Risk Management in

Islamic Financial Instruments

Monetary Authority (BMA) (where a secondary market exists), the overwhelming proportion

of transactions that occur are exclusive to the primary market only.

Though there are regulatory impediments to the implementation of certain features specific to

the Islamic finance industry, like profit-loss sharing mechanisms, some experts believe that

PLS features have their own risks. In 1999, AAOIFI identified displaced commercial risk as the

malefactor behind an Islamic bank being pressured (in order to retain investor loyalty) by

having to expend to its depositors a rate of return that was greater than what would have been

appropriate given the actual terms of the contract.

This practice, which is wholly self-

imposing, allows for situations to arise in which banks may forgo some, if not all, of

shareholders’ profits, as exampled by the International Islamic Bank for Investment &

Development in Egypt in 1998 (when the bank distributed no portion of its profits to

shareholders, while all went to investment account holders; in fact, the distribution of funds

that went to depositors amounted to a figure that exceeded the bank’s profits, the difference

appearing in the bank’s accounts as “loss carried forward”).

To conclude our outline contextualizing the different forms of risk facing Islamic financial

institutions, there is one, non-systematic risk exclusive to Islamic banks termed Shari’ah risk

that is of immense importance to our discussion. The spectrum that one may use to

understand this kind of risk is expansive, as both the type of risk as well as more generally the

field of Islamic finance is still defining itself as an industry. Shari’ah risk, according to much of

the existing literature, deals with the risk of non-compliance with the Shari’ah. Shari’ah risk

may be construed as an operational risk. Within the economic environments of many regions

around the world, Islamic banks are under intense monetary and regulatory constraints,

especially as compared to their conventional counterparts. That being said, aside from non-

compliance issues borne out negligence in a due diligence capacity, in certain, more rare cases,

non-compliance results from Islamic financial institutions’ circumventing Islamic regulations

in order to attain some sort of monetary or other benefit. From a reputation standpoint,

engaging in such activity may cause weary investors to become reticent to engage with the

bank and, more generally, with the Islamic finance industry at large. Interestingly, as you may

notice, unlike traditional law in finance, which normally serve to make transactions

enforceable in court (providing transaction security), in Islamic finance, that role is reversed.

Shari’ah risk is, contrarily, a risk that allows a transaction to be assessed and criticized on the

basis of non-Shari’ah-conformity.

In some ways related to Shari’ah risk is moral hazard, which will again be referenced later in

this paper during our discussion of microfinance. In profit-loss sharing activities when using

mudaraba,

there are clear moral hazard problems. Since the

rabbul-mal

solely bears any losses

(in case of a negative outcome), he cannot enforce the

mudarib,

the user of the funds, to take

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.

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.

Warde (2000) as 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.

Balz, Kilian. "Sharia Risk? How Islamic Finance Has Transformed Islamic Contract Law."

Islamic Legal Studies Program Harvard Law School I

Harvard University, Sept. 2008. Web.