What is Risk Management?

Risk is generally the possibility of an unplanned event that, if allowed to develop, could adversely affect all or part of the institution's business, leading to loss of revenue, failure to meet key strategic goals or objectives, reduced company reputation or missed opportunities to increase or improve any of these. Risk can be defined as the variability or volatility of unexpected outcomes. It is usually measured by the standard deviation of historic outcomes (Das, 2006).

Risk management is the term applied to the process adopted by the business for identifying, analysing, evaluating, treating, monitoring and communicating risks associated with all the activities of the business in a way that will enable the institution to minimise its losses, maximise opportunities and achieve its stated strategic objectives (Jorion and Khoury, 1996). The risk management process is a comprehensive system that includes creating an appropriate risk management environment; maintaining an efficient risk measurement, mitigation and monitoring process; and establishing an adequate internal control arrangement (Khan and Ahmed, 2001).

Risk management is a continuous and vigilant process; it is an activity more than an action. The goal of an effective risk management system is not only to avoid losses, but also to ensure that the bank achieves its targeted financial results with a high degree of reliability and consistency. Taking risks is an integral part of any financial business. Risk arises when there is a possibility of more than one outcome and the ultimate outcome is unknown (Schroeck, 2002). Though all businesses face uncertainty, financial institutions face some special kinds of risks, given their nature of activities.

Risk management, in a broad sense, is not only a discipline for specialised professionals, but permeates every activity of a financial institution. It starts with a clear definition of the chosen risk tolerance for the bank at all levels of the organisation, and includes management actions aimed at ensuring that its risk profile remains within the agreed risk tolerance. In addition, it is not limited to a narrow consideration of the risks undertaken by the institution, but evaluates these in the context of the external environment and how this can affect the bank The recent financial crisis, with the near collapse of the financial system in September–October 2008, provides a striking example of what can happen when risk is poorly managed, as is shown in Chapter 5.

Since all financial entities are directly or indirectly interwoven and interlinked, they create a complicated web of uncertainties which makes up the mass of the financial risk. Risk in a banking context arises from any transaction or business decision that contains uncertainty related to the result. Because virtually every bank transaction is associated with some level of uncertainty, nearly every transaction contributes to the overall risk of a bank (Schroeck, 2002). Risks are part of financial intermediation; undertaking a business transaction or an investment decision involves some degree of risk-taking regarding the future performance or outcome of the activity. The survival and success of a financial organisation depends on the efficiency with which it can manage its risks. According to Engel (2010) (Head of Risk Management at the European Islamic Investment Bank and one of the interviewees), “banks are in the risk business, they got to take risks. Once money has gone out of the door, the bank has taken a whole array of risks… The most insidious and dangerous risk is zero risk. This arises when a risk manager always says ‘no’ and comes up with many reasons not to do a deal.”

History of Risk Management

The appreciation of risk was the important building block in the development of modern financial systems. In the 20th century, the economist Irving Fisher was the first to appreciate the importance of risk in the functioning of financial markets (Bessis, 1999). In the 1930s a number of renowned economists, most notably John Maynard Keynes, saw the importance of risk in the selection of portfolios. However, in their analysis the role of risk was largely limited to affecting expected gains and speculative and hedging activities. This strain of analysis led to results covering the relationship of futures prices and expected spot prices, the impact of risk on assessing the value of future streams of income, and eventually to the development of the portfolio theory (Askari et al., 2009).

However, risk management as an independent topic is a fairly new field; although financial institutions have been always exposed to risks, the formal study of managing risk started in the second half of the last century. Markowitz's (1959) decisive paper initiated the risk-return trade-off discussion; it first indicated that portfolio selection was a problem of maximising expected return and minimising risks. A higher-than-expected return from a portfolio (measured by the mean) can result only from taking more risks. Thus, the problem for investors was to find the optimal risk–return combination. Markowitz's analysis also points out the systematic and unsystematic components of risk. While the unsystematic component, known as idiosyncratic risk, can be mitigated by diversification of assets, the systematic component has to be borne by the investor. Markowitz's approach, however, faces operational problems when a large number of assets are involved (Khan and Ahmed, 2001).

Sharpe's Capital Asset Pricing Model (CAPM) introduced the concepts of systematic and residual risks in 1964 (Stremme, 2005). Advances in this model include Single-Factor Models of Risk that estimate the beta of an asset. While residual (firm-specific) risk can be diversified, beta measures the sensitivity of the portfolio to business cycles (an aggregate index). The dependence of CAPM on a single index to explain the risks inherent in assets is too simplistic. Arbitrage Pricing Theory proposed by Ross in 1976 suggests that multiple factors affect the expected return of an asset. The implication of the Multiple Factor Model is that the total risk is the sum of the various factor-related risks and residual risk. According to Stremme (2005), the CAPM paved the way for more advanced capital-structuring models like the Weighted Average Cost of Capital (WACC), the Modigliani and Miller Theorem on optimal capital structure in 1959 and 1963, the Myers' Trade-off Theory (1977), the Black-Scholes-Merton option pricing, the Efficient Market Hypothesis and the renowned Pecking Order Theory, which was granted the Nobel Prize in Economics in 2001.

Modern risk management frameworks and processes have developed over the past three decades. Traditionally, risk management was engrained in management practices. Like Islamic finance, risk management has come a long way during its short history. “If you mentioned the title Risk Manager 25 years ago, people would laugh at you … Bankers only realised credit risk, all other risks including corporate governance, liquidity, money laundering, and even market risk were merely responsibilities of senior management and board members” says Lowe (2010), Head of Risk Management at Qatar Islamic Bank (UK) and one of the interviewees for this research. It was only when financial products started becoming complicated that risk management evolved as an independent integrated framework. The development of derivatives, pricing models, portfolios and sophisticated international financial trading required independent risk management teams and advanced models to identify, measure, monitor and control different risks.

It was in the mid-1990s, when JP Morgan started developing Value at Risk (VaR) models, that risk management began gaining prominence among banking executives. Gradually risk management started shifting to the hands of mathematicians and physicists, who developed sophisticated models that tempted management to take decisions based on statistical modelling rather than credit fundamentals. During the past two decades, there has been an unprecedented development in the mathematical and quantitative treatment of financial variables with critical implications for banks. An important impact of this development has been decomposing risk through financial engineering and product development, which has made risk management a serious scientific process. These innovations have led to significant cost reductions for most financial institutions. However, at the same time, additional uncertainties have been created, which could have serious consequences for risk management (IFSB, 2007). For example, executives at UBS and Merrill Lynch in some instances took decisions that relied on models that they did not fully understand. However, this wave is coming to an end and there will be a shift in power again to the basics, together with the help of mathematical models. It is a fact, however, that realising a fine balance remains a key challenge.

Systemic Importance of Risk Management

Over the last few decades, risk management has gained prominence in the global banking industry. The significant changes to the banking business have changed the nature of risks faced by financial institutions. Whereas two decades ago a financial institution was primarily faced with credit and market risk only, today's financial institution is exposed to a whole array of new risks, and this list is expanding. Risk management is today at the heart of banks' financial intermediation process, and plays a major role in determining a bank's rating and financial strength.

It should be noted that current risks can become tomorrow's potential losses unless they are managed efficiently. However, although most risks cannot be eliminated, they can be managed. The element of risk also brings opportunities, and to gain from these opportunities, the risk should be managed properly. For a bank, some of the risks can turn into losses and may even cause liquidation. A risk is in many cases hidden before it is visible as a loss. Risk and return are usually correlated: the higher the risk, the higher the return. A bank with a conservative approach may not fully utilise its funds and thus have a higher cost of capital, whereas a bank with high-risk appetite can over-lend, thereby increasing the chances of a failure. Currently, pricing of loans is largely based on risk. A risky loan which is under-priced may prove to be a drag on profitability, whereas a sound loan which is over-priced may deter good customers.

