Risk Management in
Islamic Financial Instruments
101
CHAPTER 5: SURVEY OF RISK MANAGEMENT PRACTICES
OF ISLAMIC FINANCE INSTITUTIONS OIC MEMBER
COUNTRIES
5.1 UNDERSTANDING OF RISK IN ISLAMIC FINANCIAL INSTITUTIONS
(IFIS)
Risk is the uncertainty that the actual result might be different from what is originally
expected. Commercial banks take deposits and deploy them into industrial and private
projects. The prospects of these projects largely depend on various socio-economic factors. A
sudden change of these factors may alter the original estimations made by commercial banks.
Islamic financial institutions (hereinafter IFIs) solve this problem by integrating the banking
contracts with various partnership-based contracts. Among these, the Mudarabah and the
Musharakah contracts are based on profit and loss sharing principles. One of the major
differences between these PLS-based contracts and those of conventional financial institutions
is that IFIs consider their customers as partners and share in the uncertainty with themat an
agreed upon ratio. However, not all the contracts of IFIs are equally practiced. The application
of these contracts is still in an emerging stage in purely Islamic economies and in economies
that accommodate dual banking system.
In order to maintain a healthy financial atmosphere, IFIs are expected to observe risks in
various contracts and processes on a regular basis and integrative risk management plans into
the strategic vision of the institution. This section is an attempt to identify risks in various
financial activities conducted by IFIs in OIC member countries. OIC cooperation countries
include developed, emerging and developing countries, which accommodate a range of
conventional, mixed and Islamic financial services. For instance, Malaysia is a practicing
Islamic country and visions the synchronicity of people from various races, namely Chinese,
Malay, Muslims, and Indians. Shari’ah guidelines and practices would be much wider in scope
and, at the same time, less stringent in Malaysia, when compared to the counterparts from the
Arabian and African peninsula. Therefore, IFIs expect a gradual change in governmental
direction, i.e. from the Shari’ah Advisory Council in Malaysia, to bring along a positive change
in the mind-set of the stakeholders.
Even though the social and legislative barriers have been identified as major obstacles in
Islamic finance, it is equally important to consider the efficiency of the internal system in order
to incorporate the increasing demand from the industry and society. To that respect, past
studies investigate the perception of the risk by managers of IFIs on the risk management
systems in different countries. This study widens this understanding into OIC countries.
5.1.1 Dynamics of Risk Management in Islamic Contracts
There exists a consensus that the contracts that are used in Islamic finance have a strong built-
in risk management system. The most recent example of the global crisis of 2007-08 taught us
that an unjustified profit making incentive for the conventional financial institution drove