Risk Management in
Islamic Financial Instruments
22
risk management practices at these kinds of banks are not well embedded in the banking
culture, at least not in places where Islamic banks are newly established. Understandably, both
return on equity and assets could be affected if the bank suffers losses at the hand of
operational issues. Specific facets of Islamic banking may create a banking environment
conducive to operational dilemmas, which, according to Islamic finance expert, Sundararajan
(2005), are:
I. The cancellation risks in non-binding Murabaha and Istisna’a contracts
II. problems in internal control systems to detect and manage potential problems in
operational processes and back office functions
III. technical risks of various sorts
IV. the potential difficulties in enforcing Islamic Finance contracts in a broader legal
environment
V. the risk of non-compliance with Sharia requirements that may impact on
permissible income
VI. the need to maintain and manage commodity inventories often in illiquid markets
VII. the potential costs and risks in monitoring equity type contracts and the associated
legal risks
Fiduciary risks, another type of government risk, are, in some ways, like insolvency risk, in that
they could cause banks’ reputations to diminish in the eyes of the public. Essentially, fiduciary
risk is the risk that a bank is facing legal recourse following a breach in contract and a failure to
meet contractual stipulations. Besides the reputational risks involved, banks may face
penalties, both direct and indirect. The latter is perhaps even more devastating and may
include investors withdrawing their deposits, a selling off of shares, etc. Profit-sharing modes
of financing, as you can see from the Figure 3, are perceived by the respondents as having a
higher risk profile. In addition to displaced commercial risk, discussed earlier in this report,
profit and loss sharing features introduces fiduciary risk, or becoming legally liable for a
breach of the investment contract either for non - compliance with Shariah rules or for
mismanagement of investors’ funds (AAOIFI, 1999) (Hawary, Grais, and Iqbal, 2003). This
liability leaves banks exposed to potentially direct losses given that there may be breaches of
fiduciary responsibility towards its depositors as well as indirect losses resulting from declines
in the market.9 The last type of government risk is transparency risk, the risk that a bank’s
decisions are based off a set of misinformation. Logically, decision-making based off potentially
false information presents a host of possibly devastating consequences to both conventional
and Islamic banks.
Finally, we have systematic risks, which are risks that no bank can avoid. Business
environment risks leave banks exposed to the problems pervasive within the institutional
confines in which they do business. They include legal risks, namely the inability to enforce
contractual agreements. Though many Islamic banks refrain from imposing late penalties in
9 As one would suspect, there are many risks specific to certain Islamic financial structures. To preface our discussion (s) concerning
idiosyncratic risk, I would like to present the following chart as a preface to that discussion, before defining the various risks we see in the
market place, as well as which/why those risks are specific to certain Islamic financial structures.