Understanding Islamic Finance - Doha Academy of Tertiary Studies

84 Understanding Islamic FinanceThe Holy Qur’ān enjoins us to write down and take witnesses in all transactions that involvecredit one way or the other. Similarly, the holy Prophet (pbuh) himself encouraged disclosureof all features of goods being traded and the competitive environment in which peopleget sufficient information about goods and their prices in the market. The Islamic banks’disclosure standards are stringent because their role is not limited to a passive financierconcerned only with interest payments and loan recovery. Islamic financing modes are usedto finance specific physical assets like machinery, inventory and equipment. Hence, clientsof Islamic finance must have business which should be socially beneficial, creating realwealth and adding value to the economy rather than making profit out of antisocial or merelypaper transactions.An Islamic bank is a partner in trade and has to concern itself with the nature of businessand profitability position of its clients. To avoid loss and reputational risk, the Islamic bankshave to be extra vigilant about their clientele. As such, I believe Islamic banks are lesslikely to engage in illegal activities such as money laundering and financing of terrorismthan conventional banks.4.2.9 Additional Risks Faced by Islamic BanksEven though Islamic banks can genuinely take collateral for extending finance, they cannotrely on it heavily because of the risks associated with various transactions. They are,therefore, under obligation to carry out a more careful evaluation of the risks involved. Theadditional risks that Islamic financial institutions have to face are asset, market and Sharī´ahnon-compliance risks, greater rate of return risks, greater fiduciary risks, greater legal riskand greater withdrawal risk.Asset risk is involved in all modes, particularly in Murabaha (before onward sale to theclient), Salam (after taking delivery from the Salam seller) and Ijarah, as all ownershiprelatedrisks belong to the bank so long as the goods are in its ownership. In Shirkah-basedmodes, risk is borne as per the share in the ownership. Certain developments in the economyor the government’s trade policy may affect the demand and prices of goods, leading to asset,price and rate of return risks. Receivables created under Murabaha cannot be enhanced evenif the general market rate (benchmark) rises. In the case of non-Sharī´ah compliance, notonly would the related income go to the Charity Account, but it may also lead to creditabilityrisk for an Islamic bank, which in turn may lead to withdrawal risk and the “contagioneffect” for the Islamic finance industry. Banks’ involvement in physical assets may also leadto greater legal risks than the conventional banks have to face.The results of a survey of 17 Islamic financial institutions conducted by Khan and Habib(2001) confirms that Islamic financial institutions face some risks arising from profit-sharinginvestment deposits that are different from those faced by conventional financial institutions.The bankers consider these unique risks more serious than the conventional risks faced byfinancial institutions. The Islamic banks feel that returns given on investment deposits shouldbe similar to those given by other institutions. They strongly believe that the depositors willhold the bank responsible for a lower rate of return and this may cause withdrawal of fundsby them. The survey also shows that Islamic bankers judge profit-sharing modes of financingand product-deferred sales (Salam and Istisna‘a) to be more risky than Murabaha and Ijarah.The survey further reveals that while Islamic banks have established a relatively good riskmanagement environment, the measuring, mitigating and monitoring processes and internalcontrols need to be further upgraded. The growth of the Islamic financial industry will,