Question

Give recommendation 10 strategies to upgrade the risks sharing in islamic financing?

Answer 1

For most of the people the prohibition on interest is the well known part of islamic finance. Risks and profits between the parties involved in any financial transaction arr shared by both financial institutions and depositors/savers with a pre- decided ratio.

Credit risk
Credit risk is the loss of income arising as a result of the counterparty’s delay in payment
on time or in full as contractually agreed. Such an eventuality can underlie all Islamic modes of finance. For example, credit risk in murabaha contracts arises in the form of the
counterparty defaulting in paying the debts in full and in time. The non-performance can be due to external systematic sources or to internal financial causes, or be a result of moral hazard (wilful default). Wilful default needs to be identified clearly as Islam does not allow debt restructuring based on compensations except in the case of wilful default. In the case of profit-sharing modes of financing (like mudaraba and musharaka) the credit risk will be non-payment of the share of the bank by the entrepreneur when it is due. This problem may arise for banks in these cases because of the asymmetric information problem where they do not have sufficient information on the actual profit of the firm.
Market risk
Market risks can be systematic, arising from macro sources, or unsystematic, being asset- or instrument-specific. For example, currency and equity price risks would fall under the systematic category and movement in prices of commodity or asset the bank is dealing with will fall under specific market risk. We discuss a key systematic and one unsystematic risk relevant to Islamic banks below.
Mark-up risk Islamic financial institutions use a benchmark rate to price different financial instruments. For example, in a murabaha contract the mark-up is determined by adding the risk premium to the benchmark rate (usually the LIBOR). The nature of a murabaha is such that the mark-up is fixed for the duration of the contract. Consequently, if the bench- mark rate changes, the mark-up rates on these fixed income contracts cannot be adjusted. As a result Islamic banks face risks arising from movements in market interest rate.

Mark-up risk can also appear in profit-sharing modes of financing like mudaraba and musharaka
as the profit-sharing ratio depends on, among other things, a benchmark rate like LIBOR.

Commodity/asset price risk

The murabaha price risk and commodity/asset price risk must be clearly distinguished. As pointed out, the basis of the mark-up price risk is changes in LIBOR. Furthermore, it arises as a result of the financing, not the trading process. In contrast to mark-up risk, commodity price risk arises as a result of the bank holding commodities or durable assets as in salam, ijara and mudaraba/musharaka. Note that both the mark-up risk and commodity/asset price risk can exist in a single contract. For example, under leasing, the equipment itself is exposed to commodity price risk and the fixed or overdue rentals are exposed to mark-up risks.

Liquidity risk
Liquidity risk arises from either difficulties in obtaining cash at reasonable cost from bor-rowings (funding liquidity risk) or sale of assets (asset liquidity risk). The liquidity risk arising from both sources is critical for Islamic banks. For a number of reasons, Islamic banks are prone to facing serious liquidity risks. First, there is a fiqh restriction on the securitization of the existing assets of Islamic banks, which are predominantly debt in nature. Second, because of slow development of financial instruments, Islamic banks are also unable to raise funds quickly from the markets. This problem becomes more serious because there is no inter-Islamic bank money market. Third, the lender of last resort (LLR) provides emergency liquidity facility to banks whenever needed. The existing LLR facilities are based on interest, therefore Islamic banks cannot benefit from these.

Operational risk
Operational risk is the ‘risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and technology or from external events’ (BCBS, 2001, p. 2). Given the newness of Islamic banks, operational risk in terms of personal risk can be acute in these institutions. Operation risk in this respect particularly arises as the banks may not have enough qualified professionals (capacity and capability) to conduct the Islamic financial operations. Given the different nature of business, the computer software available in the market for conventional banks may not be appropriate for Islamic banks. This gives rise to system risks of developing and using informational technologies in Islamic banks.

Legal risk
Legal risks for Islamic banks are also significant and arise for various reasons. First, as most countries have adopted either the common law or civil law framework, their legal systems do not have specific laws/statutes that support the unique features of Islamic financial products. For example, whereas Islamic banks’ main activity is in trading (murabaha) and investing in equities (musharaka and mudaraba), current banking law and regulations in most jurisdictions forbid commercial banks undertaking such activities. Second, non-standardization of contracts makes the whole process of negotiating different aspects of a transaction more difficult and costly. Financial institutions are not protected against risks that they cannot anticipate or that may not be enforceable. Use of standardized contracts can also make transactions easier to administer and monitor after the contract is signed. Finally, lack of Islamic courts that can enforce Islamic contracts increases the legal risks of using these contracts.
Withdrawal risk A variable rate of return on saving/investment deposits introduces uncertainty regarding the real value of deposits. Asset preservation in terms of minimizing the risk of loss due to a lower rate of return may be an important factor in depositors’ withdrawal decisions. From the bank’s perspective, this introduces a ‘withdrawal risk’ that is linked to the lower rate of return relative to other financial institutions.

Fiduciary risk
Fiduciary risk can be caused by breach of contract by the Islamic bank. For example, the bank may not be able to comply fully with the shari’a requirements of various contracts. Inability to comply fully with Islamic shari’a either knowingly or unknowingly leads to a lack of confidence among the depositors and hence causes withdrawal of deposits. Similarly, a lower rate of return than the market can also introduce fiduciary risk, when depositors/investors interpret a low rate of return as breaching an investment contract or mismanagement of funds by the bank (AAOIFI, 1999).

Displaced commercial risk
This is the transfer of the risk associated with deposits to equity holders. This arises when,under commercial pressure, banks forgo a part of their profit to pay the depositors to prevent withdrawals due to a lower return (AAOIFI, 1999).Displaced commercial risk implies that the bank may operate in full compliance with the shari’a requirements, yet may not be able to pay competitive rates of return as compared to its peer group Islamic banks and other competitors. Depositors will again have the incentive to seek withdrawal.To prevent withdrawal, the owners of the bank will need to apportion part of their ownshare in profits to the investment depositors.