, from a risk management perspective, from their conventional peers, and similar issues arise when it comes to diminishing Musharaka contracts. Should the customer default, said the report, the IFI's share in the financed asset would be used as collateral, the value of which might be volatile and naturally subject to scrutiny and management independently from the customer's perceived creditworthiness. Diminishing Musharaka contracts are increasingly used as a financing mechanism for Shariah compliant home purchase, particularly in Dubai.

Similarly, in Istisna'a contracts, IFIs are deemed to remain the beneficial owners of financed assets until the borrowing company pays back the final installment under the Istisna'a agreement. In the case where the borrower defaults before the Istisna'a maturity, the IFI is entitled to dispose of the financed assets, which are generally illiquid because they are specific to the nature of the plant, the industry or the enterprise to which the IFI's funds were initially allocated. In the case of default, the IFI, more than any conventional bank, becomes a merchant, behaving in the field of commerce rather than in that of pure financial intermediation.

This puts additional pressure on IFIs to equip themselves with the correct technical and professional expertise for both credit assessment and the management of underlying asset valuation, trading and liquidity, should loan foreclosure and collateral realisation occur.

In short, IFIs naturally have a high level of collateralization on their credit portfolios, and thus are in a position somewhat to reduce their economic, if not regulatory, exposures at default.

Therefore, IFIs should be in a better position to manage their credit portfolios in terms of sector diversification. Sector diversification is all the more important from a capital perspective as Islamic banks usually face concentration risks by name and geography, and are also skewed heavily towards real estate financing and investment, further weighing on the quality of their assets, and thus on their credit ratings.