Risk Management in

Islamic Financial Instruments

Monitoring risk is critical to catch problems early and prevent risk from spreading widely and

deeply. One way to mitigate risk is through diversification. Diversification includes diversifying

geographically and across sectors by expanding the depositor base. Financial risk can be

further prevented by reducing client exposure, which can lead to declining risk for

intermediaries, such as banks. It is important to manage corporate governance risks that

include operational, fiduciary, transparency, Shariah, and reputation risks (ISRA 4). Shari’ah

non-compliance risk is defined as “the risk that arises from IFI’s failure to comply with the

Shariah rules and principles determined by the Shariah board of the relevant body in the

jurisdiction in which the IFIs operate.” It is difficult to measure Shariah risk, since no risk

management model exists for it (ISRA 23-24). Iqbal proposes a four-pronged strategy for

Islamic risk management. He advices the need to understand derivatives in a Shariah context,

expanding the role of financial intermediaries, applying takaful, and using financial

engineering to develop synthetic derivatives and off-balance-sheet instruments (“Iqbal Paper

4” 10-12)

3.5.1 Liquidity Infrastructure

The

Stability Report 2013

describes liquidity management as “one of the most challenging tasks

faced by IIFS (103).” The challenges IIFS face is due to many reasons. Shariah restricts interest-

based transactions, the transfer of debt, and the use of specific instruments. In countries that

operate both conventional and Islamic finance systems, the Islamic finance industry is at a

disadvantage, as it lacks Shariah compliant instruments that, for example, can mop up excess

liquidity or allow Islamic banks to hold risk-free government papers (Grais 3-4). In addition,

there is inactivity in secondary market, weak supervisory tools, and a lack of Shariah

compliant open market operations to meet monetary policy objectives.

As a result, IFSI in a majority of the jurisdictions in the world are obliged to maintain a higher

level of cash, given the absence of

Sharī`ah

-compliant, high-quality liquid assets (HQLA), vis-à-

vis their conventional counterparts. Besides, the dominance of uncollateralized interbank

transactions such as commodity

Murābahah

transactions (CMT), interbank

ḍ

ārabah,

and

interbank

Wakālah

results in increased counterparty risk apprehension in bilateral

arrangements in stressed market conditions. Due to such market conditions, the liquidity

problems with one or more IIFS can augment the potential for systemic risk in crisis times.

(IFSB 2013)

The

Islamic Finance and Global Financial Stability Report

issued by the IFSB-IDB-IRTI in April

2010 outlined some important aspects on which the industry needs to focus its attention:

Enhancing the financial resilience and stability by the developing a robust national and

international liquidity infrastructure to enhance liquidity provisions through

monetary policy and money market operations

Developing a set of comprehensive, cross-sectorial prudential standards and a

supervisory framework covering Islamic banking,

Takāful

and the capital market