All banking institutions face risks due to the intermediary services they offer in the borrowing and financing of the funds. Islamic banking appears to use the same tenets for financing as used by conventional banking, but they greatly differ in terms of their application. Risk taking in Islamic banking differs from conventional banking as the risk and profits are shared between the banks’ owners and depositors, whereas in conventional banking the equity investors take the total risk. Traditionally, Islamic banks don’t penalize their depositors for the losses and it is borne by the equity holders but a tool does exist within the system which can reduce the risk to the owners of the bank. As a result of this profit and risk sharing structure Islamic banking has traditionally placed a greater emphasis on the viability and evaluation of the projects they finance.
Risks and Risk management
The foundation of Islamic banking lies in participation and not in simple financial intermediation. The range of risks may be considered greater in Islamic banking due to their participation as a partner, investor, buyer and seller, as compared to the status of lender in conventional banking. While they share major risks such as credit, market, operational, concentration and liquidity risks, Islamic banking also faces equity investment risk, margin risk, displaced commercial risk, rate of return risk and Sharia non-compliance risk.
Islamic banks use similar techniques as conventional banks in managing credit risk mitigation of the financing proposals, through techniques such as asset collateral, monitoring of project or asset activity and the diversification of credit exposure through various industry and sectorial limits. The management of market risk, and operational risk, is also similar in the two systems. While these major risk categories are dealt with in similar ways there are unique risks to Islamic banking.
The first of these is margin risk, the equivalent of interest rate risk in conventional banks. The Sharia system avoids interest-bearing transactions but works on Islamic financial instruments such as murabaha contracts, which operate based on a mark-up. Murabaha is a deferred payment contract in which the customer buys an asset at a cost plus profit margin. Adverse changes in the benchmark rate can create risk for Islamic firms and can lead to opportunity losses, due to a lower mark-up and vice-versa.
Equity investment risk arises because of a potential decrease in the fair value of the equity position held by the firm. A bank’s equity participation can range from direct investment in projects, or joint venture businesses, to indirect Sharia compliant investment, such as stocks.
A third risk is displaced commercial risk, which arises when owners are forced to pay returns to depositors even if the underlying assets don’t earn profits. This risk is managed by building reserves during good times and utilizing them in bad times. Rate of return risk occurs when investors react negatively and withdraw their funds because a firm’s returns are lower than market benchmark rates.
Finally, and perhaps most importantly, Sharia non-compliance is a major risk that can have a severe impact on both the earnings of an institution and the confidence of customers, depositors and shareholders. It can occur due to misinterpretation and incorrect implementation of approved transactions and procedures.
Islamic banking involves active risk management from initiation to settlement of a transaction and in managing returns to both depositors and shareholders of the institution. It is often less riskier, in terms of complexity, compared to conventional banking, due to its prohibition on the usage of derivatives except for hedging purposes, but a wider range of risks require more active management than conventional banking.
Regulatory challenge
Regulators face challenges in harmonizing the standards for both Islamic banking and conventional banking due to their different approach towards banking activities. So far, the majority of Central Banks haven’t differentiated the Basel II rules. While everyone desires a level playing field for all banks there may be a case to differentiate in the treatment of Islamic deposits versus conventional deposits.
Another important challenge looming is in the qualification of high quality liquid assets (HQLA), for the management of liquidity risks, to be implemented in line with Basel III standards. For conventional banks the market provides a wide range of high quality liquid financial instruments, but Islamic banking may struggle due to the relatively limited availability of high quality liquid Sukuks. Successful implementation of Basel III will require the industry to push for more issuance and a wider acceptance of Sukuks.
Another key challenge that is frequently discussed is the standardization of the products and transaction documentation across all Islamic banks. In general, the move to the Basel III regime will improve risk management practices, provide better governance principles and will focus on the efficient utilization of capital.
The writer is Head of Financial Risk Management and Basel II, Noor Bank. Opinion expressed here are his own and do not reflect that of the newspaper.
