Introduction
Islamic finance is one of the most effective financial organisations whose services and practices are characterised with high level of efficiency and effectiveness. The Islamic finance involves the process of restructuring the financial transactions in effort to satisfy the Islamic restrictions on practices of gambling and also the payment of risks (Kolakowski 2011).
This financial system is of great importance especially to the conservative Muslims who thought the practices by the western banking system were not fair. This made them uncomfortable with the system after which the need for a different financial system rose. Among the areas of differences was explicit payment of interest among other practices which violated Muslim ideologies.
Over the last few decades, the Islamic banks have grown at a high rate. Currently, the assets of the Islamic banks have covered large geographical areas. This is more so in the Middle East and the Eastern side of Asia where a significant number of financial institutions have risen. These institutions provide financial products to both Islamic and non-Islamic customers. However, the system refrains from integrating the concept of interest rate in their operations.
The principles and concepts which underpin Islamic finance, Islamic banking paradigm
The Islamic finance is led by several principles and concepts which guides its operations. As already seen, the Islamic banking is not feasible with the western system because of the practices which violates the Islamic law. By charging interest on the money borrowed, the action implies that an individual can just make money because they have it and another person does not have. This action is, therefore, considered as injustice. In this case, money is just seen as a commodity which can be used in generation of even more money. In other words, the Islamic finance system seeks to discourage the situation where the rich get richer while the poor get poorer.
In other words, one of the moist significant Islam finance principles is prohibition of the interest rate or Riba (Khan & Bhatti 2008). It is against Islamic law to generate income in an unjustified way. Therefore, interest should not be charged on the money borrowed either for consumption or for investment.
Islamic banking is also founded on the belief of loss as well as profit sharing. Under this system, the partners are supposed to share the loss and the profits based on the effort and shares of each individual. However, unlike the other system, the Islamic finance system does not guarantee rate of return (Usmani & Us̲mānī 2002).
Under the Islamic finance system, it is not allowed to engage in any activity that involves Gharrar. This implies that people must refrain from engaging in those practices or transactions of which they are not certain of. Every party involved in a certain transaction must have adequate information about that transaction and also the resulting implication of such activities to both participants.
The main components of the Islamic banking industry and its operating structures; Principles of Islamic business including the avoidance of riba and gharar
The Islamic finance is based on certain principles which differentiate its operations from the conventional banks. For instance, the bank is based on the principle on non-payment of riba on the money borrowed. In other words, it is wrong for the bank to charge interest on the money borrowed. This is viewed as a form of oppression against the less disadvantaged in the society. There are several principles involved in the Islamic banking.
One of the main principles is Wa’d. According to the Islamic law interpretation, Wa’d mean a promise. This suggests the willingness of an individual or a group of individuals in a certain subject. In Islamic finance, promise can be used to imply two things (Akhtar & Sadaqat 2011). This concept is widely used in the Islamic finance transactions. This can be seen in the sale and buying of Ijarah, Takaful, and Murabahah among others.
In Islamic finance, there are a number of contracts. Under the Islam finance, a number of financial contracts can be identified in the Quran. Some of the main forms of contract involve the contracts of exchange, contracts of investment partnership, contract of guarantee and the contract of charity. Others include the Murabahah, Musharakah, and Mudarabah.
Just like any other financial institution, Islamic finance is faced by a number of challenges. It is, therefore, necessary to come up with appropriate measures to mitigate these risks. There are various risk control methods which are applied in various Islamic contracts. However, the effectiveness of each method differs from each other depending on the prevailing condition.
Mudarabah risk control is another principle in Islamic finance. In order to mitigate risks, it is important to ensure a perpetual monitoring process of the loans provided. This exercise is of great importance in risk mitigation because it ensures that the loans are repaid in the right time (Ilias 2009). When there is a high loan repayment rates, then the institution becomes competitive. This will also contribute to the profitability of an organisation (Elgari 2003). As a result, there will be higher chances of expansion. In other words, it is important for every Islamic finance institution to ensure that there are adequate measures taken to follow up the loan repayment in order to ensure that a high repayment levels are maintained. This plays a significant role in determining the success of the financial institution.
In order to avoid risks in Musharakah, there is an arrangement which ensures that the entrepreneur returns the amount borrowed from the bank. The entrepreneur is allowed to do this without any pressure.
One of the main ways through which the Islam banks evade risks is through adoption of less risky products (Ayub 2009). This reduces the chances of meeting any risk in business transactions. Some of these products include Murabahah among others.
