Risk Management in
Islamic Financial Instruments
23
the case of late payments (an explicit violation of Shari’ah), many do, unfortunately, and do so
in order to deter risks of default and delinquency (Hawary, Grais, and Iqbal, 2003).
These kinds of risks are most commonly found in areas laced with institutional corruption and
a lack of stable development. Bankers in the Islamic world, like other parts of the developing
world, see such risks more frequently than in the developed banking systems of the Western
economics. Institutional risks are basically anything that could stand in the way of a bank’s
effectiveness from a business perspective; however, by definition, diverging product
definitions and practices most aptly describe this risk criterion. Lastly, we have regulatory
risks, the risk of regulatory noncompliance, often the result of inept management decisions
(which are often the result of a miscomprehension of compliance regulations), and this can be
traumatic for developing banks. Islamic banks (particularly in areas where Islamic banking is
new), are confronted with regulatory dilemmas more often than other banks. For example,
(though the regulatory framework in the US is such that non-conventional banks are usually
aware of the rigorous regulatory requirements placed upon them by the US government),
according to US regulatory mandates, banks must not assume unnecessary risk. Having said
that, most banking institutions in the US try to limit their investments (and those they offer for
outside investment) to fixed-income entities and interest-bearing securities.3 As we know,
financial structures involving interest-based mechanisms are stringently forbidden, and
Islamic banks, theoretically, are encouraged to share risks with their clients. While financial
engineers in the Islamic finance field have been able to design and implement Islamic products
into the US market that are in good-standing with US regulatory statutes, including takaful
insurance (which is based solely on the concept of shared-risk), the legal and compliance risks
involved in such undertakings create situations where the costs (viz. the risks) outweigh the
prospective benefits. Islamic banks, if found to be in regulatory noncompliance, can feel the
effects rather acutely, as such banks are typically subject to penalties and other monetary
castigations.
The conventional financial landscape in which Islamic banking operates is not always
conducive to making risk avoidance simple or, in some cases, even possible for Islamic banks
seeking to implement various Islamic financial structures. Maroun (2002) argues that the lack
of Shari’ah compatible instruments coupled with the lack of qualified market makers and
informational data limitations have served as an impediment to the development of
functioning secondary markets, something the industry must focus on in the coming years.10
Since long-term mudaraba, for example, can provide liquidity by allowing investors to trade
certificates in the secondary market without having to directly redeem them with the bank
that issued them, the establishment of International Islamic Financial Market (IIFM) and the
Liquidity Management Center (whose mission is to advance such liquidity-producing
activities) may prove helpful.11 Aside for ijara sukuk, which have been issued by the Bahrain
10 Maroun (2002) quoted in Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the
Regulated." International Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003.
11 Maroun (2002) quoted in Hawary, Dahlia El, Wafik Grais, and Zamir Iqbal. "Regulating Islamic Financial Institutions: The Nature of the
Regulated." International Conference on Islamic Banking: Risk Management, Regulation and Supervision, Aug. 2003.