RISK AND RETURN IN

ISLAMIC FIANANCE

MEANING OF RISK
Risk are uncertain future events that could
influence the achievement or the banks
objective, including strategic, operational,
financial and compliance objective.
Uncertain future events could be:
- Failure of a borrower to repay a financing
- Fluctuation of foreign exchange rates
- Fraud, incomplete security documention, etc
- Non-compliance with shariah law and princples
- Other events that may result in a loss to the
bank

RISK SHARING AND RISK

TRANSFER
ISLAMIC BANKS RISK
SHARING

CONVENTIONAL BANKS RISK

TRANSFER

SOURCES OF FUND : investors

(depositors) share the risk and
return with Islamic banks. The
return is not guaranteed and
depends on the banks
performance

Sources of funds: depositors

transfer the risk to the
conventional bank, which
guarantees a prespecified return
(interest)

Islamic banking is more safer as it Conventional banking is more

is not based on interest
risky as it is based on interest
Uses of fund: Islamic banks share
the risk in mudharabah
(participation financing or trust
financing) and musharakah
(equity financing) contracts and
finance the purchase of assets or
services in most other types of
contracts.

Uses of funds; borrowers pay

interest independent of the return
on their project. Conventional
banks transfer the risk through
securitization or credit default
swaps. Financing is debt based

SHARIAH FRAMEWORK
RELATING TO RISK

Why do we need to emphasize on

shariah governance
Objective fulfillment
e.G : Promote justice, fairness &
protection of human necessity
(Shariah)

Shariah
Compliance is
the essence of
islamic finance
Alternative
Minimizing Risk
e.g : Alternative to
e.g : Mitigate Shariah Non
Compliant
Riba based activities
risk at decision making
level
as well as operational level

THE NATION OF
GHARAR AND
ASSYMETRIC
INFORMATION

GHARAR

ASSYMENTRIC INFORMATION

In simple terms, gharar

means uncertainty, risk,
threat, deceit, doubt.
It is described as a risky
or hazardous sale, where
details concerning the item
on sale are unknown or
uncertain.
Professor
Mustafa
Al
Zarqa' defined Gharar as
the sale of probable items
whose
existence
or
characteristics
are
not
certain, due to the risky
nature which makes the
trade similar to gambling.
While some degree of
Gharar
may
be
unavoidable
in
some
situations,
excessive
uncertainty
must
be

Asymmetric information means that one

party has more or better information than
the other when making decisions and
transactions. The imperfect information
causes an imbalance of power.
The result of asymmentric information
1. Adverse selection is a term used in
economics that refers to a process in
which undesired results occur when
buyers and sellers have access to
different/imperfect information. This
results in "bad" products or services
being selected.
2. moral hazard is a situation where a
party will take risks because the cost
that could incur will not be felt by the
party taking the risk . In relation to
asymmetric information, moral hazard
may occur if one party is insulated
from risk and has more information
about its actions and intentions than
the party paying for the negative
consequences of the risk.

RISK IN ISLAMIC BANKING

AND OTHER INSTITUTION

Risk profile of Islamic Bank

Shariah
non
Complianc
e Risk

Displaced
Commercial
Risk

Rate of
Return
Risk
Unique
Generic
Operation
al Risk

Equity
Investment
Risk
Islamic
Bank

Credit
Risk

Market
Risk

Liquidit
y Risk

Generic risks for bank

Types of risks

Definition

Credit risk

The potential that a counterparty fails to meet its

obligation in accordance with agreed terms and
conditions of a credit related contract.

Market risk

The potential impact of adverse price movements such

as benchmark rate, foreign exchange rates, equity
prices on the economic value of an asset.

Liquidity risk

The potential loss arising from the Banks inability

either to meet its obligations or to fund increases in
assets as they fall due without incurring unacceptable
costs or losses

Operational
risk

The potential loss resulting from inadequate or failed

internal processes, people and system or external
events

Unique Risk for Islamic Bank

Type of risk

definition

Shariah noncompliance
risk

Risk arise from the failure to comply with the shariah

rules and principles

Rate of return
risk

To potential impact on the returns caused by

unexpected change in the rate of returns

Displaced
Commercial
risk

The risk that the bank may confront commercial

pressure to pay returns that expected the rate that
has been earned on its assets financed by
investment account holder. The bank foregoes part
or its entire share of profit in order to retain its fund
providers and dissuade them from withdrawing their
funds.

Equity
investment
risk

This risk is arising from entering into partnership for

the purpose of undertaking or participating in a
particular financing or general business activity as
described in the contract, and in which the provider
of finance shares in the business risk. This risk is

RISK IN FINANCIAL MARKETS

AND INSTRUMENTS

1. Market risk
The market risk is the risk of loss in value of the investment due to
the movements of the market factors - prices and financial
instruments, interest rates, currency exchange rates and others. The
market prices of the investors may vary due to changes in the
economic and market environment, the money policy of the central
banks, the business activity of the issuers, the demand and supply of
the market of the respective instrument.
2. Interest rates
This is the risk of the changes in the market interest rates having an
unfavourable effect on the profit or the value of the instrument. The
changes in the interest rate levels may endanger the financial
instruments owners with the risk of capital loss. The impact of the
risk is different for the respective financial instruments.
3. Currency risk
The investments in instruments, denominated in a foreign currency,
may be unfavourably affected by the lowering of the exchange rate
of this currency against another. The increase or decrease in the
currency exchange rates may cause losses or profits for the
securities in the currency they are denominated in.

4. Assimilation risk
This is the risk for investors in a given bond not to be able to find
the same investment market conditions, if a given investment has
been ceased, in the event that the issuer of the bond pays its
obligation before the maturity date.
5. Operational risk
This is the risk from direct or indirect losses as a result of
inadequate internal control, a human action, organization or
external event. This risk covers human errors, intentional damage
by employees, crash of the information systems, problems
connected to the managing of human resources, company
lawsuits, as well as external events such as accidents, fires, floods
and others.
6. Liquidity risk
The liquidity risk arises in situations, in which a party interested in
selling a given asset, is unable to do so, because no one on the
market is willing to trade with this asset. There is demand but no
supply or vice versa.

7. Risk of volatility
This is the risk connected with the price
movements of a given financial instrument. The
volatility is high, if the financial instrument is
subject to large price fluctuations in a given
period of time. The risk of volatility is calculated
as the difference between the lowest and highest
prices of financial instruments for the given
period of time.
8. Credit risk
This is the possibility that the contracting party
may not fullfil willingly or may not be able to
fullfil the obligations as agreed upon in the
contract. The investors need to assess the quality
of the issuers of financial instruments, as well as
their ability to repay their obligations.

 https://www.deltastock.com/english/mifi
d/financial_instruments.htm
https://eagletraders.com/books/afm/af
m1.php
http://www.slideshare.net/CamillePaldi
/risk-management-in-islamic-banking-39
068470
http://
www.slideshare.net/fahadzaf/risk-mana
gement-islamic-banking?related=1
http://
islamicbankingafrica.blogspot.com/2013/