Another principle in Islamic finance is Murabahah. Murabahah can be seen as the kind of sale where the seller reveals the cost of a particular commodity as well as the profit gained. In this case, the price be instant or may be deferred. In banking, Murabahah involves the agreement between the client and the bank. The client may sell a certain commodity on behalf of the bank. In order to control any risk, the bank has to mention the limits of each facility under the transaction. The facility agreement also requires security to be submitted to the customer (Kettle 2010). These practices help in mitigating risks in Murabahah. These risks are also mitigated through continuous monitoring of various practices.
In Islamic finance, Ijarah refers to the process of leasing. In Ijarah operations, the assets are owned by the bank at the same time changing the ownership or the right to use such assets by the Lessee (Hassan & Dicle 2008). Just like in other conventional banks, Islamic process of leasing finance is faced by a numbers of risks. There are some risks of the bank failing to recover the funds disbursed. In order to mitigate such risks, there is a need to have a perpetual monitoring process in order to ensure that the leasing process is only done on secure grounds (Ominium 2008).
Under Ijarah transactions, the bank is engaged in an activity of purchasing goods and then selling such goods later with profits. In this case, it is important for the Islamic banks to have complete ownership of such goods without any sharing of such assets. It is against the Shariah law for an individual or the bank to sell things which does not belong to them. Under Salam, a bank may also buy things which whose delivery may not be made instantly where the terms of sale are agreed (Archer & Karim 2007).
From the above observation, it is clear that Salam transactions involve a huge risk to the bank. For instance, the clients may fail to deliver the goods whose payment has already been done. In order to mitigate such risks, the bank is supposed to ensure continuous monitoring process.
In the Islam finance, we also have the principle of Istisna. Istisna is a form of contract applied in exchange where the delivery of the goods or services is differed. In this case, there is a need to take necessary risk control measures in order to mitigate these risks. For instance, it is important to take into consideration the past information about the client in order to understand whether they honoured their agreements from earlier transactions. It is also necessary to ensure a regular monitoring process to ensure that there is no possible risk of loss.
In the contemporary business world, there is an increased interaction among different countries in terms of trade. This service of foreign currencies is provided by the banks. However, this issue raises a major concern of exchange rates.
There are two types of exchange rates. These include the fixed and the flexible exchange rates. In fixed exchange rate, the exchange rate of a commodity is maintained constant (Ayub 2009). On the other hand, the exchange rates are adjusted freely. In the Islamic finance, purchase or sale of one currency against another is allowed. However, purchase and sale is not allowed.
The Islamic finance is exposed to a number of risks while giving credit to their customers. However, there are several measures which are put in place to mitigate these risks. In order to maximize the level of security, the creditors are required to have somebody who can act as their guarantees (Iqbal et al 2010). This is an individual who verifies that he or she clearly knows the creditor and that they have the potential to pay back the amount borrowed. In case the creditor fails to pay back the amount borrowed, then the guarantee may be forced to pay the amount owed.
The nature of Islamic law and its application
The Islamic law is of great importance to its day to day practices. The Islamic law gives the human rights a high level of recognition. It ensures that everybody’s rights are respected. For instance, it’s wrong to charge interests on the money borrowed. This is because it is a form of oppression for the poor. The Islam law also insists on social justice. It respects the rights of every individual. Through its application, the Islam law helps in improving the living standards of the poor in the community (Schoon 2009).
Every shareholder in the Islamic finance has their respective responsibility. The Shariah Supervisory Board has a significant role in the implementation of the Islam laws. The board has the responsibility of ensuring Shariah compliance in all transactions conducted in the bank (Rasid & Rahman 2010). All principles must be adhered to in every transaction taking place in the bank. The board is also responsible for supervision and approving the development of Shariah complaint process. The board is also obliged with the role of giving recommendations on the administrative decisions in an organisation. This board must also prepare an annual report on the compliance with Shariah by the banks.
In the contemporary world, there are a number of risks which are posed on the finance industry. One of the main risks is the market volatility. The modern market has become too volatile that it is difficult to make perfect predictions. This poses a great risk in the finance industry which can lead to great losses (Umar & Ahmad 2010). The exchange rates are also fluctuating. This is despite the increased level of international trade. This poses a great risk to the financial institutions in the sale and purchase of foreign currencies.
Most of the risks involved in the finance industry are common in all the financial institutions because they are usually involved in similar operations. However, there is a slight difference on these risks. One of differences emanates from the difference in the principles under which the Islamic finance is led. According to Islamic finance, it is wrong to charge interest on the money lend to others. Contrary to this, other players in the finance industry are determined to maximize their profits by charging interests on the loaned assets. Therefore, the Islamic finance is exposed to greater risks.
The key risks existing within Islamic Banking
One of the major risks involved in Islamic Finance is personnel risk. The human personnel are the most important factors which determine the effectiveness of an organisation. Similarly, personnel play a pivotal role in the Islam finance. Therefore, there is a need for the Islam banks to come up with an effective way to anticipate and manage all the personnel related risks within the industry. There are a number of threats which can be directed towards the bank’s employees. These may be both external and internal risks. These risks involve various hazards to which employees may be exposed to. Others include acts of damage, occupational health and safety, violence at work, employment, traffic and work ability and well-being (Tafri, Rahman & Omar 2011).
