Risk management techniques start to acquire the stature of science

There is at least one thing I hope has become clear from our comparison of Islamic banks and their conventional counterparts over the last few weeks.

It is this Islamic banks and conventional banks are very different institutions.

I hope it would now be easier for readers to draw a clear comparison between Islamic and conventional financial institutions.

I also expect it is easier for readers to understand the different ways the two approach financing and investment. I welcome any queries and shall do my best to respond to your satisfaction.

What has impressed me the most in comparing both institutions is the intellectually challenging nature of Islamic financing structures.

It is not always easy to combine two or more of these structures when attempting to meet the financial needs of clients, while still respecting Sharia boundaries.

I am also impressed with the emphasis these structures place on equality and fairness to all parties concerned, as far as their respective rights and obligations are concerned.

During my quarter-century of work in the world of interest-based banking, I longed to see something similar, but I remained disappointed.

Today, we will begin looking at an important and highly interesting subject connected to Islamic financing structures. This is the risk management aspect of structures such as Mudaraba, Murabaha, Musharaka, Ijara, Istithna and Salam, and how it is different from the risk management side of conventional lending.

Risk management techniques today are starting to approach the stature of a science. New techniques are being developed by large conventional financial institutions on an on-going basis, to save the institutions from any possibility of losing their money.

This reminds me of a joke I once read in a financial journal. Before signing a loan document, a bank executive asks the relationship manager if the noose has been appropriately tightened around the borrower and if there is no way the borrower can escape from the terms of the loan. The ever-quick relationship manager obediently replies: "Yes, boss we have even got his grave mortgaged to us".

Risk management is certainly important from a financier's outlook. How far, however, should a financial institution should go to secure the finance it extends? Is it a case of "the more, the merrier"? Does a financial institution really build a "secure" position by getting hold of all imaginable collaterals and guarantees? Recent history tells us that when the time to test all these collaterals and guarantees come, things can still come crumbling down like a house of cards, and the financiers holding the loans cannot do anything except to stare at the disaster in disbelief.

That brings us to the all-important question of whether is there a pragmatic and natural way of mitigating the risks inherent in a financial transaction. This question requires us to look at what kinds of risks are imbedded in a Islamically-structured financial transaction and how these can be mitigated. While doing so, we will also observe the ways these risks can be mitigated from within the transaction, ie, without resorting to seek external guarantees or collaterals.

Another aspect of this question we will look into concerns the relevance to Islamic financial institutions of the principles and practices laid down by the Basel Committee on Banking Supervision for managing credit, market, liquidity and operational risks.

In other words, we will look at whether it is fair to impose such controls on Islamic financial institutions, given the fact they differ so much from conventional financial institutions. There is also the matter of what Islamic financial institutions are doing, if anything, to convince the Basel Committee to devise and implement separate rules for such institutions.

(To be continued next week.)

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