Introduction to Islamic Banking and Finance:

Principles and Practice

M. Kabir Hassan, Rasem N. Kayed, and Umar A. Oseni

Chapter 10

Risk Management in Islamic

Finance
Learning Objectives
Upon the completion of this chapter, the reader should be able to:
1. Understand the concept of risk management from the Islamic
perspective, with particular reference to Islamic commercial
transactions
2. Be familiar with the types and characteristics of risk exposure
and the Islamic banking risks under the IFSB’s guiding principles
3. Examine the risk management techniques in Islamic banks and
how such risks can be avoided, absorbed or transferred
4.Understand risk management techniques such as hedging
through the use of the following derivatives: forwards, futures,
and swaps, based on the Sharī'ah-complaint risk mitigation
frameworks
 Learning Objective 1.1

Risk Management from an Islamic Understand the concept of

risk management from the
Perspective Islamic perspective, with
particular reference to
Islamic commercial
transactions

The Meaning of Risk and its Underlying

Principles

• Risk: exposure to chance of imminent danger (loss of life, property or

loss of investments in commercial transactions)
• Impact of such losses occasioned by market risks may be reduced
through hedging
• In Islamic finance, profit associated with risk (no risk, no gain)
• Several Islamic finance products inherently prone to risks. Islamic
banks exposed to business risk just like their conventional
counterparts
• Islamic banks also face risks associated with Sharī'ah compliance in
Islamic finance transactions
Risk Management : identification, quantification and understanding
business risks with a view to undertaking necessary measures to control
or mitigate the risk or its impact
 Learning Objective 1.1
Understand the concept of
Risk Management from an Islamic risk management from the
Islamic perspective, with
Perspective particular reference to
Islamic commercial
transactions

• Risk management or risk mitigation technique try to reduce risk

• The risk management measures applied by IFIs are either

Sharī'ah-compliant or Sharī'ah-based measures

• In Islamic finance, profits are associated with risks: -

Al-ghunm bi al-ghurm maxim links entitlement to return
with the liability of risk
• - Al-kharaj bi al-daman maxim ties entitlement to the return of
an asset to the risk resulting from its possession

• All transactions in Islamic finance (debt-based or equity-based)

are associated with risk
 Learning Objective 1.1
Understand the concept of
Risk Management from an Islamic risk management from the
Islamic perspective, with
Perspective particular reference to
Islamic commercial
transactions

Affirmative Evidence on Risk Management in Islam

• Numerous Qur’anic verses and prophetic precedents urge
Muslims to effectively manage risks associated with their
worldly activities

• Sadd al-dhari’ah (blocking the legitimate means to an evil)

is a secondary source of the Sharī'ah designed to reduce
risks in commercial and non-commercial transactions
through precautionary measures

• Measures towards blocking the means to evil are steps

towards risk management particularly when risk is imminent
 Learning Objective 1.1
Understand the concept of
Risk Management from an Islamic risk management from the
Islamic perspective, with
Perspective particular reference to
Islamic commercial
transactions

Risk Management in Islamic Commercial Transactions

• Business activities are always exposed to risks

• The general maxims in Islamic commercial transactions are:

- Al-ghunm bi al-ghurm: Entitlement to return is related

to liability of risk
- Al-kharaj bi al-daman: Entitlement to the return of an
asset is associated with risk resulting from possession

• These two maxims suggest that ‘Profit in commercial

activities means risk with responsibility’
 Learning Objective 1.1
Understand the concept of
Risk Management from an Islamic risk management from the
Islamic perspective, with
Perspective particular reference to
Islamic commercial
transactions

Risk Management in Islamic Commercial Transactions

• The criterion of legality of any return on capital investment

is risk

• Investors have to bear loss if they aim to make legitimate

profits on investment (i.e., Mudarabah and Musharakah
contracts)

• Reasonable measures are required to be put in place to

mitigate the effect of any risk

• Islamic banks face risks associated with the compliance with

the Sharī'ah in Islamic finance transactions
 Learning Objective 1.1
Understand the concept of
Risk Management from an Islamic risk management from the
Islamic perspective, with
Perspective particular reference to
Islamic commercial
transactions

