Risk Management in
Islamic Financial Instruments
14
CHAPTER 2: RISKS IN ISLAMIC FINANCIAL INSTITUTIONS
AND MARKETS
2.1 FINANCIAL INTERMEDIATION THEORY
Financial intermediaries, defined as institutions that connect the surplus and deficit agents of a
market, are arguably the most important institutions within the world’s economies, as, in their
absence, the global economy would, more likely than not, fall. Financial intermediaries do not
produce anything, per say, but rather, they act as vehicles between various financial
institutions of contrasting needs’ profiles in addition to being the site of other important
financial functions. Examples of financial intermediaries include, most notably, banks, but also
certain investment funds, such as pension and mutual funds.
As a shaper to economics around the world, financial intermediation’s seemingly incomparable
importance to economic health can be attributed largely to the fact that a large portion of
every dollar of finance, globally and especially in the US, comes from banks.3Consequently, as
“monitors”, financial intermediaries’ role in the context of banking is widespread. To be more
specific, banks, upon their providing of bank loans in corporate finance, de facto play a role in
corporate governance, acting as signals to firms in distress and bankruptcy; however, on the
consumer side, banks’ demand deposits (checks, credit cards, etc.), which are typically
redeemed at face value and put to the bank at par in exchange for currency, must be effectively
cleared by banks, ideally in a timely manner (Gorton and Winton, 2002). Islamic financial
intermediation, like all Islamic financial mechanisms, differs from its conventional counterpart,
not only theoretically, but in practice as well. Islamic financial intermediation can be dated
back to the early periods of Islam. Chapra and Ahmed (2002) examine the duties of sarrafs, or
financiers, who undertook many of the basic financial intermediation functions between
borrowers and lenders (Hawary, Grais and Iqbal, 2003). Udovitch (2002) found there to be
evidence that some of the concepts utilized by sarrafs were adapted by late eighteenth century
European financial engineers centuries later. Understandably, adaptations have taken place,
both theoretically and in practice, since traditional Islamic financial instruments and
methodologies were developed (Hawary, Grais and Iqbal, 2003).
One convention that has remained in contemporary Islamic banking, is that all IFI activities are
all firmly grounded in some sort of contractual agreement (viz.“Islamic methods” referenced
above). Islamic financial contracts can be divided into two distinct types, transactional and
intermediation. Transactional contracts govern activities, including exchange, trade, and
financing, while intermediation contracts facilitate the proper execution of the former
(Hawary, Grais and Iqbal, 2003). In the conventional space, banks refrain from certain
functions of financial intermediation used by Islamic banks, namely, Shari’ah screening and
Islamic instrument implementation. Theoretically, both systems facilitate the mobilization and
the utilization of funds on the basis of profit sharing among depositors, the bank, and the
entrepreneurs; however, in practice, Islamic banks typically employ funds by means of
3 Gorton, Gary, and Andrew Winton. "Financial Intermediation." NBER Working Paper Series 8928 (2002): 1-140. National Bureau of Economic
Research. Web.