In the financial world, therefore, risk and return are two sides of the same coin. It is easy to lend and to obtain attractive returns from risky borrowers. The price to pay is a risk that is higher than the prudent bank's risk. The prudent bank limits risk, and therefore both future losses and expected revenues, by restricting business volume and screening out risky borrowers. The prudent bank avoids losses but it might suffer from lower market share and lower revenues. However, after a while, the risk-taker might find that higher losses materialise and obtain an end performance lower than that of the prudent lender. Who performs best? Unless some measure of risk is assigned to income, it is impossible to compare policies driven by different risk appetites. Comparing performances without risk adjustment is akin to comparing apples and oranges. The rationale of risk adjustment is in making comparable different performances attached to different risk levels (PwC, 2008).

Sundararajan (2007) provides four reasons for the importance of the application of modern approaches to risk measurement and management in Islamic banking:

1. To properly recognise the unique mix of risks in Islamic finance contracts;
2. To ensure proper pricing of Islamic finance facilities, including returns to IAHs;
3. To manage and control various types of risks; and
4. To ensure adequacy of capital and its effective allocation, according to the risk profile of the Islamic bank.

It is important to state that risk management is one of the critical factors in providing better returns to shareholders, as it is an important source of value creation in banks (Schroeck, 2002). Risk management is also a necessity for stability of the overall financial system.

Risk Management Versus Risk Measurement

There is a difference between risk measurement and risk management. While risk measurement deals with quantification of risk exposures, risk management refers to “the overall process that a financial institution follows to define a business strategy, to identify the risks to which it is exposed, to quantify those risks, and to understand and control the nature of risks it faces” (Khan and Ahmed, 2001). As the definition identifies, risk management is strictly linked to risk measurement; it is difficult to manage risk if the risk measurements are not robust (McKenzie, 2007).

Risk Management Framework

There are several risk management structures available worldwide, as has been explained in different studies; however, the most commonly used framework in today's modern world is based on four key domains: (i) risk culture and governance, (ii) risk management, (iii) risk measurement, and (iv) infrastructure and information systems (EIIB, 2010b).

These four pillars of risk management should not be considered in isolation. Rather, the dynamic interaction between them is at the core of risk management, as illustrated in Figure 3.1. They are discussed in detail in the following sections.

Risk culture and governance   A strong risk culture and tone from the top management are vital for effective risk management. The board of directors and the executive committee are responsible for choosing the appropriate level of risk appetite for the bank and for ensuring that its risk profile remains within the bank's risk tolerance. The board of directors is key to providing effective checks and balances to a bank's management and ensuring that compensation policies are designed to avoid excessive risk-taking (McKenzie, 2007). At the same time, concrete support from senior management and the board is essential to ensuring that the risk function has the necessary authority, is appropriately staffed, and has the required infrastructure to measure and analyse risk in a timely manner.

As discussed in the available body of knowledge, culture, strategy and competitive position all influence risk appetite. Different banks will have different tolerances for different risks. A bank's risk appetite for credit risk in consumer lending might be quite different from its appetite for market risk in its investment banking operation. A major benefit of defining risk appetite is that it helps to ensure that the risk culture is made explicit (PwC, 2008).

The headwind that chief risk officers and risk management staff typically face, in particular in boom times, was effectively summarised by the Bank for International Settlements (BIS) in its 79th Annual Report. The BIS (2009) noted: “Without support from top management, it did not matter much what the chief risk officer said or to whom he or she said it. The structural problem was compounded by the behavioural response to a risk officer whose job is to tell people to limit or stop what they are doing. If what they are doing is profitable, it is going to be difficult to get managers and directors to listen.”

Engel (2010), one of the interviewees for this research, adds, “I keep reminding everyone at my bank to ‘Think Capital, Think Risk’; everybody has got to engage in the risk culture if you want to implement a successful risk management framework.”

Risk management   Once the risk tolerance for the financial institution has been agreed, this has to be translated into a coherent risk limitation system for different types of risks as well as for the different business activities of the bank. In addition, risk mitigation will be needed to ensure that the risk profile of specific portfolios or activities does not exceed the allocated limit – hence the link between risk governance and risk management. Figure 3.2 illustrates that a sound risk management process requires appropriate linkage between approaches and actions that enable eliminating, transferring or managing risk, and instruments that facilitate the hedging and diversifying of those risks that the organisation cannot manage.

Risk measurement   Risk cannot be managed without being measured. The crisis has made apparent that further work is required to enable banks to measure their risks with some degree of accuracy, particularly in relation to complex financial instruments, as well as to capture the interrelationship across different types of risk. In measuring and managing risk, the adoption of multiple risk measures is necessary to prevent important dimensions of risk being overlooked. For example, statistical measures, such as VaR, need to be complemented by stress-testing analysis. The results of models can be a valuable input into the decision-making process of a bank, but they cannot replace judgement. Lowe (2010) asserts that models and formulas should support a sound fundamental analysis, but never replace it.

Infrastructure and information systems   A robust risk infrastructure and good data quality are the essential elements for a bank to be able to measure in an accurate and timely manner the risks that it is taking. It is also a key element for effective risk reporting, which, as discussed above, is essential for the board of directors and the executives to make informed decisions (EIIB, 2010b). So, the risk infrastructure and information systems pillar links to risk culture and governance. Consequently, with this process the circle is closed.

Credit Risk

Credit risk is generally defined as the risk of loss arising from default or failure to perform (EIIB, 2010b). It is also referred to as ‘default risk’, which is one of the earliest recognised risks in the financial industry. Traditionally, a large part of a bank's profit came from the lending business, and the majority of bank losses were also related to this aspect of risk management; hence the focus was primarily on credit risk.

Banks have always monitored and mitigated credit risk actively, through a number of mechanisms such as country limits, counterparty limits, large exposure limits, diversification, covenants, delegations, internal and external ratings, watch lists, etc. However, credit risk assessment remains judgement-based because it cannot be precisely calculated ahead of time since the likelihood of default is highly uncertain and thus difficult to predict accurately. Credit applications, referred to as credit scoring models, play an important role in combining qualitative and quantitative risk aspects of clients including, but not limited to, operating experience, management expertise, asset quality, leverage and liquidity ratios, earnings, debt service, etc. (Akkizidis and Khandelwal, 2007).

Credit risk in Islamic banks   The IFSB Principles of Credit Risk can help to develop an understanding of the nature of credit risks in Islamic banks, as in Box 3.1.

The unique characteristics of the financial instruments offered by Islamic banks result in the following special credit risks:

1. First, access to collateral and foreclosure are difficult. One of the five key pillars of modern Islamic finance is the obligation to back any transaction by a tangible, identifiable, underlying asset. This means that IFIs – at least in theory – back their transactions with collateral. Consequently, collateral coverage is usually higher for IFIs than for conventional banks. In short, IFIs naturally have a high level of collateralisation on their credit portfolios, and thus are in a position to somewhat reduce their economic, if not regulatory, exposures at default.

   Contrary to conventional banks, whose customers are not always obliged to disclose the purpose of their borrowings, Islamic banks finance the acquisition of identifiable assets of which they have legal ownership, in most cases until maturity and final repayment. This is notably the case for ijarah and diminishing musharakah operations, in which the bank acquires the asset and leases it to the customer, with ownership transfer taking place only at maturity. The bank, as the legal owner of the asset, is therefore in a favourable position to foreclose on this asset (in the case of a default), and sell it on a secondary market (Moody's, 2008a).