Risk Management in Islamic Commercial Transactions

• Avoiding risk with zero profit in business activities is allowed

in Islam through wadiah yad damanah (savings only
deposit)

• Avoiding risk with positive profit is not allowed because this

is equivalent to interest (riba) from loans

• Avoiding risk with zero profit in business activities is allowed

in Islam; this is being applied in Islamic banking
 Learning Objective 1.2
Be familiar with the types and
Types of Risk Exposure characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Financial and/or Non-financial Risks

• Financial risks: include market risk, credit risk, liquidity risk,

displace commercial risk, and rate of return risk

• Non-financial risks: operational risk, regulatory risk, legal,

or Sharī'ah risk

• Islamic banking risks: credit risk, market risk, liquidity risk,

operational risk, displace commercial risk, Sharī'ah risk, and
rate of return risk
 Learning Objective 1.2
Be familiar with the types and
Types of Risk Exposure characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles
 Learning Objective 1.2
Be familiar with the types and
Types of Risk Exposure characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Unique Risks to the Islamic Banking Business

• The Islamic finance industry has a unique risk profile due to the
requirement of Sharī'ah compliance

• IFSB-1 identifies the following six risks that are unique to the Islamic
banking business:

- credit risk -
equity investment risk -
market risk - liquidity risk

- rate of return risk

- operational risk
 Learning Objective 1.2
Be familiar with the types and
Types of Risk Exposure characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Figure 10.1: Types of Islamic Banking Risks According

to IFSB
 Learning Objective 1.2
Be familiar with the types and
Types of Risk Exposure characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Global Islamic Finance (Risk management:

IFSP Guidelines and Basel II Framework)

First: Prior to release of IFSB guiding principles: Islamic banks and financial
institutions utilized conventional risk management techniques whilst trying to
comply with Sharī'ah-rules and guidelines

Second: In 2005, IFSB issued the Guiding Principles of Risk Management for
Institutions (other than Insurance Institutions) offering only Islamic Financial
Services

• The aim of the new set of IFSB guiding principles was to complement the
existing framework of BCBS
 Learning Objective 1.2
Be familiar with the types and
Types of Risk Exposure characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

• In Islamic finance, profit and risk must be present in every

joint venture
• It is crucial that IFIs exercise due diligence managing
investment funds
• The IFSB guiding principles developed specifically to address
needs and unique nature of IFIs
• Islamic financial institutions are required to inaugurate
necessary Sharī'ah compliant risk mitigation
• All sound principles and practices relevant to risk
management in the BCBS guidelines are considered in Islamic
finance and are adapted to suit needs of the industry
 Learning Objective 1.2

Types of Risk Exposure Be familiar with the types

and characteristics of risk
exposure and the Islamic
banking risks under the
Credit Risk IFSB’s guiding principles

• Definition of Credit Risk

Risk encountered in business transactions when there is potential for
default on the part of a party in meeting its obligations as agreed in an
underlying contract
• Definition applicable to:
- Institutions offering only Islamic financial services (IIFS)
- Institutions managing financing exposures of receivables and
leases e.g. Murābahah, Diminishing Mushārakah and Ijārah)
- Working capital financing transactions/projects e.g. Salam,
Istisnā`, or Muḍārabah) (IFSB-1, p. 6)

 
 Learning Objective 1.2

Types of Risk Exposure Be familiar with the types

and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles
Nature of Credit Risk
• A type of banking risk relating to repayment of debt at the
appointed time in accordance with the terms of the loan

• Failure to repay results in loss (a risk for the bank)

• Frequent defaults on payments ultimately result in credit

risk to the bank

• Complete default in repayment results in loss and the bank

bears credit risk
• Credit risk management becomes necessary to minimize
instances of such risks
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

IFSB Guiding Principles on Credit Risk

• Principle 2.1: to have in place a financing strategy that

recognizes potential credit exposures

• Principle 2.2: IIFS carries out a due diligence review in

respect of counterparties prior to deciding on an appropriate
Islamic financing instrument

