Islamic Finance: Risk analysis and mitigation process in Sharia structures

After having understood the purpose, structure and mechanism of Istithna, it is time that we move to our subject of risk analysis and mitigation in the Sharia structures.

Our study would cover the types of risks are associated with Istithna, if an Islamic financial institution (IFI) adopts the structure either for the purpose of selling or purchasing an asset, and how the risks are automatically mitigated from within the Istithna structure, without seeking external guarantees and collaterals from the client.

We have discussed that an IFI can adopt the Istithna in both ways, i.e. when it contracts to sell an asset to a customer as well as in the circumstances where it acts as buyer of an asset from the customer. The risk profile of an IFI in sale Istithna will be different than when it is the purchaser. We would examine both situations for the sake of clear understanding.

Our analysis would be based upon the risks categorised and identified by the Bank for International Settlements (BIS) by way of guidelines provided through Basel I and II publications which can be downloaded from the website www.bis.org.

The BIS is an international organisation which endeavours to foster greater cooperation among central banks of all countries and other financial regulatory agencies in pursuit of monetary and financial stability on a global basis.

The BIS provides banking services and risk identification and mitigation guidelines exclusively to central banks and international organisations.

The BIS has identified several risks in a financial or investment transaction, which are credit risk, equity investment risk, market risk, liquidity risk, interest rate risk (or rate of return risk for IFIs) and operational risk.

By keeping the above risk enumerator as benchmark we would first examine as to how these risks are mitigated in the sale Istithna structure where an IFI sells an asset which is required to be developed, constructed or manufactured by the IFI. We would thereafter review the risks associated with a purchase Istithna structure.

The IFI has contracted to sell the asset at a fixed sale price which includes its cost plus profit. Similar to any other commercial transaction, the profit is calculated keeping in view various factors, including the payment schedule of the purchase price by the purchaser.

Hence the IFI would be exposed to credit risk and/or the equity investment risk in the event of the purchaser defaulting in timely payment of the purchase price. This is because the equity invested by the IFI in developing the Istithna asset would be in jeopardy.

What measures are available to IFI if the purchaser defaults before or after the delivery of the asset?

If, as a result of the customer's failure to honour its commitment to pay the Istithna price, the IFI is forced to find a suitable third party buyer for the Istithna asset, it will face the market risk whereby it may not get the desired price for the asset to cover its investment in the asset.

Furthermore, the IFI would also be exposed to the rate of return risk since in the above scenario, it may not be able to fetch the desired return on its equity invested on developing the very asset.

The IFI may decide not to sell the asset to a third party at a reduced price and instead put it to some use in order to generate certain income which may be helpful in off-setting the probable loss over a period of time.

This could be a prudent decision but will force the IFI to face the operational risk, being owner and operator of the asset. We know that Sharia required that an owner must assume full ownership risks to an asset.

The writer is the vice-president, Sharia structuring, documentation and product development, Dubai Islamic Bank.