   In practice, however, collateral foreclosure can be much more difficult, especially for residential real estate. Given the take-off in residential real estate lending in Gulf Cooperation Council (GCC) countries, this question of foreclosure is set to become critical. Although an Islamic bank is in theory in a position to evict a customer from a property and resell it in the case of a default on the loan backed by the property, this would be unlikely to happen in practice, owing to the bank's ‘social responsibility’. According to Chowdhury (2010), one of the interviewees for this research, there are, however, instances when such a decision may be taken by a bank and authorised by its Shari'ah board – notably when specific conditions were set out and agreed upon before the conclusion of the transaction. In such cases, foreclosure may be easier than for conventional banks, as the property belongs to the Islamic bank. As a matter of fact, this type of structuring is sometimes used by conventional banks, as it is a strong way of reducing the problem of foreclosure.

   In addition, there are other problems with posting collaterals as securities, especially in developing countries, where most Islamic banks operate, or in declining times like the recent recession. Typical problems include illiquidity of the collateral or inability of the bank to sell it, difficulties in determining the fair market value on a periodic basis, and legal obstacles in taking possession of the collateral. Diminishing musharakah contracts are increasingly used as a financing mechanism for Shari'ah-compliant home purchase, particularly in Dubai (Moody's, 2008b).

   However, when the financing is based on other Shari'ah-compliant schemes where the property is not registered in the bank's name, the IFI will find itself in the same position as its conventional peers.

2. Murabahah is the most predominantly used Islamic financial contract. Based on the contract's similarity in risk characteristics with those of interest-based contracts, murabahah is approved as an acceptable mode of finance in a number of regulatory jurisdictions. However, such a standardised contract may not be acceptable to all fiqh scholars. Moreover, as the contract stands at present, there is a lack of complete uniformity in fiqh viewpoints. The different views among scholars can be a source of counterparty risk as a result of the atmosphere of ineffective litigation (Khan and Ahmed, 2001). The main point in this regard stems from the fact that financial murabahah is a contemporary contract which has been designed by combining a number of different contracts. There is a complete consensus among all fiqh scholars that this new contract has been approved as a form of deferred trading. The condition of its validity is based on the fact that the bank must buy (become owner) and afterwards transfer the ownership direct to the client. The order placed by the client is not a sale contract but merely a promise to buy. According to the OIC Fiqh Academy Resolution, a promise can be binding on one party only. The OIC Fiqh Academy, AAOIFI and most Islamic banks treat the promise to buy as binding on the client. Some other scholars, however, are of the opinion that the promise is not binding on the client; the client, even after placing an order and paying the commitment fee, can rescind the contract. The most important counterparty risk specific to murabahah arises due to the unsettled nature of the contract (Iqbal and Mirakhor, 2007).
3. In the case of mudarabah investments, where the Islamic bank enters into the mudarabah contract as rab al-mal (principal) with an external mudarib (agent), the Islamic bank is exposed to an enhanced credit risk on the amounts advanced to the mudarib in addition to the typical principal–agent problems. The nature of the mudarabah contract is such that it does not give the bank appropriate rights to monitor the mudarib or to participate in management of the project, which makes it difficult to assess and manage credit risk. The bank is not in a position to know or decide how the activities of the mudarib can be monitored accurately, especially if losses are claimed. This risk is especially present in markets where information asymmetry is high and transparency in financial disclosure by the mudarib is low (Greuning and Iqbal, 2008).
4. In bay' al-salam contracts, the bank is exposed to the risk of failure to provide goods on time, or supply of a different quality of goods from that contractually specified. Such failures could result in a delay or default in payment, and hence to financial losses to the Islamic bank. Salam is an agricultural-based contract and hence the counterparty risks may be due to factors beyond the normal credit quality of the client. The credit quality of the client may be very good but the supply may not come as contractually agreed due to natural calamities. Since agriculture is exposed to catastrophic risks, the counterparty risks are expected to be above-average in bay' al-salam (Iqbal and Mirakhor, 2007).
5. The counterparty risks under istisna'a contracts are similar to the risks faced by Islamic banks under bay' al-salam contracts. However, the object of istisna'a is more within the control of the counterparty and less exposed to natural calamities as compared to the object of salam. Therefore, it can be expected that the counterparty risk of the sub-contractor of istisna'a, although fairly high, is less severe than that of the salam (Akkizidis and Khandelwal, 2007). In addition, under the istisna'a agreement IFIs are deemed to remain the beneficial owners of financed assets until the borrower pays back the final instalment. In the case where the borrower defaults before maturity, the IFI is entitled to dispose of the financed assets, which are generally illiquid because they are specific to the nature of the plant, the industry or the enterprise to which the IFI's funds were initially allocated. In the case of default, the IFI – more so than any conventional bank – becomes a merchant, acting in the field of commerce rather than in that of pure financial intermediation. This puts additional pressure on IFIs to equip themselves with the correct technical and professional expertise for both credit assessment and the management of underlying asset valuation, trading and liquidity, should loan foreclosure and collateral realisation occur (Mahlknecht, 2009).
6. Credit risk management for Islamic banks is further complicated by additional externalities. For example, in the case of default by the counterparty, Islamic banks are prohibited from charging any accrued interest or imposing any penalty, except in the case of deliberate procrastination (Greuning and Iqbal, 2008). Clients may take advantage by delaying payment, knowing that the Islamic bank will not charge a penalty or require extra payments. During the delay, the bank's capital is stuck in non-productive activity. To mitigate this risk, Islamic banks tend to charge defaulting customers (who prove to be negligent) a penalty for late payments, which the banks donate to charity and do not include in their income. This helps to prevent potential similar situations.
7. Islamic banks have less sophisticated credit risk management practices, mostly because of the lack of databases and insufficient track record. Conventional banks use these tools to reduce their credit risk, a luxury not yet available to Islamic banks. For example, the calculation of probability of default (PD), loss given default (LGD), expected losses (EL), exposure at default (EAD) and credit VaR do not generally exist in Islamic banking. There are endeavours by Moody's and Standard & Poor's to develop such models for Islamic banks, or to adjust some of the existing models like CreditEdge, RiskCalc and Risk Tracker to accommodate Islamic banking. These models are still work in progress and are faced by huge difficulties stemming from the fact that there is limited systematic data available in the Islamic banking world to date.

Concentration Risk

Islamic banks tend to have a concentration base of assets and/or deposits; they face high concentration by name and sector, as well as high geographical concentration. The limited scope of eligible asset classes for IFIs increases concentration in investment portfolios, which tends to be mitigated by a lower appetite for speculative transactions. Since Islam forbids gharar and speculation, IFIs are naturally crowded out from the high-risk/high-return leveraged and/or structured investment asset classes. As such instruments tend to be, in one form or another, based either on interest (riba) or derivatives (not commonly allowed by Shari'ah supervisory boards, although Islamic ‘equivalents’ are appearing), their technical eligibility is in most cases difficult to justify. IFIs thus limit the scope of their investment strategies to ‘plain vanilla’ asset classes such as stocks, sukuk and real estate, notwithstanding their cash reserves in the form of short-term international murabahahs for liquidity purposes. A limited range of permissible asset allocations leads to concentration risks in IFIs' investment portfolios, by asset class, sector and usually also by name. This led some IFIs to suffer severe losses during the recession. For example, IFIs that invested heavily in stock markets were exposed to swings in equity prices. Moreover, IFIs are usually significantly exposed to the real estate sector, as it is compliant with Shari'ah principles. Some Islamic banks in the GCC have significant exposure to this sector (directly or indirectly through collateral or sukuk), which magnifies the market risk especially during bearish market conditions.

Because most Islamic financial transactions have an underlying asset at their centre, Islamic banks tend to own more physical assets than conventional banks, and “what is a better asset than real estate?”, wonders Marx (2010), one of the interviewees for this research.

There has been a build-up of these assets during a benign period of credit risk and rising asset values; a time when the market has seen ample liquidity (Moore, 2009). The recent straitened times that impacted on markets around the globe have still to be felt in many of the countries where Islamic banks operate; Dubai was a clear example. The particular concentrations seen in Islamic banks and the similarity of many of their operations are causes for concern.