• Principle 2.3: to have in place appropriate methodologies

for measuring/reporting credit risk exposures

• Principle 2.4: IIFS shall have in place Sharī`ah-compliant

credit risk mitigating techniques appropriate for Islamic
financing instruments
 Learning Objective 1.2
Be familiar with the types
Risk Management from an Islamic and characteristics of risk
exposure and the Islamic
Perspective banking risks under the
IFSB’s guiding principles

Operational Considerations in Credit Risk Management

• Operational considerations for credit risk management in

IIFS:
- To place credit risk management at the core of
integrated approach to management of financial risks
  - To implement holistic approaches to effectively deal
with recurrent problems of credit risk (arising from
transactions involving Islamic financial instruments)
• IIFS required to use proper frameworks in identification,
measurement, monitoring, reporting and control of credit
risks
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

IFSB-1: Proposed Framework for IIFS includes:

• An appropriate credit strategy, including pricing and
tolerance for undertaking various credit risks
• A risk management structure with effective supervision of
credit risk management; credit policies and operational
procedures
• An appropriate measurement and careful analysis of
exposures and a system to:
a) Monitor the condition of ongoing individual credits
b) Manage problem credit situations according to
an established remedial process
c) Ensure adequate provisions are allocated
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Equity Investment Risk

• Equity Investment
- For listed companies, equity investment is the buying and
holding of shares of stock by individuals/ firms from listed
stock exchange companies in anticipation of income from
dividends/capital gains
 

- For unlisted companies, equity investment refers to the

acquisition of equity (or ownership) participation in a joint
venture company

• The joint venture arrangement is also called venture capital

investing which is considered to be of higher risk than the
listed companies
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Equity investment risk: Risk arising from entering a

partnership for the purpose of undertaking/participating in a
particular financing or general business activity (described in
the contract), where finance provider shares in business risk
• The risk involved in popular Islamic finance instruments
Mudarabah and Musharakah is equity investment risk since
Mudarabah and Musharakah are:
- Equity-based products
- Based on joint venture through partnership of capital
provider and the entrepreneur
- Both parties of the contract (the financer and the
entrepreneur) undertake to share the business risk
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

The Nature of Equity Investment Risk is a confluence of

risks connected to:

- The entrepreneur or a partner in Musharakah

arrangements

- The underlying business activity for the partnership

- Operational issues
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Risk Evaluation

• Preventive measures that must be put in place to review

and evaluate risk profiles of potential partner through:

- Careful examination of past records

- Quality of business plan
- Proposed business activity
- Human resources involved

• Factors relating to the legal and regulatory environment that

may affect the viability of the investment
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

IFSB: Guiding Principles on Equity Investment Risk

Management

• Three IFSB guiding principles:

- 1st principle relates to appropriate strategies for risk

management and adequate reporting processes

- 2nd Principle focuses on appropriate valuation

methodologies for the purpose of profit allocation

- 3rd principle provides for exit strategies in respect of

the equity investment activities of the contracting parties
 
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

General Operational Considerations in Equity Investment

Risk Management

• Proper evaluation and management of applicable risks in the

acquisition of, holding and exiting from profit sharing
investments

• Appropriate management structure including a Sharī'ah

compliance organ for evaluation of investment activities
• Adequate financial reporting standards (for transparency and
accountability)
• Applicable and consistent valuation methodologies for the
purpose of profit allocation
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

• Adequate measures to address risk associated with possible

manipulation of reported profit
• Services of independent bodies/parties to carry out audits
and valuation of the business investments for the overall
interest of relevant parties
• Mutual agreement on criteria for exit strategies and timing of
exit within investment period
• Mutual agreement between IIFS and investing partner on the
treatment of retained profits
• All agreements, contracts and processes must be reviewed
and approved by Sharī'ah Board of IIFS to ensure Sharī'ah
compliance
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Market Risk (also known as systematic risk)

• According to IFSB-1, market risk is defined as the risk of losses
in on- and off-balance sheet positions arising from movements in
market prices i. e.
- On balance sheet: fluctuations in values in tradable,
marketable or leaseable assets (including sukūk)
- Off-balance sheet individual portfolios (for example
restricted investment accounts)
• Restricted investment accounts: account portfolios where
account holders authorize IFIs to invest funds in Sharī'ah
compliant business ventures with restrictions as to where, how
and for what purpose the funds are to be invested
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Nature of Market Risk - volatility of market

