Risk Management in
Islamic Financial Instruments
20
2.4 RISK PROFILE OF ISLAMIC FINANCIAL INSTITUTIONS
Islamic banking, like conventional finance, is vulnerable to a wide range of risks. From credit
and market risk to the myriads of vulnerabilities present within the global financial
environment, Islamic business professionals must be attune to the dynamics of risk so that
they are effectively able to mitigate them.
As one would suspect, there are many risks specific to certain Islamic financial structures.
Below, we examine the multitude of potential risks present in Islamic banking, as adapted from
Hawary, Grais, and Iqbal’s presentation materials from the International Conference on Islamic
Banking (2003).
Credit risk is the failure of the counter party to meet the obligations stipulated by the
contract. Such risk can be related to the timeliness by which the counter party engages in the
requisite tasks placed upon them by the contracts, or their inability to effectively fulfill the
agreed upon terms. Credit risk is often found in Islamic contracts like Bay mua’jal, mudaraba,
musharaka and murabaha, in particular, where the actions of the counter party may be partly
contingent on an amalgam of uncertain factors. One example could be the occurrence of a
drought leaving the counter party unable to yield the agro-materials needed to complete a
specified task. Credit risk could also be, on the depositors’ side, the risk that a bank does not
honor withdrawal requests at face value/market value. Since murabaha, Istisna’a, Ijara,
salaam, and other sales-based facilities make up the majority of the asset side of an Islamic
bank (a figure, according to Sundarajan (2005) is between 80 and 100%), credit risks are of
principal importance, as are the methods used to measure them. Effectively, there are two
ways credit risk is measured: by a rating class system, which assigns probabilities of default to
each counter party, and the credit value-at-risk method (Credit VAR). Both of these methods
use the same approach in order to best estimate an expected loss on an exposure (or a
portfolio of exposures), based on prospective credit events (default, rating downgrade, etc.) as
well as to calibrate unexpected losses (deviations from the mean) that may occur, given some
probability method (Sundarajan, 2005).
Market risk is another type of commonly encountered risk, and it deals with the risks
associated with changes to the underlying market value of a pool of assets. Market risks are
systematic, meaning that all investors in the market are susceptible to potential disruptions
they may cause. Foreign exchange risk, for example, which is the risk of exchange rate
movements on assets of foreign currency, is always present. Though for certain groups of
investors, this may serve to their benefit, the risk that exchange rate risk could be detrimental
is never absent from the market. Mark-up risk is another type of operating risk facing Islamic
banks, and it details with the divergence between a contract’s mark-up, say, for example, a
mudaraba contract, and that of the benchmark rate present in the market. This type of risk
places Islamic banks utilizing contracts that entail deferred trades especially at risk.
Exposure to various forms of market risk can be measured using traditional means commonly
utilized in conventional risk management, namely (Sundarajan, 2005):
 Net open position in foreign exchange
 Net open position in traded equities