In addition, the immaturity of securitisation in the industry means that this financial technology has not been widely used to remove such excess concentrations from the balance sheet, although 2007 did see the first few transactions of commercial property loans and residential ijarah mortgages. In particular, sukuk are scarce and constitute an illiquid market where investors tend to stick to a buy-and-hold approach rather than move toward more active bond trading (Moody's, 2011a).

Moreover, concentration risks arise from the banks' limited geographic reach, as most IFIs are domestic players and only a few have material operations outside their home country. One interesting exception is the Al Baraka Banking Group, which has a material presence in more than a dozen jurisdictions across the Muslim world that brings a good amount of de-correlation between the Group's sub-portfolios.

Islamic banks also suffer from concentration on the liability side, leading to poor asset–liability management (ALM), as discussed in the section ‘Asset–Liability Management’. At present, IFIs rely heavily on maintaining good relationships with depositors. However, these relationships can be tested during times of distress or changing market conditions, when depositors tend to change loyalties and shift to large financial institutions which they perceive to be safer. By diversifying their base of depositors, Islamic banks could reduce their exposure to displacement or withdrawal risks. According to Askari et al. (2009), with the changing face of banking and the introduction of internet-based banking, achieving a high degree of geographic diversity on the liabilities side is conceivable and should be encouraged.

Concentration and potential volatility in the credit quality of portfolios have made it necessary for IFIs to maintain strong capitalisation despite rapid growth. This has in turn put pressure on dividend payouts, and sometimes also on shareholders to inject fresh capital.

Market Risk

Market risk is generally defined as the risk of loss arising from changes in market prices and profit rates, which will result in a change in earnings or fair value of a financial obligation resulting in a capital gain or loss upon realisation of the asset (EIIB, 2010d). The losses can be in on and off balance sheet positions arising from adverse movements in market prices, i.e. fluctuations in yields and profit rates (rate-of-return risk), foreign exchange rates (FX risk), equity and commodity prices (price risk). The price volatility of most assets held in investment and trading portfolios is often significant. Volatility prevails even in mature markets, although it is much higher in emerging or illiquid markets.

Market risk was recognised in the late 1980s, after the increase in the importance of stock markets, when banks started investing heavily in securities (Davis, 2009a). Market risk is difficult to measure due to diversified portfolios, since it will consist of several markets, currencies, indexes and instruments. The larger the diversification of the portfolio, the more difficult it is to accurately estimate market risks due to the correlation between risks.

Market risk management   By its very nature, market risk requires constant management attention and adequate analysis. Although there are several ways to measure and manage market risks, which vary among banks, most banks have limits and triggers for portfolios, individual transactions, sectors and even traders. Banks also use marking to market, stop-loss provisions, gap analysis, back-testing and stress-testing for the daily risk management of banking and trading books. Stress-testing is gaining more popularity to help predict expected losses.

Factor sensitivities and VaR can be used for marked-to-market trading. VaR is the most well-known methodology to quantify and evaluate market risk in a systematic fashion. It is one of the newer risk management tools that indicates how much a firm can lose or make with a certain probability in a given time horizon. VaR summarises financial risk inherent in portfolios into a simple number. It is the value of potential losses that will not be exceeded in more than a given fraction of possible events. This fraction, expressed as a percentage, is called the ‘tolerance level’. For example, stating that VaR is 100 at the tolerance level of 5% means that the chances that futures losses exceed 100 are equal to 5% (Bessis, 1999). Though VaR is used to measure market risk in general, it incorporates many other risks like foreign currency, commodities and equities. In fact, VaR applies to all levels of risk management, including credit risk, although it is often associated with market risk only (Bessis, 1999). It has many variations and can be estimated in different ways like the Monte Carlo approach, the Parametric approach and the Historical approach. However, VaR models possess some latent weaknesses arising from the fact that they are tailor-made models. As a risk indicator, VaR works best for smaller positions in liquid markets. In the most recent crisis (like many in the past), the biggest losses occurred when several firms built up concentrations, sometimes unknown to their managers and often unknown to each other. Then, when liquidity evaporated, firms were stuck with big positions or were forced to liquidate at the same time, exacerbating the trend in falling values. In either case, increases in observed market volatility caused the VaR attributed to remaining positions to rise. Thus, VaR has also been criticised for being a pro-cyclical risk measure. The use of other measures to supplement VaR, such as Expected Shortfall (the average of all the hypothetical losses beyond daily VaR), can help provide better market risk management (Moody's, 2009c). Therefore, data inputs should be carefully assessed before the appropriate model is applied. In addition, the conventional market is full of complex derivative products for hedging the positions to manage market risk.

Market risk in Islamic banks   The IFSB Principles of Market Risk Management, as illustrated in Box 3.2, introduce the risk management strategy for market risk.

Market risk in Islamic financial markets inherently exists within the lifetime of Islamic contracts. The management of market risks is made more difficult for Islamic banks due to the limited number of risk management tools/instruments available to them. For example, it is difficult for an IFI to use hedging instruments, such as derivatives, as these are generally forbidden. On a positive note, the prohibition of gharar usually tempers the risk profile of Islamic banks simply by limiting the size of their trading operations. Market risk for IFIs can be divided into six categories as follows:

Rate-of-return risk (profit rate risk)   The IFSB Principles of Rate-of-Return Risk Management, as in Box 3.3, introduce the risk management strategy for rate-of-return risk.

Islamic banks are not exposed to an ‘interest rate risk’, as interest is not compliant with the Shari'ah. However, they potentially face even more complex rate-of-return risks and benchmark risks. Lee (2008) explains that Islamic banks do not operate in a closed economy; if interest rates rise sharply in relation to mark-up rates, deposits will flow from Islamic banks into conventional banks and vice versa.

This results from a mismatch between the yield earned on the bank's assets and that served on its liabilities. Controlling margin rates is at the heart of IFIs' ALM. The management of interest rate risk is one of the fundamental tasks of the ALM committees of conventional banks. Similarly, IFIs face the same issue of identifying, measuring and controlling the risk exposure stemming from the expected cash inflows and outflows of assets and liabilities according to their economic maturities. Like conventional banks, IFIs have both a portfolio yielding fixed income over the duration of contracts and a portfolio generating floating rates of profit.

However, unlike conventional banks, the charge attached to funding costs is supposed to be a function of asset yields, as per the core principle of profit-sharing underlying Islamic banking and finance (IBF), which is at the heart of Profit-Sharing Investment Accounts (PSIAs). Should there be no smoothing of returns to PSIA holders, those IFIs that resort materially to PSIAs for funding would in theory be less profitable than conventional banks when the interest- or profit-rate cycle is at its peak, because when conventional banks face a predetermined cost of funds, IFIs would on the contrary be in a position to share more returns with PSIA holders (Thun, 2010).

The opposite scenario would also be true: when the interest- or profit-rate cycle trends down toward its trough, IFIs would buffer the decline by distributing less profit to PSIA holders, whereas conventional banks would have to absorb the same cost of funds at a time when net asset yields had shrunk, therefore reducing more substantially their margins. If PSIA principles are applied, a lower income on outstanding loans and participations goes hand in hand with lower payments to depositors and the bank's solvency is not endangered (Visser, 2009). In practice, however, the losses of Islamic banks are not shared with PSIA holders and often a minimum yield on deposits is ‘implicitly’ guaranteed. As a result, the potential benefits of PLS finance cannot be realised. There is often an implicit promise of some minimal return on deposits, or a de facto guarantee of non-negative returns (Turen, 1995).