The volatility of market values of assets results in market

risk, caused mainly by:
- Transactions that involve future delivery or deferred
payment such as Salam contract or murabahah contract
 

- The fluctuations in foreign exchange rates lead to

market risk
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Nature of Market Risk – Salam Contract

• Salam Contract is a commodity sale involving advance

payment where delivery of the commodity is deferred
• Risk exposure in Salam contract manifests in different ways:
  - Arising in market risk as a result of price expectation
reversal after the bank has earlier concluded a salam
contract for future delivery of the commodity
- the risk that a failure of delivery of the commodity
would leave the IBIs exposed to commodity price risk
(in the case of parallel Salam)
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Nature of Market Risk – Ijarah Contract

Ijarah Contract: The owner of an asset leases it to a client at

an agreed rental fee, which is a consideration for the
beneficial use of the underlying asset
Market Risk is the result of
- default of payment on the part of the lessee due to price
variation. The resultant effect of such default is market
risk
- default on the asset delivery by the bank/lessor
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Ijārah Muntahia Bittamlik (also known as Ijārah wa Iqtina)

is a form of lease contract that offers the lessee an option to
own the asset at the end of the lease period either by:
- Purchase of the asset through a token consideration
- Payment of the market value
- By means of a gift contract

Market Risk: the lessee’s default on lease obligations. The

lessor will be exposed to market risk on the carrying value of
the leased asset
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
Nature of Market Risk – Foreign-exchange IFSB’s guiding principles

Contract

Foreign exchange contract : exchange of money for money,

regulated and restricted by relevant Sharī'ah rules
Foreign-exchange risk: risk arising from changes experienced
in currency exchange rates
• An adverse movement in exchange rates will always result in
currency risk or exchange-rate risk
• Sudden changes in exchange rates affects:
- The value of investment by the IIFS
- IIFS that engage in export and import business
activities - IIFS that engage in international investments
• IIFS are exposed to foreign exchange fluctuations arising from
general FX spot rate changes
 Learning Objective 1.2

Types of Risk Exposure Be familiar with the types

and characteristics of risk
exposure and the Islamic
Operational Considerations in Market banking risks under the
Risk Management IFSB’s guiding principles

Figure 10.2: Strategies for Market Risk Management

in Islamic Financial Institutions
 
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Liquidity Risk

• Liquidity risk: the potential loss anticipated by Islamic

financial institutions arising as a result of insufficient liquidity
to meet normal operating obligations and needs

• Sometimes considered as part of market risks. But for the

purpose of IIFS, liquidity risk is regarded as a separate risk

• Involves a systemic failure on the part of the financial

institution where it fails to meet expected and unexpected
cash flow needs
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Liquidity risk can be caused by:

• Incorrect judgment and complacency

• Unanticipated change in cost capital
• Abnormal behavior of financial markets
• Range of assumptions used
• Risk activation by secondary sources
• Breakdown of payment systems
• Macroeconomic imbalances
• financial infrastructure deficiency
• Contractual forms
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Nature of Equity Liquidity Risk

• The major funds directly managed by the IIFS are:

- Current account holders
- Unrestricted Investment Account Holders (IAH)
• The IIFS must maintain a stable level of liquidity in order to:
- Regulate the cash flow process
- Meet requirements for withdrawals of two account
holders
• The Current Account holders:
- Only make cash withdrawals
- Do not share in the profit
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

• The IAH have a share in the profits and risk of the business
of IIFS as investors

• Apart from general withdrawal needs, the withdrawals made

by IAH may be the result of:

- Lower than expected or acceptable rates of return

- Concerns about the financial condition of the IIFS
- Non-compliance by the IIFS with Sharī`ah rules and
principles in various contracts and activities
(IFSB-1, p. 19)
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

IFSB Guiding Principles on Liquidity Risk

• Principle 5.1: IIFS shall have in place a liquidity

management framework (including reporting) taking into
account separately and on an overall basis their liquidity
exposures in respect of each category of current accounts
and unrestricted investment accounts

