Risk Management in
Islamic Financial Instruments
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3.3.1 Islamic Financial Services Board (IFSB)
The Islamic Financial Services Board (IFSB) is set up as an international platform to promote
and enhance the soundness of the industry by issuing global prudential standards and guiding
principles for the Islamic financial services industry. Its mission is to promote the development
of a prudent and transparent IFSI through introducing new, or adapting existing, international
standards consistent with Sharī`ah principles. The function of the Islamic Financial Services
Board is to provide supervision and regulation of IIFS to promote stability of the IFSI, which
includes banking, capital markets and insurance sectors (10 Year Framework 6). The IFSB
creates new or modifies existing international finance standards to comply with Shariah so
IIFS can integrate the standards in their own work. Three of the IFSB’s initiatives include the
Guiding Principles on Liquidity Risk Management for IIFS, Guiding Principles on Stress Testing for
IIFS, and Exposure Draft-15: Revised Capital Adequacy Standard. The Liquidity Risk Management
for IIFS was created for both IIFS and supervisory authorities to better manage liquidity risk.
Following the global financial crisis of 2007 and European sovereign debt crisis, the IFSB has
undertaken a number of initiatives to address the development taking place in the global
financial industry. Such initiatives include the issuance of the IFSB’s Guiding Principles on
Liquidity Risk Management for IIFS, the Guiding Principles on Stress Testing for IIFS, and ED-15:
Revised Capital Adequacy Standard.
The Stress Testing for IIFS was published in response to the recent global financial crisis and
discusses stress testing from the BCBS and the Committee of European Banking Supervisors.
The stress testing framework provided IIFS with stress testing scenarios and advised on how
to identify and manage shocks. It was intended for supervisory authorities to use as
surveillance to tool to determine the stability of the IFSI, to identify weaknesses in the system,
and to design policies. For IIFS, risk management evolved due to differences in the operations
and balance sheet structures of Islamic institutions and that of traditional financial institutions.
In order to conduct stress testing, the risk factors causing the stress need to be identified. Risk
factors specific to IIFS include credit risk, market risk, liquidity risk, rate of return risk,
displace commercial risks, investment risks for Mudrabah and Musharakah, and Shariah non-
compliance risk. Unlike the other risk factors, the Shariah non-compliance risk is a qualitative
risk factor, rather than a quantitative risk factor.
Furthermore, according to the IFSB, certain characteristics such, as Shariah compliancy in risk
mitigation, securitization, real estate investment and commodity Murbahah transactions need
to be considered in the design of stress tests. While it is important to consider and incorporate
the Islamic characteristics of risk, the stress tests for IIFS must also complement existing
international standards. RSA were to begin implementing the Guiding Principles on stress
testing by 2013. However, challenges to implementation include, but are not limited to, weak
disclosure regimes on stress testing practices, lack of regulatory guidelines, lack of expertise
on the stress test models, and lack of good data (IFSB 66-71).
The ED-15 was issued in November 2012 and provided guidelines on the application of capital
adequacy regulations and macro-prudential tools, with emphasis on integrating the new
features of the Basel III standards, such as the capital conversion buffer, the counter-cyclical