Another difference between Islamic and conventional banks is their respective capacity to use derivatives to hedge their loan books against adverse interest-/profit-rate scenarios. IFIs have a natural preference for short-term exposures or contractual credit terms that would allow for quick re-pricing schemes, such as ijarah or diminishing musharakah, which typically re-price every quarter, behaving like floating profit rate loans. These mechanisms make it less necessary for Islamic banks to resort to (expensive) profit rate swaps for hedging purposes. Less than a handful of IFIs to date have had access to such hedging instruments for Shari'ah related reasons and because so far these instruments are still very scarce, illiquid, based on over-the-counter arrangements, and thus still quite costly (Askari et al., 2009).

In the longer term, IFIs are expected to be increasingly exposed to project finance and mortgage lending, two of the most likely and powerful engines for the future momentum of Gulf banking markets. In both lines of business, an IFI's capacity to supply long-term fixed-rate financing would be viewed as a key competitive advantage. From a balance sheet management perspective, the IFI's corresponding capacity to manage the derived profit rate risk would be critical, particularly under Basel II's Pillar 2.

In some cases, IFIs can employ nascent Shari'ah-compliant hedging techniques. Dubai Islamic Bank and Deutsche Bank AG have stated that they have established the first ever Shari'ah-compliant profit rate collar (Ayub, 2007). For less sophisticated IFIs, the matching of floating and fixed yields can be used as a natural way to cover these risks. An ijara portfolio – with a floating margin or re-pricing characteristics – could be used to reduce an IFI's exposure to margin risk resulting from the use of PSIAs as a funding source. As IFIs usually benefit from a large portion of unremunerated deposits, as is the case for Saudi Arabia-based Al Rajhi Bank, this can also be a good mitigating factor for margin-related risks.

The core opportunity comes from developing products to manage profit rate risks and FX risks using fixed/floating profit swaps and currency swaps. Profit rate swaps rely mostly on the double murabahah approach, referred to as the ‘dual murabahah’ agreement (Marx, 2010). Although straightforward FX contracts are not permissible, there are several alternative solutions, which all have their respective challenges, such as: back-to-back qard al-hasan, dual commodity murabahah contracts, waad, arboun and others as discussed under the ‘Risk Mitigation in Islamic Banking’ section.

Equity investment risk   The IFSB Principles, as in Box 3.4, introduce the risk management strategy for equity investment risk management.

Most banks, whether conventional or Islamic, deal in quoted and non-quoted equities all over the world. Typical examples of equity investments are holdings of shares in the stock market, private equity investments, syndications, management buyouts, etc. However, the nature of Islamic finance contracts, particularly the musharakah and mudarabah contracts, may result in specific equity risks to IFIs. This is mainly because one of their main characteristics lies in the sharing between the IFI and the partner of profit and loss that is driven by the share in the investment's equity (Grais and Kulathunga, 2007). Therefore, the degree of risk under those contracts is relatively higher than that of other investments.

Mudarabah can expose the IFI to moral hazard and to principal–agent problems when the bank enters as rab al-mal and the mudarib is the agent. While the bank bears all the losses in case of negative outcome, it cannot oblige the mudarib to take appropriate action or exert the required level of effort needed to generate the expected level returns. Such situations might be exploited by the mudarib (Greuning and Iqbal, 2008).

This moral hazard problem would be reduced in musharakah, where the capital of the partner is always at stake. Furthermore, the bank's position as an equity partner would minimise the problem of information asymmetry, as it would have the right to participate in management of the project in which it is investing. However, the musharakah asset class has an associated cost in the form of adverse selection and therefore requires extensive due diligence in terms of screening, information gathering and enhanced monitoring afterwards. Each musharakah contract requires careful analysis and negotiation of PLS arrangements, leading to higher costs of intermediation.

In addition, equity investments may not generate steady income, and capital gain might be the only source of return. The unscheduled nature of cash flows makes it difficult to forecast and manage them.

As a result of the additional equity problems associated with both types of contracts, IFIs in practice tend to allocate limited funds to these asset classes. This implies an increased reliance on asset-backed securities, which limits the choice of investments and ultimately might hamper the bank's ability to manage risks and diversify its portfolio (Greuning and Iqbal, 2008). A few IFIs also tend to build portfolios of participations in the capital of a set of financial and industrial companies held for strategic purposes. Usually, mudarabah contracts are used, as is the case for Shari'ah-compliant investment and/or private equity firms such as Arcapita Bank and Gulf Finance House in Bahrain.

Mark-up risk   Islamic banks are exposed to mark-up risk, as the mark-up rate used in murabahah or other trade-financing contracts is fixed for the duration of the contract, while the general ‘market mark-up rate’ used in the financial market may rise or fall over that time period (FRSGlobal, 2009). This means that the prevailing market mark-up rate may rise beyond the rate the bank has locked into a contract, making the bank unable to benefit from higher rates. Very often the mark-up rate (or benchmark rate) will be an international one such as the London Interbank Offered Rate (LIBOR), which gives rise also to a so-called ‘benchmark risk’.

Benchmark risk   Benchmark risk is the risk of loss due to a change in the margin between domestic rates of return and the benchmark rates of return, which may not be linked closely to domestic returns. For instance, Islamic products issued in Malaysia can be linked to the Kuala Lumpur Interbank Offered Rate (KLibor), the national variant of LIBOR, but this is certainly not the case for all countries and contracts (Mahlknecht, 2009). In the absence of an Islamic benchmark or reference rate, a questionable but common practice has been to use the LIBOR as a proxy which aligns the market risk closely with the movement in LIBOR rates.

According to an interview with Yaccubi (2010), the practice of using LIBOR as the reference benchmark was originally considered an exception allowed by Shari'ah scholars under the law of necessity. This exception has become a general rule and the practice is so prevailing that most practitioners do not even question it. Yet, using LIBOR as a benchmark has its proponents and opponents.

The proponents of the practice argue that it is simply a reference point of the current capital market indicating the opportunity cost of capital, which should not be different in global markets where Islamic and conventional banking coexist (Askari et al., 2009). If the opportunity cost of capital is not the same, arbitrage opportunities will arise. They also argue that using a non-Shari'ah-compliant reference point does not invalidate a Shari'ah-compliant transaction, as the index is just used as a reference. Moreover, an Islamic benchmark is not expected in the near term. According to the Shari'ah scholar Aznan Hasan, “A dual system which has both Islamic and conventional benchmark financing rates could throw markets into disarray … People will arbitrage. Once they see conventional financing is much better, they will go for conventional. Once they see Islamic is much better, they will go for Islamic. In that situation, it will give a big turbulence to a country. The subject has to be treated very delicately” (Y-Sing, 2009).

On the other hand, opponents of this practice argue that in an Islamic economic system, the rate of return on a financial asset should be derived from the rate of return in the real sector and using LIBOR as a benchmark does precisely the opposite, and thus violates the foundation of an Islamic financial system (Askari et al., 2009).

Currency risk   Currency risk is of a ‘speculative’ nature and could result in a gain or loss depending on the direction of exchange rate shifts and whether a bank is net long or net short in the foreign currency. For example, in the case of a net long position in the foreign currency, domestic currency depreciation will result in a net gain for a bank, and a currency appreciation will produce a loss, and vice versa, explains Fochler (2010), who was interviewed for this research.

As for conventional banks, IFIs' exposure to foreign exchange risk can be harmful. While conventional banks can easily hedge themselves through swaps or other hedging instruments, these are generally forbidden in Islamic finance, making the situation more challenging for IFIs. However, most Islamic banks are active in the GCC, where local currencies are pegged either to the US dollar or to a basket of international currencies, reducing tremendously their volatility. In the longer run, GCC economies might converge toward a single regional currency, the anchor of which might not be the US dollar or the euro, but potentially a wider mix of internationally recognised currencies. This would in turn allow for some discrepancy between the reporting currency of GCC-based IFIs and the various cash flows they generate from multiples geographies. This will become even more obvious as IFIs such as Kuwait Finance House, Al Rajhi Bank and Qatar Islamic Bank are expanding abroad in a more ordered and ambitious manner, sometimes in other emerging markets including the relatively volatile economies of Pakistan, Turkey, Sudan and even Yemen. These jurisdictions are increasingly the key to the future growth of IFIs as they have far larger Muslim populations and are comparatively underbanked (Standard & Poor's, 2010b).