• Principle 5.2: IIFS shall assume liquidity risk proportionate

with their ability to have sufficient recourse to Sharī`ah-
compliant funds to mitigate such risk

• Adequate funding capacity, with particular reference to the

willingness and ability of shareholders to provide additional
capital when necessary
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
Operational Considerations in Liquidity IFSB’s guiding principles

Risk Management

Firstly, the IIFS should maintain adequate liquidity at all points

• IFSB-1 suggests the following liquidity management policies:

  - Strategy for managing liquidity involving effective BOD
and senior management oversight
- A framework for developing and implementing sound
processes for measuring and monitoring liquidity
- Adequate systems in place for monitoring and reporting
liquidity exposures on a periodic basis
- liquidity through fixed asset realizations and
arrangements
- Liquidity crisis management
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Operational Considerations in Liquidity Risk Management

Secondly, the IIFS should have a liquidity contingency plan

• Identification of liquidity gap or situation which acts as a

triggering event where withdrawals do not follow predictable
patterns

• A need to liquidate assets or investments in an orderly

manner to meet such a liquidity gap or situation

• Emergency measures to be taken in the event that the

previous steps fail to meet the liquidity gap adequately
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Rate of Return Risk

• Rate Of Return: gain or loss on investment over a specified

period, shown as a percentage increase over initial
investment cost

• Rate of return risk is risk associated with potential impact

of returns of an Islamic financial institution, arising from
unexpected change in rate of returns in business transactions

• IFSB-1 differentiates between the ‘rate of return risk’ and

‘interest rate risk’
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Nature of Rate of Return Risk

• Rate of return risk may lead to Displaced Commercial Risk
(DCR)
• The IIFS must retain their fund providers to avoid insolvency
and an ultimate liquidation
• The IIFS may give up their share of profits in the mudarabah
arrangement with the IAH to prevent fund providers from
withdrawing their funds from the IIFS
• The IIFS maintains the following two reserves as part of their
risk management strategy
- A Profit Equalization Reserve (PER)
- An Investment Risk Reserve (IRR)
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Operational Considerations in Rate of Return Risk Management

• The mitigation of any mismatch between assets and balances from

funds of investors
• The implementation of an appropriate management processes that
cater for the identification, measurement, monitoring, reporting
and control of the rate of return risk
• The utilization of balance sheet techniques to minimize exposure to
risks
• The IIFS must identify the expectations of their shareholders and
IAHs and implement an appropriate policy and framework to meet
such expectations

•  
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Strategies for the mitigation of Rate of Return Risk

• Determining and varying future profit ratios according to

expectations of market conditions

• Developing new Sharī`ah-compliant instruments

• Issuing securitization tranches of Sharī`ah permissible assets

 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
Operational Risk IFSB’s guiding principles

Risk arising from execution of business functions of an Islamic

bank
• Causes: 
- Failures in the internal controls of a financial institution
involving processes, people and systems
- Non-compliance with the Sharī'ah requirements
- Any failure in the fiduciary responsibilities of the financial
institution towards the IAHs and current account holders
• Costs: operational risk may lead to withdrawal of funds by the
fund providers and ultimate closure of accounts costing Islamic
banks.
- Loss of income, good reputation, business opportunities
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Nature of Operational Risk

• The operational risk relates to (a) Sharī'ah non-compliance
risk and (b) fiduciary risk
• Operational risk must be properly handled to ensure the
sustained confidence of fund providers
• Relevant governance organs are required to play their roles
in properly mitigating operational risk
- The Sharī'ah Board must play supervisory role to ensure
total compliance with the rules and principles of Sharī'ah
• Failure to uphold fiduciary relationship between financial
institutions and their clients may result in loss of investments
and the bankruptcy of financial institution
 Learning Objective 1.2
Be familiar with the types
Types of Risk Exposure and characteristics of risk
exposure and the Islamic
banking risks under the
IFSB’s guiding principles

Operational Considerations in Operational Risk

Management

• Sharī'ah non-compliance risk: The IIFS must ensure that

total compliance is maintained in all contracts, procedures,
processes and services. Sharī'ah compliance involves:
- The compliance of contract documentation
- Sharī'ah compliance review (Sharī'ah audit) after the
implementation of the contracts

