Risk Management in Islamic Finance

By Amit Khandelwal

Banking, in all its forms, contains risks that pose a challenge to banks and supervisory authorities. Islamic banks, like their conventional counterparts, are financial institutions providing services to depositors and investors on the one hand, and offer financing to companies, public sector and individuals, on the other.

They are therefore subject to many risks that are similar to those confronted by conventional banks. In addition, Shari'a compliant banking has its own risks. In principle, there is a range of activities through which Islamic banks can work in different ways that enable them to provide funds.

These activities are adapted to meet the principles governing Islamic banking, the most important of which is the principle of risk sharing. Therefore, there is an urgent need to identify, measure, manage, monitor and control such potential risks and mitigate them within the capacity and capital adequacy of the relevant bank.

The most important challenges confronting Islamic banks are risks arising from financing formulas and Shari'a compliant banking, especially investment risks, the method of applying Basel II proposals, capital market and financial derivatives risks. In addition, Islamic banks bear a wide range of risks that differ, in nature, from those borne by commercial banks.

It is necessary to emphasise that the role entrusted to the supervisory authorities is to pursue a comprehensive control method based on risk assessment process and not to make any discrimination in a way that may suggest that Shari'a compliant banks are being rated differently or confronting larger risks.

Corporate governance, risk management, transparency, disclosure and internal control requirements in the Islamic financial services industry should always be developed, and adjusted to meet the needs specified for Islamic banks, especially that an important part of the work of these banks is based on impression and reputation of the nature of their work. Therefore, these banks should be aware of the role entrusted to them, especially the ethical one.

The nature of risks faced by Islamic banks may raise specific issues in terms of assets and inventory assessment, investment costs, regular income and recognition of losses, adequacy of guarantees and others. It is crucial that development of mechanisms to cover such risks continues.

This underlines the importance of integration into global financial markets, encouragement of competition, and provision of a proper climate for on-going innovation so that Islamic banks can consolidate their positions in all markets and boost their ability to provide products for all segments of customers.

On the other hand, a difference of opinion is sometimes raised and comparisons are made between Islamic and conventional banks in terms of degrees of risk, exposure to insolvency, and capital adequacy. However, it is important to be aware of and understand the risks, develop mechanisms to cover such risks, and the ability to compete in markets and meet the needs of customers.

Perhaps it is imperative here to emphasize that it is important for Islamic banks to provide all information about their activities and financial statements with full transparency, especially that they bear moral responsibility. This would enhance their credibility, contribute to their good reputation to be accepted on a broader range, and remove any false beliefs concerning their activities.

Hedging, Risk Management Tools and Financial Innovation
One of the most effective applications of financial engineering has been in the area of hedging, which has become an important instrument in today's risk management. Without hedging, financial institutions and corporates may suffer substantial losses with knock-on effects for the whole economy.

To understand the problem, let us assume that a Saudi businessman places an order for Japanese goods worth US$1m (SAR3.75m) to be delivered three months from now. If the rate of exchange is 117 yen per US dollar and if the exchange rate remains stable, Y117m will be due at the time of delivery of the goods. Since exchange rates are not stable and, consequently, if the yen appreciates over these three months by 5%, the Saudi importer will have to pay SAR3.94m for the goods instead of SAR3.75m.

The Saudi businessman will, therefore, incur an unforeseen loss of SAR190,000. One way of protecting himself against such loss would be to purchase today the yen total payable three months later.

This will freeze his financial resources unnecessarily and create a liquidity crunch for him. To avoid such liquidity tightness, the alternative solution available in the conventional financial system is to purchase Y117m in the forward market at the current exchange rate of Y117 per US dollar plus or minus a premium or discount. All that the importer has to do is to pay a small percent of the total amount as deposit for this purpose. This is a basic hedging transaction.

The question for Islamic finance is whether the mechanism of hedging to protect the importer from exchange rate fluctuations is permissible. The verdict of the fuqaha' (Shari'a scholars) so far is that hedging is not permissible. This opinion is based on three objections. These are that: hedging involves gharar (excessive uncertainty), interest (riba) payment and receipt, and forward sale of currencies. All three of these are prohibited by Shari'a law.

However, as far as gharar is concerned, I do not think that the objection is valid, because hedging helps eliminate gharar by enabling the importer to buy the needed foreign exchange at the current exchange rate. The bank, which sells forward yen, also does not get involved in gharar, because it purchases the US dollar at spot price and invests them until the time of delivery.

The bank, therefore, earns a return on the yen that it invests for three months but also loses the return that it would have earned on the Saudi riyals or the US dollars that were used to purchase the yen. The differential in the two rates of return determines the premium or the discount on the forward transaction.