Commodity and price risks   In the case of salam contracts, IFIs are exposed to commodity price volatility during the period between delivery of the commodity and its sale at the prevailing market price. This risk is similar to the market risk of a forward contract if it is not hedged properly. In order to hedge its position, an Islamic bank may enter into a parallel (off-setting) bay' al-salam contract (Greuning and Iqbal, 2008). Similarly, when the istisna'a contract is used, the delivery of the commodity is at a specific time in the future, where its price may differ from the set one.

In addition, salam contracts are neither exchange traded nor traded over the counter. Thus, all the salam contracts end up in physical deliveries and ownership of commodities. These commodities require inventories exposing the IFI to storage costs and other related price risk. Such costs and risks are unique to Islamic banks (Greuning and Iqbal, 2008).

In murabahah contracts the bank is financing the contract on a certain profit added to the initial commodity price. The difference between the agreed and the future market price of the commodity is the actual exposure of the corresponding risk that banks take, at least in theory. In practice, the bank takes the commodity risk for a few seconds as it purchases and sells the commodities to commodity brokers – like Dawnay Day, Richmond, Aston commodities and others – who enter into a purchase undertaking with the bank. This practice, referred to as tawarruq, has been criticised by many Shari'ah scholars. It was approved initially as an interim solution until IFIs move to genuine commodity murabahah, but it seems that several banks took advantage from this interim approval and prefer to stick to tawarruq as it bears minimal commodity risks to the bank.

In addition, in the case of an operating ijarah, the IFI is exposed to market risk in the case of a fall in the residual value of the leased asset at the maturity of the lease term (Ahmed and Khan, 2007).

Finally, IFIs have been investing heavily in the sukuk market. However, given that the secondary market for sukuk is very limited, the prices of such instruments are highly distorted. Thus, IFIs holding such securities are exposed to volatility in yield, unless they hold the sukuk until maturity.

Managing market risk for IFIs   In order to manage market risk, first Islamic banks must be able to measure it accurately. To date, there is not a single Islamic banking system that is capable of measuring market risk properly (Marx, 2010). According to Bhat, one of the interviewees for this research (from InfrasoftTech, a specialised IT company for developing technology solutions and systems for Islamic banks): “I am confident Islamic banks will get there, it is a matter of time. One has to remember that conventional banking has mega banks that are capable of spending millions on developing sophisticated systems, something that Islamic banking is missing, given its relative nascent state.” His interview was not included in the final sample, however.

In the absence of Shari'ah-compliant hedging tools and liquid secondary markets, managing market risk is more expensive in Islamic banking than it is in conventional banking. Marx (2010), one of the interviewees for this research, adds “for example, to carry a profit rate swap in the Islamic banking market, I have to pay around 30 bps higher than what this would usually cost in the conventional market. This is because very few banks have the capability, systems and credit lines available to write Islamic profit rate swaps and they exploit this position.”

Most advanced market risk management tools, such as VaR, and simulation models require huge trading volumes, a long history of price changes and volatility in order to be able to perform back-testing and stress-testing. This is simply unavailable for Islamic banking given its relatively new state and the limited market liquidity. VaR does not work well for illiquid markets with high concentrations; unfortunately this is the current state of most Islamic banking operators. In addition, issuers in Islamic finance tend to have a relatively small number of issues with short-term maturities. Furthermore, there tends to be a wide gap between the bid/offer spreads on Islamic instruments due to limited liquidity. All these factors indirectly distort the applicability of conventional market risk management tools in Islamic banking. “Islamic banking is not mature enough to apply existing conventional market risk mitigation and hedging techniques. It needs to develop its own set of risk management tools” adds Qaedi (2010), one of the interviewees for this research.

In the absence of sophisticated tools, Islamic banks tend to use traditional risk management techniques to manage their market risk. Simple stress-testing, marking to market, stop-loss provisions, position limits, duration methodologies, scenario analysis, price sensitivity and profit rate analysis are the most commonly used practices, mainly carried out using spreadsheets rather than sophisticated IT systems. “Very simple models, but currently adequate given the complexity of Islamic banking” comments Lowe (2010), one of the interviewees for this research.

Liquidity Risk

Liquidity is necessary for banks to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth. It represents a bank's ability to accommodate the redemption of deposits and other liabilities and to cover the demand for funding in the loan and investment portfolio (Iqbal and Mirakhor, 2007). Liquidity needs usually are determined by the construction of a maturity ladder that comprises expected cash inflows and outflows over a series of specific time bands; liquidity management is related to a net funding requirement.

Liquidity risk results when the bank's ability to match the maturity of assets and liabilities is impaired. In other words, the risk arises due to insufficient liquidity for normal operating requirements reducing the bank's ability to meet its liabilities when they fall due. This risk may result from either difficulties in obtaining cash at reasonable cost from borrowings (funding risk) or sale of assets (asset liquidity risk). While funding risk can be controlled by proper planning of cash flow needs and seeking newer sources of funds to finance cash shortfalls, the asset liquidity risk can be mitigated by diversification of assets and setting limits of certain illiquid products (Khan and Ahmed, 2001).

The market turmoil that began in mid-2007 has highlighted the crucial importance of market liquidity to the banking sector. The contraction of liquidity in certain structured product and interbank markets, as well as an increased probability of off balance sheet commitments coming onto banks' balance sheets, led to severe funding liquidity strains for some banks and central bank intervention in some cases. These events emphasised the interrelationship between funding, liquidity and credit risks, and the fact that liquidity is a key determinant of the soundness of the banking sector (BCBS, 2008). Financial innovation and global market developments have transformed the nature of liquidity risk in recent years. The funding of some banks has shifted toward a greater reliance on the capital markets, which are potentially a more volatile source of funding than traditional retail deposits. In addition, the growth and product range of the securitisation market has broadened as the originate-to-distribute business model has become more widespread. Northern Rock is a classic example of a bank that was brought down due to lack of liquidity rather than any credit or solvency risk. The bank simply borrowed for the short term from the capital markets and lent for the long term to residential mortgages.

Inspired by international drive from the Basel Committee on Banking Supervision (BCBS) and the Committee of European Banking Supervisors on liquidity management, regulators around the globe have been working on introducing a series of new rules outlining features of a new liquidity regime which proposes much higher levels of stress-testing and stricter liquidity management approaches. Basel III is the most obvious example.

Liquidity risk in Islamic banks   IFSB Principles, as in Box 3.5, introduce the risk management strategy for liquidity risk management.

Islamic banks have traditionally held high levels of cash/liquid assets, ideally to safeguard the interests of their depositors, investors and shareholders against credit upheavals and liquidity crunch. This reduces liquidity risks in an economic downturn. In addition, from a leverage perspective, IFIs' operational models are built upon conservative fundamental values that discourage the use of disproportionate levels of debt to finance assets, as well as speculative and doubtful investments, a position which has inhibited the industry in terms of its use of leverage. As a result, IFIs' funding portfolios are highly concentrated in a few liquid assets and are deficient in terms of a securitised asset base (IFSB, 2008a).