• Fiduciary risk: The interest of the fund providers must be

protected at all times in all business policies and investments
 Learning Objective 1.3
Examine the risk
Risk Management Mechanisms in management techniques in
Islamic banks and how
Islamic Banks such risks can be avoided,
absorbed or transferred

The risk management mechanisms for Islamic banks and

financial institutions are intended to:
- Mitigate
-Transfer
- Avoid
- Absorb the risk in a particular business undertaking

• Hence the terms are:

- Risk mitigation
- Risk transfer
- Risk avoidance / elimination
- Risk absorption / management
 Learning Objective 1.3
Examine the risk
Risk Management Mechanisms in management techniques in
Islamic banks and how
Islamic Banks such risks can be avoided,
absorbed or transferred

General Mechanisms for Risk Identification and

Management
The first mechanism is based on certain standard techniques,
which are consistent with the Sharī'ah including:
- Risk reporting
- Internal and external audit
- GAP analysis
- Risk-adjusted return on capital (RAROC) etc.

The second mechanism comprises techniques that require

adaptation and further development to suit the requirements of
Sharī'ah compliance
 Learning Objective 1.3
Examine the risk
Risk Management Mechanisms in management techniques in
Islamic banks and how
Islamic Banks such risks can be avoided,
absorbed or transferred

Figure 10.3:
Management of
Key Risks in a
Diminishing
Musharakah
Contract
 Learning Objective 1.3
Examine the risk
Risk Management Mechanisms in management techniques in
Islamic banks and how
Islamic Banks such risks can be avoided,
absorbed or transferred

Risk Avoidance (is also known as risk elimination)

Risk avoidance or elimination techniques in Islamic banks
include:
• Measures that promote risk avoidance

• Approval of Sharī'ah Board of Islamic bank of all processes,

procedures and services rendered by the financial institution

• All business-related documents must be standardized in line

with the requirements of the Sharī'ah and endorsed by the
Sharī'ah Board

• All elements of uncertainties (gharar) and undue enrichment

through interest (riba) are excluded from the contract
Risk Management Mechanisms in
Learning Objective 1.3
Examine the risk
Islamic Banks management techniques in
Islamic banks and how
such risks can be avoided,
Risk Absorption absorbed or transferred

• Risks that cannot be eliminated nor transferred must be absorbed or

effectively managed by the Islamic financial institution

• Risks that cannot be easily separated from the assets of the bank and
its investors must be accepted by the financial institution because such
risks are central to their business

• Financial institution must be prepared to bear some risks while hoping

to maximize profits - “Entitlement to return is related to the liability of
risk”

• Credit risk and market risk are the most prominent

• Risk absorption techniques include collateral (security against credit
risk), guarantees (supplements collateral to avoid absorb credit risk),
loan loss reserves and allocating capital
 Learning Objective 1.3
Examine the risk
Risk Management Mechanisms in management techniques in
Islamic banks and how
Islamic Banks such risks can be avoided,
absorbed or transferred

Risk Transfer
• Risk transfer involves: -
The use of derivatives for hedging
- Changing borrowing terms and selling or buying of
financial claims

• Risk transfer mitigation techniques include:

- Swaps such as debt-asset swap, swap of
liabilities, deposit swap
- Forward such as currency forward
- Futures include salam and commodity futures,
currency forward and futures
- Options include parallel contracts, bai al-
urbun, bai’ al- tawrid with khiyar al-shart (optional
condition in a contract), or embedded options
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: mitigation
frameworks forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
Derivatives
Derivatives are financial instruments or securities whose value
depends upon or derived from:
- The value of an underlying asset
- The value of a rate
- The index of asset value
Derivatives are generally used - As
instrument to hedge risks
- For speculative purposes within the secondary market
The most common types of derivatives are:
- Futures contracts, -
Forward contracts -
Options - Swaps
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: mitigation
frameworks forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
Forward & Futures Contracts
• Forward contracts are derivatives whereby there is a cash
market transaction where the delivery of the underlying
asset is deferred to a future date
• The parties agree on the delivery price on the spot (at the
time of entering into the contract) but the underlying asset
is delivered at a specified future time
• The parties “lock-in” the price while entering into the
contract to avoid future fluctuations in the market
• Forward contracts can be used as derivative securities to
hedge risks especially those associated with currency or
exchange rate risk
Mitigation Techniques in Islamic
Learning Objective 1.4
Understand risk management
Finance techniques such as hedging
through the use of the following
derivatives: mitigation
frameworks forwards, futures,
Forward & Futures Contracts and swaps, based on the
Sharī'ah-complaint risk

