General Requirements There is a comprehensive reporting process and Risk Management in Islamic Banking, including appropriate board and senior management oversight, to identify, measure, monitor, report and control relevant categories of risks.
Posted on September 10, by Salman Ahmed Shaikh Salman Ahmed Shaikh In this article, we discuss the major risks that Islamic banks face in their commercial operations and the tools with which they mitigate these risks.
Credit Risk Credit risk is generally defined as the risk that the counterparty fails to meet its obligations in accordance with agreed terms. Credit risk includes the risk arising in the settlement and clearing of transactions. But, since clean borrowing is not possible in Islamic banking, Islamic financing is asset backed and adequately collateralized.
Furthermore, the title of ownership rests with the bank in Ijarah and Murabaha until the actual sale transaction is made.
Therefore, an Islamic bank can foreclose the asset in the case of default. However, the ownership of the asset will remain with the client. First and Second Charge on Assets First and second charge rank the order in which the proceeds of the liquidated asset s are used to pay off liabilities.
All else equal, financiers will prefer to have first charge. Takaful Takaful can be used to insure a tangible movable or immovable asset. The insurance cost can also be added back in sale price or rentals. Hamish Jiddiyah As an alternative to down payment or security deposit, some advance rental could be taken which may be adjusted for future rental payments.
It could also be used as partial settlement price for the sale of asset. However, any amount received in this case at the beginning of the contract cannot be taken as income for that period. Market Risk It refers to the risk arising from adverse movements in interest rates, commodity prices and FX rates.
Commodity risk is also present in Murabaha, Ijarah and Salam. Tools to Manage Market Risks Parallel Contract if permissible To mitigate the storage risk and avoid inventory cost, parallel contract can be done for the same date in the case of Salam.
Takaful for Asset Risk Takaful can be used to insure a tangible movable or immovable asset. The insurance cost can also be added back in the sale price or rentals.
Equity Risk It refers to adverse changes in market value and liquidity of equity held for investment purposes. It covers all equity instruments including Mudarabah and Musharakah. Tools to Manage Equity Risks Seek diversification of capital contribution.
Use Musharakah than Mudarabah together where possible. Limiting period of contract. Liquidity Risk Liquidity risk is the potential loss to the Islamic banks arising from their inability to meet their obligations as they fall due without incurring unacceptable costs or losses.
Tools to Manage Liquidity Risks Diversify Sources of Funds Increase in non-remunerative deposits can reduce the cost of raising funds from the public.
Reliance on few big deposits is risky. It is better to have a widespread deposit base. Reduce Concentration of Funding Base It is better to have efficient liability mix with adequate availability of short term and long term deposits.
Maturity matching on both sides of balance sheet can solve much of the problem systematically. Rely on Marketable Assets It is better to finance those assets on priority basis that have secondary market and that are somewhat standardized and widely used in the real sector of the economy. Legal Risk It refers to inadequate legal framework, conflict of conventional and Islamic laws and conflict between Shariah rulings and legal decisions.
Tools to Manage Legal Risks Documenting agreements to make them enforceable. Covering contingencies in design of agreements. Strong internal compliance, due diligence and audit. Displaced Commercial Risk It refers to the risk that the Islamic banks may confront commercial pressure to pay returns that exceed the rate that has been earned on its assets.
Tools to Manage Displaced Comercial Risks Floating rentals so that increase in benchmark rate is absorbed effectively on both sides of the balance sheet.
Using profit equalization reserves.description of risk management in Islamic banking by covering views of risk management problems in Islamic financial contracts, Islamic Financial Services Board .
Risk Management in Islamic Banking can be defined as a forecasting of financial risks and applying necessary procedures to minimize their impact, while practicing the Islamic Banking.
Risk Management Guidelines provide a set of best practices for establishing and implementing effective risk. Risk Management In Islamic Banks 2 Fundamental Differences Between Conventional Banking and Islamic Banking There were fundamental differences between the operations of an Islamic bank and a conventional bank, which brought a unique set of additional risks.
The five key differences were: 1. Prohibition of interest (riba). 2. Worse to mention also that’s the Islamic banking carry a unique risks more than the generic risks existed in the conventional system, but not based on the credit risk like the conventional system.
and there is where the Islamic financial system derives its strength. Risk Management is a tool used by all conventional banking institution in the name of good governance, risk mitigation and prudent practice.
It looks at financial exposures and its inherent risks to the business, and deeply believe in the risk-rewards pay-off within the . 10 Risk management in Islamic banking Habib Ahmed and Tariqullah Khan Introduction Risk entails both vulnerability of asset values and opportunities of income growth.