Risk Management in
Islamic Financial Instruments
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CHAPTER 6: SUMMARY AND POLICY RECOMMENDATIONS
6.1. RISKMITIGATION AND REGULATION IN ISLAMIC FINANCE
The following section was derived largely from Ahmed and Khan (2007). Risk identification
and management available in Islamic banks is of two types. The first type is comprised of
standard techniques, such as risk reporting, internal and external audit, GAP analysis, RAROC,
internal rating, etc., which are consistent with the Islamic principles of finance. The second
type, outlined by Ahmed and Khan, consists of techniques that either need to be developed or
adapted, while keeping in view the requirements for Shari‘ah compliance.
Gharar can be mild and sometimes unavoidable; however, it could also be excessive and cause
injustices, contract failures, and defaults. A number of appropriate contractual agreements
between counterparties work as risk control techniques. Ahmed and Khan cite:
“To overcome the counterparty risks arising from the non-binding nature of the contract
in murabahah, up-front payment of a substantial commitment fee has become
permanent feature of the contract. To avoid fulfilling the promise by a client in taking
possession of the ordered goods (in case of murabahah), the contract should be binding
on the client and not binding on the bank. This suggestion assumes that the bank will
honor the contract and supply the goods as contractually agreed, even if the contract is
not binding on it.”
Since the murabahah contract is approved with the condition that the bank will take
possession of the asset, at least theoretically, the bank holds the asset for some time. This
holding period is almost eliminated by the Islamic banks by appointing the client as an agent
for the bank to buy the asset.
In istisna, contract enforceability becomes a problem particularly with respect to fulfilling the
qualitative specifications. To overcome such counterparty risks, Fiqh scholars have allowed
band al-jazaa (penalty clause). Again, in istisna financing, the disbursement of funds can be
agreed upon on a staggered basis, subject to different phases of the construction, instead of
lumping them towards the beginning of the construction work. In several contracts, a rebate
on the remaining amount of mark-up is given as an incentive for enhancing repayment.
Fixed rate contracts such as long maturity installment sales are normally exposed to more risk,
compared to floating rate contracts, such as operating leases. Due to the absence Islamic courts
or formal litigation system, dispute settlement is one of the serious risk factors in Islamic
banking. To overcome such risks, the counterparties can contractually agree on a process to be
followed if disputes become inevitable. Specifically, Islamic financial contracts include choice-
of-law and dispute settlement clauses (Vogel and Hayes 1998, p.51). This is particularly
significant with respect to settlement of defaults, as rescheduling similar to interest-based debt
is not possible.
In order to manage interest rate risk, the use of GAP analysis and the use of two-step contracts
are advised. Since it is impermissible for a guarantee to be provided as a commercial activity