• Futures contract is a standardized contractual

agreement between two parties to
exchange a specified asset with a
known standardized quantity and quality
at a price agreed upon by the parties
on the spot while delivery is made at
a specified future date

• The price is known as futures

price or the strike price

• Futures are used primarily by buyers

and sellers in the futures market
to hedge risk or speculate
 
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks

Differences between forward and futures contracts

• While forward contracts are non-standardized contracts,

futures contract are standardized

• The forward contracts are not exchange-traded while

futures are exchange-traded derivatives. The futures
contract is traded on the floor of a futures exchange
 

• Futures contracts are always standardized with a clear

stipulation of the quantity and quality of the underlying
assets or financial instrument negotiated at a specified price
to be delivered at a specified future date
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks
Options

• An Option is a financial derivative sold by the option writer

to an option holder (a contract sold by one party to
another) 

• In options, the buyer is given a right to buy (call) or sell

(put) a security at an agreed price within a specified period
of time
• The buyer is only given the right and not an obligation
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks

A call or call option: a financial contract between buyer

and seller where the buyer is given the right (but not
obligation) to buy an agreed quantity of an underlying
commodity or financial instrument from the seller of the
option at a particular time and at a fixed price

- The option remains with the buyer. Once he or she

decides to buy, the seller is obligated to sell it at the
agreed price and within the specified period of time

- For the buyer to be able to exercise this right, he or she

must pay a fee called a premium. The risk of the buyer
is only limited to the premium paid
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks

A put or put options is a financial contract between a buyer

and the seller where the buyer of the put has the right, but
not an obligation, to sell the asset at a specified period of
time and at a certain price
 

- In this case, the buyer would want the stock to go

down so that he or she can exercise the right

  - Put can be used to limit the risk of the seller’s (writer’s)

portfolio
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks
Swaps
• Swap can be defined as the exchange of one security for
another for the mutual benefit of the parties.
• The parties may swap: -
Currency -
Interest rates
- Bonds, etc.
• Firms may engage in swaps:
- To change the quality of issues, either as bonds or stocks
- Because of a sudden
change in investment objectives
• The ‘fair fixed rate’ is used when pricing a SWAP
• Swaps are used to hedge certain risks e.g. interest rate risk
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks

The Different Types of SWAPS include

- Interest rate swaps

- Currency swaps
- Commodity swaps
- Equity swaps
- Credit default swaps
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks

Concept of Hedging
• Hedging: a proactive business position intended to reduce
impact of potential loss that may be incurred by a
companion investment

• Hedging in business investments meant to reduce

exposures to various risks within the market environment

• Portfolio managers, investors and corporations reduce the

potential effects of business risks on them
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks
Approaches to Hedging

There are three approaches to hedging:

- Economic hedging

- Cooperative hedging

- Contractual hedging
 
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks

How to Hedge

• Two prominent derivatives are used in hedging: options and

futures

• These investment strategies allow the investor to offset a

loss in one investment through a gain in a derivative (acts
as a risk mitigation technique for investors)
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
The Islamic Perspective on Hedging mitigation frameworks

• Hedging can be modified to suit requirements of Sharī'ah

• Majority of Islamic finance experts have agreed that hedging is
allowed - provided the fundamentals prohibitions in Islamic
commercial transactions are excluded
• Hedging is applicable if the sole purpose is to protect against loss
of value as a result of issues e.g. currency fluctuation
• Market speculators not allowed to deliberately expose themselves
to risk to gain profit from currency fluctuations
• Any futures, forwards, swaps or options contracts involving
market speculations are not Sharī'ah compliant
• In conventional hedging, speculation in derivatives often carried
out to maximize profit rather than facilitating business activity
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks
Islamic Promissory Forward Contract

