RISK MANAGEMENT IN ISLAMIC BANKING

BANKING RISKS

Common to both Conventional and Islamic Banks, we have market, interest

rate, credit liquidity, operational and legal risk

CREDIT RISK

Credit risk is the risk that counterparty will fail to meet its obligations timely
and fully in accordance with the agreed terms. This risk can occur in the
banking and trading books of the bank. In the banking book, loan credit risk
arises when counterparty fails to meet its loan obligations fully in the
stipulated time. This risk is associated with the quality of assets and the
probability of default.

MARKET RISK

Market Risk is the risk originating in instruments and assets traded in well-
defined markets. Market risks can result from macro and micro sources.
Systematic market risk results from overall movement of prices and policies
in the economy. The unsystematic market risk arises when the price of the
specific asset or instrument changes due to events linked to the instrument
or asset.

MARK-UP RISK

The benchmark 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. Markup risk can also appear in
profit-sharing modes of financing like mudaraba and musharaka as the profit-
sharing ratio

LIQUIDITY RISK

Most banks now keep protective reserves on top of planned reserves. While
the planned reserves are derived either from regulatory requirements or
forecasts, the amount of the protective reserve depends upon the
managements attitude towards liquidity risk. Liquidity management must
keep track and coordinate the activities of all departments that raise and use
funds in the bank. Decisions regarding the banks liquidity needs must be
analyzed continuously to avoid both liquidity surplus and deficit.

OPERATIONAL RISK

Given the different sources in which operational risk can arise, a common
standard for identification and management of these needs to be developed.
Care needs to be taken to tackle operational risk arising in different
departments and organizational units due to people, process, and
technology. As such, a wide variety of guidelines and rules have to be spelled
out.

LEGAL RISK

Legal risk relates to the risks of unenforceability and lack of standardization

of financial contracts. Legal risk can be considered as a part of operational
risk. Regulatory risk arises from changes in a regulatory framework of a
country.

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 banks
perspective, this introduces a withdrawal risk that is linked to the lower rate
of return relative to other financial institutions.

FIDUCIARY RISK

A part of the fiduciary duty of the management is to keep the risks arising in
assets financed by demand deposits separate from those in investment
deposits. The funds provided in the form of mudarabah-based investment
deposits entail certain fiduciary duties on the part of the bank. The interests
of the fund providers must be protected and the funds managed efficiently
and in a Sharih compliant manner.

DISPLACED COMMERCIAL RISK

Situations may arise when an Islamic bank operating in full compliance with
the Sharih requirements may not be able to pay competitive rates of return
as compared to its peer group of Islamic banks and other competitors. In
such situations, depositors may have the incentive to withdraw their funds.
In order to prevent withdrawals, IFIs may be under pressure to pay the IAHs a
return that is higher than their due returns.

BUNDLED RISKS

It is uncommon for the various risks to be bundled together. However, in the

case of most Islamic modes of finance, more than one risk coexists. For
example, in salam, once the bank has made an advance payment, it has
started to take the counterparty risk concerning delivery of the right
commodity on time, the market risk of the commodity, the liquidity risk of its
conversion into cash, the operational risk of its storing and movement and so
on. The same is the case with istisnaa, financial murabaha, ijara and
musharaka/mudaraba.