Risk Management in
Islamic Financial Instruments
21
 Net position in commodities
 Rate-of-return gap measures by currency of denomination
 Duration measures of assets and liabilities in the trading book
Aside from the market and credit risks discussed above, there are several other concerns of
Islamic banks, namely those resulting from competition and other pressures coming from
oppositional entities. These business risks include displaced commercial risk, which is the risk
that an asset’s performance diverges from expectations for returns and liabilities. Within the
context of certain Islamic contracts, investment depositors may have to forgo portions of the
shares they are entitled to as mudaribs. Consequently, this type of risk can cause a bank’s
return on equity to decline, potentially resulting in an adverse effect on the value of capital. In
turn, shareholders are at risk of receiving lower shares of bank profits. Withdrawal risk, due to
the inherent exposure faced by surges in deposit withdrawals could result in the bank being
exposed to severe liquidity problems and the erosion of its franchise value. Insolvency risk is
another, related risk confronting Islamic banks and is especially threatening to their
reputations, which, in this incipient phase of the Islamic banking industry, are not well
grounded in the minds of institutional investors and retail consumers alike.
Next, we have three treasury risks of particular importance to our discussion of risks: (1)
asset and liability mismanagement (i.e. ALM risk) could leave a bank with an unfavorable
capital profile; (2) liquidity risk, the risk of a bank being unable to access sufficient liquidity
and leaving them unable to meet their obligations (ex. a bank is unable to access deposits, on
the bank side, and investors being unable to access the monies they have deposited at the
banks); and (3) hedging risk, the possibility that a bank is unable to effectively mitigate their
exposure to risks of all varieties.
Regardless of how one interprets liquidity risk in the context of Islamic banking, it is with little
doubt a significant risk consideration for Islamic financial institutions, due to the limited
availability of Shari’ah compatible money market instruments (Sundarajan, 2005). Aside from
the most frequented method of liquidity risk, the liquidity gap for each maturity bucket for
each currency, the share of liquid to total assets (or to liquid liabilities) is another commonly
used method (Sundarajan, 2005). Though many Islamic financial institutions disclose
computed liquidity gap measures and, as a result, Sundarjan (2005) states that calculating the
rate-of-return or reprising is relatively straightforward. Given the importance of equities and
commodities in Islamic banks’ balance sheets, market risk is calculated, typically, using a
variety of different VAR measures. For example, for both commodities and equities, VAR based
on a 99 % confidence level could be computed and based on quarterly equity returns
( mudaraba or musharaka profit rate) net of a risk free rate (or quarterly or monthly charges in
commodity prices) (Sundarajan, 2005). With regards to commodity markets, the cancellation
risks in murabaha and the fact that, according to Shari’ah, murabaha contracts must be sold at
par, along with the Shari’ah prohibition of secondary salaam and Istisna’a contracts (both
discussed in Sundarajan, 2005) make the potential for liquidity problems greater.
Government risks are present more in certain regions, commonly where economies are still
developing, than in others. Operational risks are the failure of internal processes relating to
people or systems. Islamic banks are definitely not immune to this kind of risk, especially as