• Islamic promissory forward contract (IPFC) used for risk

management in Islamic financial transactions

• IPFC structured to reflect wa’d (promise) in forward contracts

• The binding nature of wa’d extended from murabahah

transactions to other Islamic finance structures

• Conventional futures in which payment and delivery of goods

are postponed are not allowed under the Sharī'ah due to the
presence of gharar and riba
 
 Learning Objective 1.4

Mitigation Techniques in Islamic Understand risk management

techniques such as hedging
Finance through the use of the following
derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
Islamic Swap mitigation frameworks

Islamic Foreign Exchange (FX) Swap a contract designed for

Islamic hedging mechanisms to minimize exposure of market
participants to volatile/fluctuating currency exchange rates
• Islamic swaps are different from the conventional swaps
- Islamic swaps subject to exclusionary rules on all
prohibited elements such as riba, gharar, and jahl
-Islamic swaps linked to asset-backed transactions
e.g. ijarah, murabahah, Bai Bithaman Ajil
• Main instruments of Islamic swap
- FX Swap
- Cross Currency Swap
- Profit Rate Swap
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks

Islamic Cross Currency Swap (ICCS)

• ICCS allows the Islamic banks to hedge the interest and

currency exchange risks of their investments in foreign
denominated assets

• ICCS
- Serves as a tool for risk management
- Reduces cost of raising resources
- Helps in identifying appropriate investment
opportunities
 
 Learning Objective 1.4

Mitigation Techniques in Islamic Understand risk management

techniques such as hedging
Finance through the use of the following
derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
Islamic Profit Rate Swap (IPRS) mitigation frameworks

• IPRS:
- Provides a risk control mechanism for the Islamic
financial institutions by matching funding rates with
the return rates of investment to have a healthy profit rate
swap.
- Protects the financial
institutions from fluctuating
borrowing rates
• IPRS which is a Sharī'ah-
compliant version of interest
rate swap serves as an
appropriate Sharī'ah-
compliant mechanism to
reduce risk exposures.
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks
The Objectives of IPRS
• To match funding rates with return rates (from investment)
• To achieve lower cost of funding
• To restructure existing debt profile without raising new
finance, or altering the structure of the balance sheet
• To manage exposure to interest rate movement
• To extend Islamic Financial Market
• A good example of IPRS is the CIMB Islamic Profit Rate
Swap
• Refer to your textbook for more on the three stages in the
CIMB IPRS
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks
Islamic Options
• Islamic option is a contract of promise to buy or sell an asset
at a predetermined price within a stipulated period of time

• Islamic option is a risk management technique where the

buyer tries to avoid or eliminates future market volatility

• In Islamic jurisprudence, there is a reference to options in

commercial transactions:
- Under the doctrine of contractual stipulations
(al-khiyarat)
- In bai al-urbun
Note: bai al-urbun is only permitted by the Hanbali jurists
 Learning Objective 1.4
Understand risk management
Mitigation Techniques in Islamic techniques such as hedging
through the use of the following
Finance derivatives: forwards, futures,
and swaps, based on the
Sharī'ah-complaint risk
mitigation frameworks

Trading in Options –the Ruling of Organization of

Islamic Conference (OIC)

Islamic Fiqh Academy of the OIC in its seventh session, 9-14

May, 1992) ruled that Option contracts as currently being
applied in the world financial markets are not permissible in
Sharī‘ah

Therefore, options has a limited scope of utility in Islamic

banks as a risk management technique.
Key Terms and Concepts

• Aleatory transactions • Investment account holders

(IAH)
• Bay al-tawrid
• Liquidity risk
• Bay al-arbun
• Operational risk
• Counterparty
• Rate of return risk
• Credit exposure
• Restricted investment
• Credit risk
accounts
• Debt-collection agency • Risk absorption
• GAP analysis • Risk-adjusted return on
• Ijarah muntahia bittamlik capital (RAROC)