Another kind of risk involved in Islamic banking is the Shariah compliance risk. Shariah compliance risk is posed by the possibility that a certain product or service is not in compliant with the set Shariah values and principles. This risk is closely associated with the systems failure in a certain market. This risk may also arise through the uncertainty in laws and regulations of the Shariah laws. This may have adverse effects on the bank’s transactions. In some cases, a number of institutions may be incapable of making any judgments involving the Shariah laws (Ali et al 2005). For example, most judges in courts practice Shariah laws rarely get adequate training on Shariah laws. Therefore, such judges are not capable of delivering effective judgment.
Just like any other financial institutions, Islamic financial institutions are prone to legal risks. Legal risks may arise from a number of factors. For instance, an institution may lack exposure to the changes in the laws and regulations. In such cases, the management may be involved in illegal financial practices. This may also be caused by the uncertainty in laws. However, the legal risks usually arise through the uncertainty in laws and regulations. This may even affect the transactions which may have been done in the right way. As already noted, a number of institutions may be incapable of making any judgment involving the Shariah laws (Thomas & Kraty 2005). For example, most judges in non Shariah courts rarely get adequate training on Shariah laws. Therefore, such judges are not capable of delivering effective judgment.
Therefore, the major step through which this problem can be mitigated is by reduction of such uncertainties in the laws and regulations. Legal risks can also be mitigated through codification of the Islamic laws. It is also advisable to create supporting legal institutions which are important in promoting justice.
Tax risk is also common in Islamic finance. According to the Islam financing system, the party who lends is usually the owner of the financed assets. Therefore, it is necessary to consider the legal issues surrounding the maintenance of the commodities. For instance, it is important to know whether the structure is entitled for tax. In some cases, the lender may not be conversant whether such assets are exposed to taxes based on the location, operations or other specific characteristics of an asset. Therefore, financing of certain assets poses a great tax risk to the Islamic finance operations.
Islam finance is also exposed to the compliance risk. This is any potential or current risk to either capital or earnings which arises from lack of compliance with the laws, regulations or the ethical standards which are expected in financial practices (Metricstream 2011). When such risk occurs, the bank will suffer a cost through fines, penalties and other sanctions depending on the violated regulations or laws as well as the extent of such violations. Uncertainty in laws and regulations is the major factor which contributes to this.
Regulatory risk can be viewed as that kind of risks which arises from the probability that the regulatory bodies will make changes in the existing rules. Just like other banks in the industry, Islamic finance is posed to the regulatory risk. The bank can undergo reputation duration in case they don’t comply with such regulations. They may undermine the bank’s performance. Non-compliance with the increasingly changing regulations may also cause an organisation to lose its earnings (Regulatory Risk Governance, Inc. 2011). This may affect their financial stability. There is, therefore, a need to have the necessary measures in order to solve the problem.
The Reputational risk is the kind of risk which leads to destruction of the bank’s reputation. This poses a big threat to Islam finance banks because it can lead to the loss of the shareholders. It is the goal of any organisation to retain a high level of reputation to the public. This risk leads to several consequences to the bank. These include the loss of experienced employees, loss of partners and clients, loss of revenue and even litigation (Al-Amine 2008). In order to avoid this kind of risk, there is a need to have a critical assessment of reputational risk. This assessment is necessary in making effective decisions in order to retain the bank’s reputation.
On the other hand, assets and liability mismatch risk is the risk which results from the change in value from a digression between assets and the liability cash flows, carrying amounts or prices. This may be caused by a number of factors. For instance, this may result from a change in the actual cash flows among other factors. This may also result from future expectations of cash flows. Accounting discrepancies may also result into assets and liability mismatch risk (Oracle White Paper 2008).
Asset risk is another common risk to which Islam finance is exposed to. In some cases, an asset may get damaged or destroyed or even get out of condition while still under the ownership of the financier (Rehman 2010). This poses a risk on the side of the financier who in this case is the bank. However, in case the client is the cause of the damage, then the financier does not bear these risks.
Maturity mismatch risks is that kind of risk which arise from the differences in the maturities of both short and long positions kin a cross hedge (Hassan and Lewis 2007). The maturity mismatch can have an adverse impact to the bank. In most cases, the maturity mismatch risks occur in situations where the assets are long term liabilities and liabilities are short term (Allen 2002). The maturity risks can lead to other risks like the roll over risks, which is the risk that the debts will not be refinanced. This risk may also lead to interest rate risk.
