Risk Management in
Islamic Financial Instruments
25
actions required to produce the expected level of returns. 16 In addition to the fact that the bank
cannot monitor or participate in the project (and is vulnerable to a potential loss of 100% of
their principal investment in addition to its potential profit share if the entrepreneur’s books
show a loss), the mudarib can exploit their position of control toward their own benefit, not
that of the project as a whole. 17 Generally, the user of the fund’s ability to increase their
consumption of non-pecuniary benefits that don’t benefit the project (since such consumption
is partly borne by the bank, as the benefits are consumed entirely by the entrepreneur) is not
exclusive to mudaraba arrangements. In musharaka transactions, experts, Grais and others
(2003), have argued that a moral hazard problem exists, too, despite the fact that the capital of
the partner (musharik) will also be at stake.18
Policy Suggestions
The paper above outlines many of the sources of risk within the Islamic finance sector as well
as the potential reasons for their existence in the first place. There have been many
suggestions as to how to best mitigate these risks, from industry-wide standardization in order
to improve transparency and create a sustainable coalescence of Islamic financial entities to
specific regulatory proposals. Having said that, Arun Sundarajan in his 2002 work on risk
management presented several policy modifications concerning the improvement of Islamic
financial institutions with regards to risk mitigation as well as prevention. He posited that
appropriate measurement of credit and equity risks IFIs could potentially benefit from
systematic data collection efforts, namely the establishment of credit (and equity) registries.
Sundarajan (2002) states that such registries can be developed by including data on Islamic
Finance contracts in existing credit registries, or by developing registries specifically for
Islamic contracts. He mentions that doing so could be very useful as a first step toward
adopting more pragmatic standards for Islamic finance. The latter, he claims, is based on
adaptations of new Basel capital accord to incorporate the specific features of Islamic finance,
as well as to serve as a transitional step toward more advanced capital measurements in due
course.
Sundarajan (2002) also claims that IFSIs would require both centralized and integrated risk
management that help control different types of risks, while at the same time allowing
disaggregated risk measurements to price specific contracts and facilities (including the risk-
return mix offered to investment account holders). He mentions the significance of appropriate
regulatory coordination and cooperation among banking, securities, and insurance supervisors
in order for such policies to be effective. Another important point is that IOSCO Securities
Regulatory Principles and Basel Core Principles for Effective Banking Supervision should be
adapted to the specifics of Islamic Finance by issuing additional guidelines and advising on
specific issues. In the context of Islamic Finance, doing so is vital to more advanced risk and
16 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.
17 Errico & Farahbaksh (1998) and Lewis and Ahmed (2001) 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.
18 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.