Risk Management in
Islamic Financial Instruments
19
from the bank’s businesses related to the investors’ investment, the investor receives a share
in those profits. The second tier is between the bank (as the fund supplier) and the
entrepreneurs seeking funds in order to produce profits from specified economic activities,
and those profits are shared with the bank according to a contractually dictated percentage.
This model does not have any special reserve requirements on either the investment or
demand deposits; however, in addition to investment deposits, banks would accept demand
deposits, too, which would be repayable on demand (on the liability side). This feature of the
model is in contrast with that of the “two-windows” model with regards to reserve
requirements. The “two windows” model divides liabilities into two distinct windows, one for
demand deposits that are strictly liabilities and the other for investment deposits, which are
not. The depositor chooses in which window to invest.
In practice, the “two windows” model requires banks to hold a 100 percent reserve on the
demand deposits, which are guaranteed by the bank, and zero percent on the investment
deposits used by banks to finance instruments bearing risk, making the risk for demand
account holders essentially non-existent. Investment account holders are investors/depositors
who enter into a mudarabah contract such that profit-sharing investment deposits are not
liabilities, as the investors share in profit accruals to the bank’s investments, which, in this
case, are on the asset side (Greuning and Iqbal, 2008). Greuning and Iqbal (2008) state that, in
some regions, Islamic banks will offer special investment accounts developed either on the
basis of special purpose, restricted mudarabahs, or musharakah (P/L).
Also worth discussing is that Islamic banking experts have cited the one-tier mudarabah model
as being one of the more effective practical frameworks to engage in Islamic banking.
Specifically, the liability side of this model is mudarabah based, PSIA, while, on the asset side,
multiple fixed-income investment tools are often utilized, namely murabaha, ijarah, istisna, and
others. Worth noting is that, through profit equalizing reserves being deducted from gross
income and investment risk reserves being deducted from the income of PSIA depositors (after
the bank’s share is deducted) to meet losses on PSIA financed investment, the model features
inherent profit rate smoothing. Lastly, despite Islamic scholars’ disapproval of penalties for
late payments and defaults, this model is often structured such that penalties are often
effected, with the collected funds being given as charitable donations.
Another model, like that above, utilizes fixed income investment tools on the liabilities and
equities side; however, this model is most known for tawwaruq accounts on the asset side.
Typically referred to in some way by tawarruq, such models utilize tawarruq, an Islamic
financial structure that replicates a loan transaction and can be structured in such a way that it
can replace many (and, in specific cases, all) different modes of Islamic investments, like salam,
ijarah, istisna, etc. Since this model does not link the return on assets and liabilities, it can be
argued that the stability of the model is weakened.