In every organisation, there is a need to have an effective recording and reporting process in order to avoid any inconvenience. In some cases, some transactions may be recorded in wrong ways. This poses a great risk because it may lead to huge losses to the organisation. This may also have a significant impact on the bank’s reputation because it may affect partners or clients. Such kind of risk is referred to as recording and reporting risk.
The profit equalization reserve is a mechanism which is applied in mitigating the problem of oscillating rates of return. This arises from the flux of income total deposits and provisioning (Islamic Bankers: Resource Centre 2010). Profit equalization reserve plays an important role in ensuring that the Islamic banking institutions rates of return are maintained at a competitive level. On the other hand, investment risk reserve is usually maintained through the income of the investors and depositors following allocation of the bank’s share (Greuning and Iqbal Not dated). This is done in order to neutralize the impacts of any future investment losses. The amount to be applied is computed and then implemented. However, the method of computing these amounts must be clear and should be done openly so that every shareholder is aware of the process of setting such amounts.
Implementation and execution risks is the risk that the projected plans by the bank will not work as expected. For instance, there may be a slight change in the Shariah laws. In this the management will not be completely sure that such systems will work or not. There is also a risk that the implementation process will not be successful (Abdullah & Chee 2010). This risk can be mitigated by ensuring that all the shareholders are involved. This will increase the chances of success in banks operations and any change process.
Asset risk can be viewed as those risks which are associated with the market changes. This may also result from a poor performance in the financial assets. These could be shares, currency or even futures. In other words, such assets are subject to changes in value as a result of changes in the market conditions (Allen 2002). When this happens, the bank may dip into huge losses which may lead to inefficiencies. There is, therefore, a need to have a critical analysis in order to make appropriate projections in case of uncertainties.
Islamic treasury entails the practices which are carried out in the manner which does not go against the conscience, principle or the Islamic laws. These regulations include prohibitions against gambling, riba and ambiguity (Kahf 2006). In some cases, these regulations are not applied in some regions. For instance, the professional handling a certain case involving the violation of these laws may not be competent in handling cases involving Islamic laws. This poses a risk to the Islamic principles. By engaging in the interbank activities, banks are able to borrow or lend among themselves. In this case, the interbank market is important. There are several activities which are involved in the interbank market. One of the main mechanisms is the Mudarabah Interbank Investment (MII) (Bacha 2008). In this case, the banks can lend or borrow from each other. The ones in surplus can also invest with the ones undergoing deficits.
This interdependence, however, poses a risk to the Islamic finance. For instance, in case one bank fails completely, it is likely going to affect other banks. Moreover, the banks are also exposed to the rate of interest risks (Barghothi 2011).
The company’s products and benefits are of great importance in determining its success. The Islam finance provides a wide range of products to its customers. The nature of these products is of great importance for both short and long run success of an organisation (Greuning & Iqbal not dated). Nevertheless, there is a peril engrossed in the process. For instance, the product may fail in one way or another. For instance, the bank may undergo a deficit. In such a situation, the bank may not be able provide lending services effectively. This may cause the organisation to lose its reputation.
The Shariah structure risks occurs when the transactions entered by the Islamic finance institutions is proclaimed as impermissible (Firoozye 2009). When a bank finds itself in such a situation, it usually has a significant impact on its performance. For instance, the bank will lose the profit since it is required to settle this in order to be compliant. The bank may also lose its reputation in the process (Firoozye 2009). It also leads to a significance loss of revenue in an organisation. Close to this is the concept of Mazhab.
Market risks can be viewed as the risks of loss on and off balance sheet positions which comes as a result of movements in the market prices (Mills & Presley 1999). This involves the fluctuations in the marketable and tradable assets. The market risks also relates to the risks related to the market volatility on the value of certain assets and the exchange rates. This may include the market value for a sukuk and the commodity price of Salam asset. Also included is the market value of Murabahah assets which may be required to be delivered in a certain period duration. For instance, a transaction on a certain asset may be made today but the delivery be made after a certain period duration. In such a case, the asset may depreciate within that period. This is a good example of a market risk.
In cases where IBIs are applied in the purchase of the assets, which may not be actively traded, it is advisable to consider the factors that determine liquidity of the assets in a certain market. It is also advisable to take a research on the assets which carries the highest level of risks (Jobst 2007).
Intermittent exchange rates affect the transactions across different countries where different currencies are used. Therefore, this poses a great risk for both receivables and payables in transactions involving foreign currencies. However, these risks are mitigated using the Shariah compliant methods.
Included in this category is the credit risk. This applies to the financing as well as managing receivables and leases. This will also include the working capital as well as the financing of projects (Margrabe 2002). There are several credit risks which are associated with Islamic financing contracts. There is a need to have a rigorous credit evaluation as well as the controls of these investments. This exercise plays an important role in viewing how they are exposed to capital impairment (Said, Shafqat and Rehman not dated). The credit risks also entail the risks involved in the settlement and clearing transactions.