At the same time, underutilised surplus liquidity on most IFIs' books has led to weak asset–liability management, which translates into liquidity risk. This risk arises from the scarcity of medium- and long-term funds to reduce the gap between assets and liabilities. The analysis in Figure 3.3 categorises the assets and liabilities of a sample of 20 leading Islamic banks into short term, medium term and long term. IFIs use short- and medium-term liabilities to finance long-term assets. Currently, IFIs are highly dependent on short-term funds to manage their longer-tenure liabilities. This issue has become even more crucial in today's capital market environment because the frequency of asset write-downs is on the rise. In the wake of global financial developments, liquidity has become one of the most critical risks for IFIs for the following reasons:

1. Limited availability of Shari'ah-compliant liquidity management instruments because most instruments used for liquidity management purposes are interest-based and Shari'ah does not allow the sale of debt, other than at its face value. Thus, to raise funds by selling debt-based assets is not an option for IFIs;
2. Shallow secondary market exists to enable IFIs to manage their liquidity (Qaedi, 2010);
3. Absence of lender of last resort (central bank), which is vital for meeting the bank's need for short-term cash flow;
4. Wide maturity mismatches between assets and liabilities as funding is still dominated by short-term customer deposits, whereas credit portfolios (namely in the retail, mortgage and project finance segments) tend to witness longer tenors and duration (Moody's, 2009c); and
5. Certain characteristics of some Islamic finance instruments give rise to liquidity risks. For instance, liquidity becomes a problem given the cancellation risks in murabahah or the inability to trade murabahah or salam contracts (Alvi, 2009a).

Despite the efforts of the Central Bank of Bahrain (CBB) and others to provide a range of liquid instruments in which Islamic banks can place their surplus cash, there is still a great shortage of liquid instruments, which means IFIs tend to have more non-earning assets on their books. Typically, Islamic banks would place their excess cash reserves into short-term interbank murabahahs, at a cost compared to conventional banks. Indeed, short-term murabahahs resemble money market interbank placements, but as murabahah contracts make it necessary for commodity brokers to be involved, costs for managing liquidity might be high. As a consequence, IFIs are truly – and often more visibly – subject to the constant trade-off between profitability and liquidity in a binary way (Moody's, 2009c).

Contrary to conventional banks, which benefit from a range of asset classes displaying different characteristics in terms of liquidity and profitability, IFIs at this stage of the development of the Islamic financial industry barely have an alternative – profitable but highly illiquid asset classes (such as credit exposures and sukuk); or highly liquid short-term murabahahs with international investment-grade banks, but at a cost. Even before the present crisis, liquidity on the secondary sukuk markets was quite limited. The fact that most sukuk investors have always adopted a buy-and-hold strategy only exacerbates the normal problems associated with a relatively new market. Critically in the current environment, such a situation could also continue to slow the efforts of central banks to boost sukuk liquidity.

The assets side of the balance sheet will typically show investments in securities, leased assets and real estate. It will also show equity investments in joint ventures or capital ventures and sales receivables, and also inventories of assets held for sale. Most of these assets are illiquid and it is unlikely that any could be sold in a short space of time.

Fortunately, yields on Islamic assets in many markets are still sufficient for the cost of managing liquidity, because ‘borrowers’ are often willing to pay a premium for the Islamic nature of the banking relationship they build with the IFI. In the future, however, as the industry matures, margins might come under pressure and the trade-off between liquidity and profitability might lead to an increase in IFIs' risk appetite, provided that instruments for liquidity management purposes are not designed for the benefit of IFIs (Moody's, 2009c).

Figure 3.4, extracted from a typical credit application for an anonymous counterparty at the European Islamic Investment Bank, illustrates a typical liquidity structure of many Islamic banks with an imbalanced funding continuum heavily reliant on short-term customer deposits. IFIs normally have a high volume of assets, which are generally of longer term than most deposits. Islamic banks have to manage this funding gap carefully: if there were a liquidity freeze like the one that struck Western banks, the damage among Islamic banks would be greater.

Islamic banks use cash from deposits and short-term liquid assets to finance long-term liabilities. As a result, the liability makeup affects their funding structures differently and reflects an institution's specific asset–liability management policies. In comparison with conventional banks, asset-backed transactions (depending on the character of the asset) can expose an IFI both as an investor with high credit risk and also as an owner when dealing with long-term assets such as property and/or infrastructure. In order to mitigate this long-term liability-related risk, an IFI should have a vast pool of assets with a maturity range at its disposal to close the asset–liability gap (Lowe, 2010; Lowe was interviewed for this research).

As a result, the Islamic banking industry is faced with a conundrum: its institutions maintain high concentrations in current/short-term liabilities, but, at the same time, they are exposed to highly profitable, but illiquid, long-term assets (e.g. property and infrastructure, and sukuk), and they have limited access to long-term funding solutions. The nature of the Islamic banking model and Shari'ah-compliant laws applicable to the available asset classes means that these banks are persistently faced with a swap between liquidity and profitability (Moody's, 2009c).

According to McKinsey & Company (2009), on the liquidity front, as depicted in Figure 3.5, Islamic banks have a more pronounced maturity mismatch than conventional banks. However, Islamic Banks source more funds from deposits.

Attempts to reduce liquidity risk for Islamic banks   The abovementioned factors made liquidity risk management far from an easy task for IFIs, which need to weather possible liquidity shortages in light of unforeseen events. For instance, during the financial crisis in Turkey during the period 2000–2001, IFIs faced severe liquidity problems and one, Ihlas Finance, collapsed (Standard & Poor's, 2010a). Market participants hope that the greater use of innovative asset classes will complement the currently variety-starved asset section on the balance sheet and help IFIs deal with liquidity concerns more efficiently. Several developments have taken place with a view to meeting this challenge.

In Saudi Arabia, the Saudi Arabian Monetary Agency (SAMA) has developed an ad hoc instrument called mutajara, which behaves like a repurchase agreement, known as ‘repo’ in the banking world. Contractually, it is a term deposit with SAMA or other financial institutions, but 75% of this deposit can be ‘repoed’ at SAMA at any point in time for liquidity purposes. This is notably the case for Al Rajhi Bank, which has an investment portfolio that can be repoed with SAMA (Moody's, 2009c).

In Bahrain, the CBB is also working on developing a Shari'ah-compliant repo scheme. In addition, the Liquidity Management Centre (LMC) was founded in 2002 in Bahrain to facilitate the investment of surplus funds of IFIs into financial instruments structured in accordance with Shari'ah principles. It also aims to assist the International Islamic Financial Markets (IIFM) in the creation of secondary market activity with designated market makers where such instruments can be actively traded. Early in 2009, the IIFM announced that it has plans to cooperate with the International Capital Market Association (ICMA) to develop a repo-type liquidity management tool in order to manage overnight liquidity more efficiently in the future (Mahlknecht, 2009).

Similarly, the Central Bank of Sudan has introduced Shari'ah-compatible securities to provide liquidity in the market (Greuning and Iqbal, 2008).

Malaysia had also taken steps to reduce liquidity risk among Islamic banks. The central bank, Bank Negara Malaysia, introduced the Islamic Interbank Money Market (IIMM) in early 1994. The activities of the IIMM include the purchase and sale of Islamic financial instruments among market participants, interbank investment activities through mudarabah interbank investment scheme, and a cheque clearing and settlement system. The Islamic financial instruments that are currently being traded in the market on the basis of bay' al-dayn (sale of debt) are bankers' acceptances, Islamic bills, Islamic mortgage bonds and Islamic private securities. In addition, IFIs can sell government investment issues to the central bank, as and when required, to meet their liquidity needs. In turn, IFIs can buy Shari'ah-compliant investment issues from the central bank (Greuning and Iqbal, 2008).

Whereas the contract of bay' al-dayn is commonly accepted and practised in the Malaysian financial markets, it is not accepted by the majority of Shari'ah scholars outside of Malaysia, who maintain that debt can be traded only at par. According to one of the interviewees for this research, Kailani (2010), if trade is not at par, they feel that the practice opens the door to riba.

Mahlknecht (2009) suggests creating a common pool to which all IFIs contribute a specific percentage of their deposits in exchange for the right to receive interest-free loans overnight or for up to three days. He adds that an exceptionally promising route would be to integrate the IDB into such structures in order to encourage cross-border participation by Islamic banks.