The other two objections are, however, perfectly valid. Of these two, the objection with regard to interest can be handled by requiring the Islamic banks to invest the yen or other foreign currencies purchased by them in a Shari'a-compliant manner as far as is possible.

The third objection is, of course, very serious. Islamic teachings clearly prohibit forward transactions in currencies. However, we live in a world where instability in the foreign exchange markets has become an unavoidable reality. It is not possible for businessmen, as well as Islamic banks, to reduce their exposure to this risk.

How is this be managed? It is very risky for them to carry unhedged foreign exchange or other assets on their balance sheets, particularly in crisis situations when asset values depreciate steeply. If they do not resort to hedging, they actually get involved in gharar more intensively.

In addition, one of the important objectives of the Shari'a, the protection of wealth (hifz al-mal), would be unnecessarily compromised.

Financial institutions, which provide the needed protection through hedging, are well qualified for this service because of their greater resources and better knowledge of market conditions. The fee that they charge can be'Islamised' by using Islamic instruments.

The question, therefore, is whether hedging could be accepted in an unstable exchange rate environment. To curb speculation and misuse of this facility, hedging could be confined to foreign exchange receivables and payables related to real goods and services only. Moreover, this facility may be allowed only as long as exchange rates and commodity prices remain volatile.

If not, then is it possible for Shari'a scholars to suggest some other permissible mechanism whereby individuals and businesses may protect themselves against exchange rate and commodity price risks.

There has been substantial development in finding ways to apply derivatives to reduce certain risks such as currency and commodity risks, e.g. in Malaysia, some Shari'a-compliant hedging instruments, such as profit rate swaps, have been introduced. However, much of this progress remains localised with limited scope for cross-border application and further work is still needed.

Credit Risk

Timely recovery of debt is critical for the success of Islamic financing. In general, debt is created with actualisation of obligations of a client. Payment defaults, whether in lieu of some installment or the principal, can adversely affect business plans of Islamic banks, their working and, above all, settlement with different groups of depositors.

Shari'a law bars creditors from charging for payment delays. The prohibition of indexation for inflation of loans and debts can make the matters worse in inflationary regimes. In an Islamic environment, these problems will have to be addressed at several levels.

The nature of Islamic financial instruments implies that Islamic banks face not only the traditional commercial credit risk of their clients but also other risks associated with the instruments. For example, market risk for salam financing or potentially damaging claims due to ownership of assets in lease financing.

Several such risks can be addressed through design of financial contracts. As for commercial credit risk of the client, Islamic banks can reduce it through the following action:

Careful evaluation of financial requests including credit rating of clients.

Innovative collateral arrangements, third-party guarantees and credit rating of clients by specialised institutions.
Choice of an appropriate financial instrument available in the Islamic setup.

Proper pricing of Islamic financial products.
Effective covering contracts and efficient machinery for enforcement of contracts.

Islamic banks are likely to have advantage in risk management as compared with their interest-based counterparts who can make recourse to only the second and the fourth option.

Legal Risk

At present, with notable exceptions including Iran, Sudan and Malaysia, Islamic banks are functioning in many Muslim countries without proper legal cover.

In general, legislative needs for Islamic banking can be minimised by legislating the Shari'a principles and the Shari'a restrictions for contracts, while leaving practical details for adjudication by the courts. Despite this, some aspects of legal risk do need to be scrutinised and understood.

Murabahah financing means purchase and resale, i.e. two trading transactions. This need not be seen as such for sales tax purposes, because Islamic banks do not buy things under financing for their personal needs.

Registration requirements and associated agreements need to be simplified as the associated costs may impede lease financing. There is also need for special legal cover in order to facilitate and implement musharakah (partnership) agreements by Islamic banks. Adjudication of recovery of bank receivables is presently interest-based.

Its alternatives need to be developed and provided for in the law. One issue that will continue to be relevant in the foreseeable future is prospect of Islamic banks working in the prevalent interest-based framework. It is obvious that Islamic financial instruments and their documentation and accounting requirement would be different.

Therefore, the room for putting Islamic financial norms into practice in the existing framework would be limited. This, in turn, implies that Muslim countries should consider providing separate legal cover for Islamic financing.

Ratings

Various agencies rate Islamic financial institutions, such as Standard & Poor's, Moody's and Fitch. However, I think there is a need of a specific Islamic rating agency, for the following reasons:

Rigorous and consistent analysis of quantitative and qualitative factors.

Assessment of risk profile of institution or product.
Removal of asymmetry in information on the variety of business operations.

Investors in Islamic countries desire to know the credit worthiness of the institutions and products and the legitimacy, in terms of Shari'a compliance, of institutions and products.

Such an agency would not only consider the creditworthiness of obligors, their overall risk management abilities and governance structures, but also the systems, processes and methodologies the institution has in place to measure, monitor and demonstrate Shari'a compliance.