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Islamic Finance news Guide 2008
Page 56
Risk Management in Islamic Banking: Key Issues (continued...)
However, this growth could not remain untouched by the
complexity and issues related to risk management. Risks exist
in all forms of banking and Islamic banking is no different and
is not shielded from the risks. The prohIslamic bankingition of
rIslamic bankinga, as a basic tenet of Islamic banking, does
not make it completely safe from interest-rate risk. Islamic
banking cannot, and does not, operate in an isolated world of
banking. It has strong linkages with conventional banking and
operates in complete harmony with it.
As a systemic partner of the banking system as a whole,
Islamic banking is affected by the risks faced by conventional
banks. Risks in Islamic banking are distrIslamic bankinguted
in a different way as compared to conventional banking. Since
Islamic banking is based on contracts such as Murabahah,
Musharakah, Mudharabah, Istisna, Ijarah and Salam, the
risks are also woven around the combination of factors in the
contracts. The timeline in the contracts relating to events,
which are related to either cash fl ows or change of liabilities,
affects the risks.
Trends and developments
In the early 1980s, conventional banking risk management
techniques were applied to Islamic banking as there were no
specifi c standards for risk management for Islamic banking.
The original Basel 8% norm of capital adequacy was applied
to Islamic banks also. When Basel II was released, Islamic
banks attempted to fi nd ways of managing the risks specifi c
to Islamic banking. It was realized that the provisions in Basel
I, and later on, Basel II, were insuffi cient for handling risks
in Islamic banking. Pillar I of Basel II failed to answer the
complexities of the Islamic contracts. However, Pillars II and
Pillar are fundamentally applicable to Islamic banking also.
Due to the gaps in existing risk management standards,
the Islamic Financial Services Board (IFSB) attempted to
systematize the risk management framework for Islamic
banking. It released the risk framework for IFIs in 2005.
The role of IFSB is commendable since it brings the risk
management discussion to the core of risk recognition. IFSB
stresses the need to recognize the risks at the point of origin.
It also recognizes that the risks are dynamic and change
during the lifetime of the contracts.
On the technology front, tools and solutions for Islamic banking
have also evolved over the last decade. While several core
banking solutions specifi c to the industry are widely available,
risk management solutions are not. The solutions available
also address silo risks and do not integrate all fi nancial risks.
Conventionally, risk factors were single and not so complicated
and interwoven. As the complexities in the market increased,
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risks became correlated with each other. For example, change
in the market prices of the indices (market risk) affected the
credit rating of the counterparties, affecting their liquidity
positions (liquidity risk), which fi nally affected the risk of
default or changed repayment conditions for the bank (credit
risk). Thus, different risks started interacting with each other,
making it mandatory to look for solutions that offer truly
integrated fi nancial analysis and not just silo solutions. The
risks in Islamic banking are even more complex and need
integrated risk analysis.
Challenges and solutions
Islamic banking’s present success still poses some serious
challenges on the internal and external fronts (Figure below).
Figure 2: Major challenges for Islamic banking
On the internal front, and due to recent rapid developments,
there is a shortage of qualifi ed manpower for Islamic banking.
Business development, risk management, compliance and
so on are some of the areas where Islamic banking has
signifi cant gaps in terms of qualifi ed manpower. More training
programs, user seminars, conferences and study groups can
solve the problem to a certain extent.
Risk identifi cation is more complicated in Islamic banking
because the relationship between contract parties changes
as the contract enters into a new phase. The risk should be
identifi ed carefully and should be based on the timeline in
the contract.
Risk measurement is similar to conventional banking. The
mitigation techniques are sometimes unique in Islamic banking
due to the absence of standard insurance and other mitigation
methods. Shariah compliant risk mitigation techniques
can solve the problem to a certain extent. The most critical
issue in Islamic banking is liquidity risk management. Due to
the diffi culties related to intra-bank money market and other
money market instruments, coupled with heightened risks of
defaults, liquidity management is one of the most important
factors in Islamic banking.
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