Other risks which usually face Islam finance include non-compliance by some of the clients. For instance, some of the clients may fail to honour their promises to pay back the money borrowed in the agreed time. When this happens, a bank may incur huge losses. Other risks include the loss of essential data. This may pose a great danger to the bank. For instance, loss of customer’s records may undermine quality of services provided.
Another kind of risks is the rate of return risks. The rate of return risks refers to the possible impact on the total net income arising from the effects of changes in the prevailing market rates and any other relevant benchmark rates on the returns which are payable on funding (Wikiinvest 2006). This case usually occurs when uncontrolled IAH funds which re-invested on fixed return assets. Some of these assets include Murabahah among others. The rates of return are usually higher when there is greater absorption of the risks by IIFS (Kennon 2011).
On the other hand, operational risks are those risks which arise from the failure of the Islamic finance institution in the internal processes. This involves the people as well as the systems involved in the transactions in which the bank is engaged in. This may also involve other external events. The Islamic banks are also prone to the risks which involve the compliance with the shariah conformity and other responsibilities (Ali 2011).
In order to promote the efficiency in these institutions, it is, therefore, necessary to ensure that necessary measures are put down. For instance, there is a need for continued review of the operating procedures. It is also necessary to ensure that there is full compliance with Shariah laws while making any reviews (Riskglossary 2004).
Many financial institutions are also faced by equity investment risks. This entails the risks which are associated with the holding of the equity instruments which is done with the aim of making investments. There are certain risks which are associated with holding equity instruments. There is liquidity as well as credit risks which contribute in the volatility of capital. In this case, equity risk can be seen as the risk which arises when parties enter into a partnership with an aim of participating in a certain financing or other business activity where the party providing the finance shares the businesses risk (Said, Shafqat and Rehman not dated). Some of the aspects of such equity investments are associated with such considerations as the quality of the partner in the agreement, the business activities involved as well as the prevailing operational issues.
As already seen, Islamic banking is faced by a number of risks. Therefore, there is a need to have an effective risk management process in order to mitigate these risks. The success and efficiency of any finance institution largely depends on its ability to mitigate risks. In order to have an effective risk management process, there is a need to apply the discussed mix of risk factors in Islamic Financial Contracts. This will help in suppressing the risks to which financial institutions are exposed to.
In one way or another, the Islamic finance products are connected with the external environment. Due to this dependence, there is a risk posed to the institution. One of the major external risks posed on the Islam finance is recession. When there is recession, the whole economy suffers a major blow and the rate of economic growth is usually slow (Kuen 2010). This may significantly reduce the ability of the debtors to repay what they borrowed. This may significantly affect the bank’s operations.
Compliance risk is the risk which is posed by the possibility that a certain product or service is not in compliance with the set values and principles. This risk is closely associated with the systems failure in a certain market. This may result from inadequate internal processes. This risk may also arise through the uncertainty in laws and regulations of the Shariah laws. The control risk arises when the operational activities involving people, systems and process fails. When one of these fails, the all other activities are affected. This can also be caused by poor governance. There is a need for the managed to provide assurance of the operations and their reliability in order to mitigate these risks. The financing is done only for those assets which are capable of giving increments either through market forces or by their nature (Said et al not dated).
The risk profile in the classical financial contracts is based on the axiom of realism (Kahf 2006). In other words, Sheria emphasizes on the real life happenings rather than making assumptions and other additions. There are a number of essential financing elements which applies for the Islam finance. To start with, there must be an asset which acts as justification of earning; in this case, the assets can either be given to the manager or taken back to be leased again or even for sale. There is also Shariah and moral screening to facilitate Shariah compatible investment and other financial contracts (MinterEllison 2007).
In reverse line of credit, Islamic finance providers’ requirements for funding depend on their resources as well as their deposits (Hassan 2011). Such deposits can either be based on loan or Murabahah. Under the reversed line of credit, the Islamic bank is the order. In reverse line of credit, transactions must be true. This implies that is, there is a need to have real services or goods. These will be bought by the Islamic bank and then sold to the customers.
Risk appetite is the amount of risk that an organisation is prepared to pursue, take or retain. It can also be viewed as the amount one can take for their investment. The concept of risk appetite is also applicable in the Islam finance. For instance, there is a point to which an individual can be involved in such activities since they may gain in the long run. However, an individual may reach at a point where they feel they can no longer be in the game. This is similar in Islamic finance where some times individuals may invest only to dip into losses.
