This checklist examines the key issues surrounding managing risk in Islamic finance.
There are differences between Islamic finance and conventional finance, but some fundamental principles involved in managing risk apply equally to both. In particular, rigorous risk management and sound corporate governance help to ensure the safety and soundness of financial institutions in both the Islamic and non-Islamic worlds.
The key difference between Islamic finance and conventional finance is that Islamic finance involves risk sharing rather than risk transfers. Thus, all parties involved in a transaction must share the rewards and the risks equitably. Furthermore, institutions in the former category must ensure that their activities are always compliant with the restrictions imposed by shariah law. This is complicated by the fact that scholars can and do change their minds over what is permitted under shariah.
Islamic institutions are confronted with unique risks as a result of the asset and liability structures that compliance with shariah law imposes upon them.
Liquidity risk is also more complicated than in conventional finance. This is because Islamic bank funding comes from personal customer accounts, the vast majority of which are on call or very short notice. In addition, until very recently, hedging risk by using conventional methods was not in compliance with shariah. Furthermore, there is no central receiver and provider of liquidity to and from the Islamic financial market. Finally, and again unlike the conventional market, most debt is not tradable.
In addition, some of the tools used to manage risk in Western financial institutions either cannot be used or have limited use in the Islamic world because they contravene shariah law. Thus, derivatives have been few and far between in Islamic countries, despite their widespread use in the West to protect against market volatility. Islamic institutions have had limited access to derivative products, mainly because shariah law requires the underlying assets in any transaction to be tangible. This excludes most of the mainstream derivative instruments.
However, Islamic finance is developing apace, and products are being launched that can have useful risk management attributes and even mimic risk tools used in the West without contravening shariah law.
In March 2010, for example, the Bahrain-based International Islamic Financial Market, in cooperation with the International Swaps and Derivatives Association, launched the Tahawwut (Hedging) Master Agreement, which gives the global Islamic financial industry the ability to trade shariah-compliant hedging transactions such as profit-rate and currency swaps, which are estimated to represent most of the current Islamic hedging transactions.
Under shariah principles, the tahawwut or hedge must be strictly linked to underlying transactions and cannot be a transaction that has the sole purpose of making money from money. The lack of hedging products for managing risk has put many investors and institutions involved in Islamic finance at a disadvantage.
The Tahawwut Master Agreement should pave the way for quicker and cheaper Islamic risk management and more frequent cross-currency transactions. The contract creates a standard legal framework for over-the-counter (OTC) derivatives in the Islamic market, whereas currently contracts are arranged on an ad-hoc basis.
The lack of risk tools that are widely used in the West, such as derivatives, and the avoidance of certain sectors, such as banks, means that Islamic financial markets have a low correlation to other financial markets. This has provided protection from market turbulence, such as that seen during the subprime crisis.
Many argue that the use of risk tools such as derivatives does not protect against volatility but simply increases it, while financial institutions earn vast profits through their deployment to the detriment of clients. Thus the lack of such tools in Islamic finance may benefit investors.
The Islamic finance industry is governed by a patchwork of national banking regulations, its own standard-setting bodies, and scholars interpreting Islamic laws, making contracts much more complicated.
Islamic scholars are split on the legitimacy of risk tools such as derivatives: some see them as permissible instruments to hedge risk, but others regard them as speculative transactions, which Islam forbids.
While Islamic banks have avoided the complex instruments that were central to the credit crisis, they have still been susceptible to the downturn. Nonperforming loans and investment impairments in the region have mounted, partly due to inadequate risk-monitoring systems.
Establish whether compliance with shariah law creates unique risks, and create systems and tools that can monitor and protect against such threats.
Dos and Don'ts
Ensure that any risk-management methods are compliant with local shariah rules governing finance. Rules can vary widely from one jurisdiction to another.
Establish whether shariah-compliant tools for managing risk are available. The market is developing at a very rapid pace.
Don’t ignore the fundamentals of risk management, including credit and counterparty checks.
Don’t assume that shariah law governing financial management is rigid. It is partly a question of interpretation, and there are usually solutions to even the most complex problems.