Islamic finance has grown substantively in the past few years and with it there has been a growing interest and debate on the appreciation of its risk architecture and profile. It is now well recognised that, by and large, Islamic banks are prone to the same risks as conventional banks. Concurrently, however, Islamic banks face additional risks that emanate from the unique characteristics of Islamic finance transactions, along with risks associated with the real or perceived non-compliance of Shariah principles that may erode customer/investor confidence.
To understand the complexities of an appropriate risk and reward-sharing mechanism embedded in Islamic finance transactions, a better understanding of the management and mitigation of the risks associated with certain Islamic products is necessary. This requires a change of mindset for both the Islamic banking industry and the regulators, whose primary focus has been debt-based financial intermediation.
At the same time, it requires the development of a financial, legal and regulatory infrastructure to help manage principal agent-entrepreneur relationships in profit and loss-sharing transactions, where commercial banks are exposed directly to equity exposures of partners in business while catering for investment account holders’ concerns.
Most importantly, Islamic banks are generally exposed to substantial liquidity risk owing to the lack of access to standardised sharia-compliant investment portfolios and liquidity management instruments. This has affected their ability to successfully manage the maturity profile of both assets and liabilities, and has curtailed diversification.
Lack of instruments
Risk management in Islamic finance is further complicated by the lack of adequate risk hedging instruments and techniques. Sharia prohibition of riba and gharar means many techniques based on conventional tools, such as options, futures, and forwards, are not yet available to Islamic banks and this lack has increased banks’ vulnerability to foreign exchange, interest rate, commodity and equity price risks.
In order to address liquidity risks, the Islamic financial industry must develop appropriate liquidity management instruments. Moreover, the compound risks faced by Islamic banks have necessitated the development of a sharia-compliant derivatives market. Besides providing hedging, such derivative instruments are expected to improve transactional efficiency. However, further progress in this area would require substantial research and employment of financial engineering and innovation.
Further, the disclosure regime in Islamic banking needs to improve to ensure proper market discipline, removal of information asymmetries, better risk-return profile, building trust in sharia compliance and improvement in internal governance. Better disclosure would also contribute towards the development of equity-based financing such as mudarabah and musharika.
Consistent with the best practices of the corporate governance framework, Islamic banks also need to conform to its well-accepted and time-tested principles, in recognition of the fact that sharia offers a stakeholder-oriented model of corporate governance implicit in Islamic property and contract provisions. Also, the model of governance is affected by the role of investors as depositors, in addition to the oversight of Islamic banks by sharia advisory boards, and is critical for ensuring credibility and sanctity.
Regulatory framework
Work also needs to be accelerated to develop proper understanding of prudential regulations and sharia inspection and supervision of Islamic banks. Guidance on a prudential regulatory framework should incorporate appropriate amendment and refinements to the Basel II framework or other best practices, with the objective of providing effective treatment of risks associated with Islamic products and balance sheets.
There has been considerable movement in recent times in the development and promulgation of international best practices in Islamic risk management principles. In this regard, the work done by international bodies such as the Islamic Financial Services Board guides the industry and regulators. Notwithstanding, as the risk architecture for Islamic finance continues to evolve, a fuller appreciation of its risks will emerge as more empirical evidence comes forth with the growth in the size of the industry.