Risk register is one of the risk management tools which are used in assessing the risks in an organisation. Risk assessment register plays a pivotal role in risk mitigation in Islamic finance. While developing a management plan, the first thing to include is the risk management plan. At this point, there is a need to integrate the views from various stakeholders. This will significantly contribute in coming up with the most effective risk management process. After the preparation of the risk register, the bank managers are supposed to use the register in identification, assessment and the management of such risks to sustainable levels.
The framework for Basel II – does this provide additional challenges to the Islamic firm Credit risk
The base II framework was developed in 1998 by the Basel Committee. The new framework was more sophisticated than the Basel II framework. These efforts were geared towards the protection of the depositors as well as the financial system in general. It outlines the guidelines to the calculation of capital requirement. This comes with the restrictions to the bank on what they should lend. These efforts protected the depositors from the risks of losing all their money in case the economy undergoes a downturn. This framework has posed a challenge to Islamic finance because it has come along with more restrictions. There are several aspects involved based on this framework.
In Islamic finance, Exposure at Default (EAD) is the term used to refer to the total money value that will be lost in case of default and maturity of exposure (MOE). In other words, this can be viewed as an estimation of the extent to which a certain bank can be exposed to a particular risk in the time of that counterparty’s default (Rockboro Analytics 2011). This is calculated through Basel Credit Risk Model within a period of one year or the time of maturity. However, this will depend on which comes earlier. This approach has also been applied in Islamic banking in mitigating risks in its operations.
On the other hand, Loss given default can be viewed as the total value to which a bank is exposed to during the time of default. It can also be viewed as the amount which a firm can lose as from a default on exposure at a default figure (Biz 2 Information 2011). Under the Basel Credit Risk Model, Islamic finance is subject to exposure at Default as a measure of exposure in currency. This can be within a period of one year or at the maturity. In every transaction, a bank must provide an estimate representing the exposure amount of every transaction.
Probability of default can be viewed as the possibility that the loan will not be repaid back and that it will fall into default. Calculation of the probability of default is of great significance in Islam finance. In this case, the credit history of the customers as well as the nature of investment is all taken into account while calculating the probability value. The probability of default has a significant role in combating the risks in banking.
In Base II terms, Standardized Approach is a method which is applied in classifying operational as well as the credit risks. This set of operational risk management technique was proposed under the Base II. Under this approach, banks are required to put aside certain amount of capital for operational risk. Islamic banks are required to observe these specifications in order to promote security in the banking industry. This approach towards risk mitigation allows the banks to determine the risks in the most typical ways. For instance, this approach helps the Islamic banks with the most standardized way to assess credit risks. This is based on the external assessment of credit. In the case of the commercial agencies, all banks in a certain designated area are allocated a risk weight which is usually one notch below the risk weight assigned to its sovereign (eSharianomics 2011). Similarly, this approach has helped in risk mitigation in Islamic finance industry.
Advanced Measurement Approach is another practice which has significantly contributed in improving the risk management in the bank’s operations. Advanced measurement approach has also helped in promoting the organisation in identification, assessing of risks across every unit of an organisation. This approach has significantly improved the risk management process in the Islamic finance. Through this method, it is easy to eradicate all the risks across an organisation.
Liquidity risk takes place when a bank’s liquidity level falls significantly. In such a situation, the bank’s ability to meet its liabilities falls significantly. In such a situation, Islamic bank may even fail to fund increases in assets.
A bank can apply several measures to mitigate this kind of risk. One of the strategies which can be applied is construction of instrument maturity ladders. This will help the bank in realizing an effective liquidity management strategy. It is also advisable for the institution to use proper structures for liquidity management and measurement. This will significantly help in mitigating such risks.
Just like other banks, Islamic banks are engaged in various strategies. Various strategies are of great importance in every organisation as they help in improving the performance of an organisation. This may include a certain change in the operations or even introduction of new ways of doing things. In some cases, the bank may not be sure of whether a certain strategy will succeed. In some cases, a strategy may fail and, therefore, the bank may not be able to reach the projected level of performance.
However, this risk can be mitigated by conducting intensive research in order to be able to employ the most feasible strategies in an organisation.
Reputational risk is the kind of risk which leads to destruction of the bank’s reputation. This poses as big threat to Islam finance banks because it can lead to the loss of the shareholders. It is the goal of any organisation to retain a high level of reputation to the public. This risk leads to several consequences to the bank. These include the loss of experienced employees, loss of partners and clients, loss of revenue and even litigation. In order to avoid this kind of risk, there is a need to have a critical assessment of reputational risk. This assessment is necessary in making effective decisions in order to retain the bank’s reputation.
Basel II Capital adequacy
The base II capital adequacy is the latest international framework which is applied in the determination of the amount of capital which the banks are supposed to hold. This is based on the nature of the risks which these banks take.
