Risk Management in
Islamic Financial Instruments
41
swapping or exchanging a series of profit payments in one currency for another currency. She
also notes that the common underlying Islamic contracts used by the banks in Islamic swaps
are tawarruq, commodity murabahah and wa’d.
At present, all Islamic derivative contracts are privately negotiated or concluded over-the-
counter, which naturally brings into play issues of transparency, standardization, regulation
and other risks discussed in this paper (Kunhibava, 2010). In addition to the Shari’ah
questions surrounding derivatives, it will be many years before the Islamic banking
community bears witness to their mass availability and frequent use.
2.9 RISK MITIGATION AND REGULATION IN ISLAMIC FINANCE
The following section was derived largely from Ahmed and Khan (2007). In order to be
reductive with regards to bibliographical citations, this should be noted.
The Risk identification and management available to the Islamic banks can be of two types.
The first type comprises standard techniques, such as risk reporting, internal and external
audit, GAP analysis, RAROC, internal rating, etc., which are consistent with the Islamic
principles of finance. The second type, outlined by Ahmed and Khan (2007), consists of
techniques that either need to be developed or are adapted, keeping in view the requirements
for Shari‘ah compliance.
Gharar can be mild and sometimes unavoidable; however, it could also be excessive and cause
injustices, contract failures and defaults. A number of appropriate contractual agreements
between counterparties work as risk control techniques. Ahmed and Khan cite:
To overcome the counterparty risks arising from the non-binding nature of the contract in
murabahah, up-front payment of a substantial commitment fee has become permanent
feature of the contract. To avoid fulfilling the promise by a client in taking possession of the
ordered goods (in case of murabahah), the contract should be binding on the client and not
binding on the bank. This suggestion assumes that the bank will honor the contract and
supply the goods as contractually agreed, even if the contract is not binding on it.
Since the murabahah contract is approved with the condition that the bank will take
possession of the asset, at least theoretically the bank holds the asset for some time. This
holding period is almost eliminated by the Islamic banks by appointing the client as an agent
for the bank to buy the asset.
In istisna contract enforceability becomes a problem particularly with respect to fulfilling
the qualitative specifications. To overcome such counterparty risks, Fiqh scholars have
allowed band al-jazaa (penalty clause). Again in istisna financing, disbursement of funds can
be agreed on a staggered basis subject to different phases of the construction instead of
lumping them towards the beginning of the construction work.