Risk Management in
Islamic Financial Instruments
42
In several contracts, a rebate on the remaining amount of mark-up is given as an incentive
for enhancing repayment.
Fixed rate contracts such as long maturity installment sale are normally exposed to more
risks as compared to floating rate contracts such as operating leases.
Due to absence of an environment with no Islamic courts or formal litigation system, dispute
settlement is one of the serious risk factors in Islamic banking. To overcome such risks, the
counterparties can contractually agree on a process to be followed if disputes become
inevitable. Specifically, Islamic financial contracts include choice-of-law and dispute
settlement clauses (Vogel and Hayes 1998, p.51). This is particularly significant with respect
to settlement of defaults, as rescheduling similar to interest-based debt is not possible.
In order to manage interest rate risk, they advise the use of GAP analysis and the use of two-
step contracts. Since it is impermissible for a guarantee to be provided as a commercial activity
under Shari'ah , in a two-step contract, it can be provided by the Islamic bank’s participation in
the funding process as an actual buyer that utilizes two mudarabah contracts (one as a
supplier with the client and the other as a buyer with the actual supplier). Another mitigative
function recommended by Ahmed and Khan is on-balance sheet netting, i.e. the matching out
of mutual gross financial obligations and accounting for only the net positions of the mutual
obligations.
Immunization, in order to mitigate potential FX risks, and risk transferring techniques,
including the use of credit derivatives, namely swaps and options contracts, are also functional
for risk mitigation purposes. Please see the previous section on Islamic derivatives to learn
more about the procedures through which these instruments are executed. Collateral,
guarantees, and loan loss reserves are protective mechanisms in and of themselves, as they
improve credit quality, so they allow for a reduction in credit risks.
Ahmed and Khan (2007) conclude by citing that there is a need to introduce a risk
management culture in Islamic banks and that the non-availability of financial instruments to
Islamic banks presents a challenge to manage their ability to combat market risks, as
compared to the conventional banks. As discussed in the last section, doing so may not be
possible if Fiqhi related issues and Shari’ah decisions do not fall in the way of increased Islamic
derivative development.