Risk management is one of the most important practices in the bank. Risk management system involves the identification, monitoring, reporting as well as controlling risks. In order to be able to operate efficiently in an environment which is full of uncertainties and high levels of risks, it is advisable for the Islamic finance banks to have effective measures to handle such problems. For instance, the Islam finance usually involves products which are credit-based. In such a case, there are high levels of risks and it is, therefore, necessary to have effective risk management system. There are several methods which are applied in the risk management.
Standardized approach is one of the approaches which the banks have applied in is weighing of the assets. “The standardized Approach increases the risk sensitivity of the capital framework by recognizing that different counterparties within the same loan category present far different risks to the financial institution lender” (Natter 2005). Therefore, rather than putting all the commercial loans under the total risk, this method takes into consideration the credit rating of the borrower.
The other method is the internal rating based approach. The internal based approach allows the banks to evaluate their respective credit risks using their own models (Basel Committee on Banking Supervision 2001). However, the financial institutions are expected to choose between the advanced and foundation. This approach is significant in Islamic finance because individuals are able have an effective assessment of their individual credit risks since they can be able to select the most feasible model for evaluation.
In business analysis, there are a number of models which are used in identification, assessing and guiding in finding solutions to various problems. In the banking sector, the model based approach has been of great significance in approaching risk measurement. This is based on the price and position data coming up from bank’s trading activities (Damak & Volland 2008). This is integrated with other parameters and then entered in a computer model which generates a banks measure of the extent of risk exposure. This measurement is important since it helps the bank in coming up with a specific maximum amount which a bank can lose based on a certain degree of confidence.
The Islamic finance sector is subject to the process of Scrutinisation. This is done to assess the financial position of the bank. It is also done to ensure that the bank practices are within the set regulations. This process plays a pivotal role in protecting investors from total loss. In the financial industry, the regulators aims at ensuring that all the banks and financial institutions are not exposed to any form of difficulty by ensuring that they have an adequate level of capital. This protects the entire economy as well as the depositors (Moneyterms 2005). Under Basel II, new rules over capital adequacy have replaced the previous guidelines. This includes the use of risk models in determining whether any additional capital will be reasonable.
The risks and controls within Takaful firms Control and risk self-assessment
Takaful can be seen as Shariah compliant insurance. This is structured in such a way that it facilitates risk sharing and mutual aid. In other words, this is like a form of insurance cover where the lost property compensated for hence mitigating the possibility of complete failure. This process plays a pivotal role in covering risks in Islamic finance.
In Islamic finance, the stock selection process is of great importance in determining the success of an organisation. Islamic funds are usually invested in foreign securities. Therefore, they are faced with a major risk through the unfavourable economic, political and social developments in foreign countries. Therefore, the stock selection process is guided by the criteria which are developed by the Shariah Supervisory Board (Sundararajan not dated).
Key risk indicator is one of the measurements which are used in Islamic finance in assessing how risky an activity is. It measures the likelihood of certain undesirable impact in the future. On the other hand, performance indicator is the measurement used to measure how good a certain thing is being done. This understanding is of great importance in Islam finance as it helps in early identification of the activities which will be of benefit and those will lead to negative effects.
Risk appetite can be viewed as that amount of risk that an organisation is prepared to pursue, take or retain. It can also be viewed as the amount one can take for their investment. The concept of risk appetite is also applicable in the Islam finance. For instance, there is a point to which an individual can be involved in such activities since they may gain in the long run. However, an individual may reach at a point where they feel they can no longer be in the game. This is similar in Islamic finance where sometimes individuals may invest only to dip into losses.
In every organization, data is of great significance in every business exercise. An organization can incur huge losses in case they lose their data. In Islamic banking, data security is also important. However, the banks are faced by the risk of losing its data. In order to mitigate these problems, the bank applies various security measures which reduce the probability of losing important data. Some of the methods applied in data security include maintenance of the data backups, using fire resistant safes and using antivirus in their computer systems.
In the contemporary world, stress testing has become one the useful tools in testing financial stability. This tool is widely used in testing financial stability in the Islamic banks’ financial stability. For instance, the bank is able to use credit and interest rates risks through stochastic and deterministic simulations (Foglia 2009). This analysis has become more useful than any other time due to increased market volatility and increased concerns by the shareholders over risk management models in the modern market.
In Islamic finance, there is a need to have accurate decisions in granting of credit facilities. There are a number of scoring models which are applied in this case in order to standardize as well as automate to the possible extent credit decisions (Glennon not dated) The data on customers generated through the bank’s operations is useful in this evaluation. Again, this evaluation plays a significant role in reducing risks in Islamic finance.
There are a number of measures which are applicable in the development of a credit scoring model. For instance, one can use the computation of generic credit score in the assessment. Customer’s credit profile across can also be useful in this analysis.
