Risk Management in
Islamic Financial Instruments
102
these century old institutions into catastrophic increases in leverage that were supported by
gradual deregulation in the financial industry. Additional leverage was collected to invest in
short-term profit making by sacrificing the long-run stability of the entire system. Islamic
Shari’ah prohibits unjustified profit making by charging interest, undertaking excessive risky
investments, engaging into corruption, and living in ignorance. Moreover, if a customer does
not get a loan in a conventional bank, bank managers adjust the credit rating of the customer in
order to accommodate the loan, which eventually increases the cost of the loan. In IFIs, there
are number of partnership arrangements to suit the demand of the customers. For instance, if
an individual cannot share capital s/he cannot ask for a Musharakah contract, but can still find
a Mudarabah contract based on entrepreneurial skill. Entrepreneurial skill is more important
in IFIs, while conventional finance places it in the credit risk matrix.
Since IFIs run on profit-loss-sharing contracts, the employees of IFIs’ have to be as equally
qualified as the loan-seekers in order to manage the entrepreneurial challenges. In order to
understand the financing need of a specific set of entrepreneurial ventures, IFIs’ must have
strong internal mechanisms to work closely with these partners. Innovation in IFIs drives us
towards using more complex instruments. IFIs should have highly trained management and
systems in order to understand the challenges posed by these innovations. For instance,
various IFI contracts rely heavily on changes in market prices of commodities. The
management of IFIs should have a system of identifying the changing market prices and decide
on a plan to diversify these risks. Since the use of derivative financial instruments for IFIs is
still very limited, it is the clear knowledge and the built-in internal mechanisms that can save
IFIs.
The following sections will shed light on what managers of IFIs think about risks in their
operations, about the reporting of risks in IFIs, and the readiness of IFIs’ in handling these
challenges. This study, which is profoundly influenced by other existing studies, has included
four major types of risks faced by IFIs. These risks are the operational risk, the credit risk, the
liquidity risk and the mark-up risk. Six major types of modes of financing were considered.
These are the Mudarabah , Musharakah , Murabahah, Ijarah, Salam and Ijtisna. The primary
objective of this study is to analyse the perception of the risk managers of IFIs towards the
types of risks, risk identification, measurement and management procedures, and other risk-
related issues in selected banks.
Financial institutions are in the business of managing risk for their clients. In a conventional
setting, banks are risk managers. Risks are also available in Islamic forms of business.
However, the Islamic financial institutions try to minimise these risks based on Shari’ah
principles. Islamic Shari’ah saves the IFIs from a large part of the risk by prohibiting a number
of risky activities, including speculation and investing in a highly uncertain business
environment. Due to a proactive avoidance from risky business, the identification of the
remaining risky activities becomes easier. However, due to peculiar types of financial activities
of IFIs that are primarily through trading, conventional risk-identification models do not
directly fit into IFIs. Consequently, due to cross border collaboration and other operating
challenges, IFIs have to prepare to understand their risk patterns and the ways in which to
share those risks with their partners. Table 5.1 offers a detailed review of the risks faced by IFI.