For instance, the pattern of how customer has been servicing their loans in the past can help in determining their credit worthiness.
The analysis of the corporate and individual customers differs to some extent. Customer analysis deals with individual aspects that define their behaviour in financial transactions with the bank. On the other hand, corporate analysis entails the general aspects of the entire organisation. Corporate analysis includes the general performance of the customers including the growth possibilities. The practice of customer identification is also applied in Islamic finance. This practice is necessary in mitigating the financing of criminal activities. In order to identify the customer’s needs, the new bank applicants are usually required to provide information about their own. The Federal law requires customer identification in order to prevent terrorism as well as money laundering (Financial Crimes Enforcement Network 2004). This has significantly helped in combating terrorism as money laundering practices.
In some cases, the banks may practice connected lending. In connected lending, a bank may lend money to related companies or individuals together. In Islamic finance, the bank supervisors are required to observe the necessary requirements in order to prevent the abuse which tends to rise in connected lending. For instance, connected lending is only allowed for those individuals or companies who are extremely close to each other. This has significantly helped in risk mitigation. The quantitative limits should also be approved by the bank directors before the whole transaction is proposed. The bank must also be able to clearly identify the connected exposures (Financial Services Commission 2000). This ensures that the relationship of the parties under the transaction is genuine.
As already noted, the Islamic finance is led by the principle which forbids payment of interests for the money borrowed. This is because the act is viewed to a way of taking the advantage of the poor to generate more wealth. However, it is important to consider the ability of the person to pay the borrowed money or any other kind of asset before the transaction is proposed. In other words, it is important to analyse the credibility of the borrower before any transaction.
As already noted, the Islamic bank is involved in lending services. Therefore the process of debt recovery within the Islamic finance is of great importance in determining the effectiveness of the bank’s activities. An effective debt recovery process promotes the financial stability of a bank. Unrecovered debt can lead to significant financial hardship in an organisation. One way through which the bank can recover its debt is through mediation or courts. In this case, the debtors are forced to pay the amount owed by the court. The problem can also be solved through the tribunal.
In this case, there are several issues which arise from the practice. To start with, the practices applied in the credit recovery process must be under the Shariah requirements. For instance, the process should not be used to oppress the poor more. This is because it is against the Islam values and beliefs. The credit recovery process also reveals the need for having a careful evaluation of the credit requests in order to avoid complications in the future (Tahir 2003).
Risk Management of Islamic Finance Instruments
As noted earlier, in Islamic finance, the creditors are able to enjoy interests which are enjoyed by other conventional banks by transacting in religiously acceptable manner.
“The concept of put-call parity illustrates that the three main types of Islamic finance represent different ways to re-characterise conventional interest, through the attribution of economic benefits from the ownership of an existing or future (contractible) asset by means of an implicit derivatives arrangement (Jobst not dated).).
This aspect has characterized the Islamic banks in the industry.
In Islamic finance, explicit derivatives are more open and clear than in the case of implicit derivatives. While making any decision in every exercise, the Islamic bank is expected to ensure adherence to the Shariah. Shariah compliance risk is the risk which is posed by the possibility that a certain product or service is not in compliance with the set Shariah values and principles. This risk is closely associated with the systems failure in a certain market. The bank must ensure that its activities are guided by these regulations to avoid any inconveniences.
Islamic Swap Transactions
There are several Islamic swap transactions which can be identified in banking activities. Cross currency swap typically consists of three flows. These include a spot exchange of principal at the outset, a continuing exchange of interest payments during the swap’s life and a re-exchange of principal of the maturity of contract (Mahlknecht & Hassan 2011). However, the proscription of riba, gharar and maysir will such kind of structure unsustainable. The Islamic Cross Currency Swap helps the customers by ensuring that they are provided with Shariah compliant instrument in order to manage cross currency swaps.
Another kind of swap transactions is the Islamic profit rate swaps. This can be viewed as a mutual agreement to exchange the rates of profits between a floating rate party and the fixed rate party or the vice versa through the execution of various contracts to trade specific assets based on the Shariah contracts (Aziz 2009). However, every individual is entitled to their own pricing formula. The Islamic profit rate swaps are usually important in maintaining security in Islamic banking. For instance, it helps financial institutions from the fluctuations in the level of borrowing rates as well as providing them with risk control mechanisms (Abdullah et al 2011). In other words, it aims to harmonize the rates of returns with the cost of funds.
Under the Islamic finance, the issues about financial intermediation are new to the Shariah. This has been developed from the western countries some time back. This understanding is vital in understanding the hybrid financial contracts. Over the recent past, Islamic financial engineering has been actively engaged in development of new contracts that fits the recent industry. However, the success or failure of these efforts is based on their ability to the attributes of prohibition of interests as well as preservation of its objectives (Kahf 2006).
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