Finally, the introduction of sukuk is a good development that can provide the foundation for the development of secondary markets. A sukuk structured on murabahah, salam and istisn'a should be held to maturity, while sukuk structured on equity basis (musharakah and mudarabah) or ijarah sukuk can be traded on the secondary market (Dar Al Istithmar, 2006). Legislative steps, including the creation of Saudi sukuk and bond market under the Tadawul (the Saudi stock exchange), are improving the prospects of sukuk becoming an attractive liquid instrument. Recent similar reforms in South Korea and Indonesia should also support the longer-term viability of the primary sukuk market and the establishment of an active secondary market, which will benefit the longer-term prospects of sukuk as an investment instrument among issuers and investors alike. According to Standard & Poor's (2009), such developments are timely steps that should both diversify Islamic finance assets and address investor needs, as well as adding depth to the market and enhancing transparency and efficiency among market participants.

Sukuk offer a longer-term and more stable source of funding. In addition, governments and government-related institutions have made it clear on several occasions that their role on the sukuk market would not be limited to that of a benchmark-setter; issuing sovereign and public sector sukuk would also contribute to enhancing the overall liquidity of the market. However, sukuk still constitute a very small proportion of the balance sheet despite the recent rapid growth in this funding source. Still illiquid, dominated by local issuances and hardly traded globally, sukuk cannot be considered an effective fixed-income instrument for active management of balance sheets and liquidity. According to one of the interviewees for this research, Marx (2010), most repurchase agreements (repos) with bank counterparts or central banks are riba-based, so sukuk can hardly be used as repo collateral and very seldom serves as the basis for raising emergency liquidity in the event of need.

The gradual introduction of sukuk funds will help create a secondary market for sukuk, whereby investors, including banks, can price their sukuk fairly, enhancing both liquidity and secondary market tradability (Moody's, 2009d).

Market observers have pointed out that the lack of sukuk liquidity is still a primary weakness compared with conventional bonds. Another interviewee in this research, Masri (2010), argues that central banks and major international institutions do not accept any of the currently issued sukuk for repos: (i) because of the lack of secondary market for sukuk; (ii) because of the non-convertibility to other currencies; and (iii) because most sukuk issues are not rated by international rating agencies. The first sukuk that is expected to be internationally accepted for repos is the long-anticipated sukuk to be issued by the UK government. Masri believes that, until a sophisticated repos market is developed for Islamic finance, the liquidity problem will persist. “There are initiatives to develop a Shari'ah-compliant repo market but for the time being Islamic banks have only limited scope for getting hold of money in a quick way. The lack of Shari'ah-compliant assets and a tendency for Islamic investors to buy and hold their investments have stunted the secondary market”, as identified by Qaedi (2010), one of the interviewees for this research.

So far, IFIs have preferred an originate-and-hold business model due to the lack of a secondary market for loans and sukuk. However, in the longer term, IFIs with limited capital resources might be more inclined to adopt an originate-and-distribute business approach, provided disintermediation picks up, market depth and liquidity improves, and growth in Islamic assets continues unabated.

The effect of the credit crisis on the sukuk market and the emergence of defaults are thoroughly discussed in Chapter 5.

Furthermore, Marx (2010), who was interviewed for this research, explains that traditionally Islamic banks have circumvented the lack of an Islamic money market by entering into bilateral commodity trades with Western banks that produce a return very close to the equivalent money market instruments. Although this is a valuable source of liquidity, it is an inadequate and fragmented solution to a problem that is perceived to be one of the greatest hindrances to a fully integrated Islamic financial system. One of the aims of the LMC is to provide instruments that have greater Shari'ah credibility and are more competitively priced than the commodity murabahah transactions currently undertaken in the market.

Because of the lack of adequate Shari'ah-compliant money market instruments for liquidity management and the underdevelopment of Islamic money markets, the studies by IFSB in March 2008 provide suggestions for the development of the Islamic money market. Among the suggestions are to design a low-risk Islamic money market and Islamic government financing instruments and to incorporate Islamic government financing instruments as an integral part of the overall public debt and financing programme and foster its development (IFSB, 2008a).

Finally, October 2010 saw the signing and launch of the International Islamic Liquidity Management Corporation (IILM), the latest transnational body to serve the global Islamic finance industry. The ultimate aim of the IILM is to enhance international integration of the Islamic money market and capital markets and to better equip them to face any liquidity crises. This breakthrough will surely help take Islamic finance to a higher level of development. It was proposed by the IILM to include only AAA-rated Shari'ah-compliant sukuk issued by sovereigns, quasi-sovereigns and a selected number of major corporates. However, critics have suggested that the pool of AAA-rated papers is not sufficient. Governor Zeti, Bank Negara Malaysia, stated, “we inject or withdraw liquidity from the system. There are very strict criteria for the eligibility of assets, as it is not the shareholders themselves that would allocate assets. Central banks can nominate entities to donate assets, which can be monetised. They will issue Islamic commercial papers against these assets through special purpose vehicles. They will be the primary dealers and they will create the markets” (IFSB, 2011).

Asset–Liability Management

Asset–liability management (ALM) is closely correlated with liquidity risk management. It is simply the practice of managing risks that arise due to mismatches between the assets and liabilities of a bank. ALM is a management tool that involves the raising and use of funds in terms of strategic planning, implementation and control processes that affect the volume, mix, maturity, profit rate sensitivity, quality and liquidity of a bank's assets and liabilities. The primary goal of ALM is to produce a high-quality, stable, large and growing flow of net interest/profit rate income (Greuning and Iqbal, 2008). This goal is accomplished by achieving the optimum combination and level of assets, liabilities and financial risk.

Funding sources for IFIs   Table 3.2 shows that the limited range of possible funding sources for IFIs leads to concentrated liabilities, imbalanced funding mixes and stretched capital management strategies. IFIs' wholesale liabilities tend to be concentrated as they are generally well entrenched in retail banking, which gives them access to a large, and increasing, pool of relatively cheap deposits. When these are not in the form of Profit-Sharing Investment Accounts (PSIAs), Islamic banks benefit from the fact that a portion of Islamic deposits tend to be non-interest-bearing. This lowers their cost of funding compared with conventional banks, increases their margins and improves their profitability. In addition, Islamic depositors tend to display a strong sense of loyalty as they are less rate-sensitive. This results in a longer-term behavioural nature of deposits. However, as in most cases the contractual tenor of those deposits is short term: the banks remain exposed to maturity/liquidity risk. In other words, in times of crisis the bank may witness substantial withdrawals.

There are two types of PSIAs: restricted and unrestricted. For unrestricted PSIAs there is no identified asset allocation, while for restricted accounts the bank acts in a fiduciary capacity, with the investor choosing the nature of the investment to be made. In some cases these are accounted for as off balance sheet. For these accounts, banks maintain two types of reserves: a profit equalisation reserve to smooth returns and Investment Risk Reserves (IRRs) to absorb capital losses. While contractually investors are expected to absorb losses (the bank being liable only if there is negligence or fraud), the reality may be very different. Banks are under pressure to offer competitive returns and repay in full on the due date to ensure these assets continue to be funded. PSIAs in general have maturities of 12 months, and the assets financed tend to be fungible (Moody's, 2008a).

Apart from retail accounts, which are in most cases both granular and stable across business cycles, IFIs also resort to wholesale creditors for funding. So far, sukuk have not served as the main term funding source: only a handful of IFIs have issued medium-term sukuk so far, or are expected to do so in the near future, such as Sharjah Islamic Bank, Abu Dhabi Islamic Bank and Al Baraka Banking Group. For asset-backed sukuk, an Islamic bank needs to originate enough income-generating contracts, the underlying assets of which are owned by the bank (like in ijarah and/or musharakah), for the sukuk to be possible. However, the majority of sukuk issued so far, particularly in the Gulf region, have been asset-based rather than asset-backed, with ‘par value repurchase undertaking’ structures whereby the market value of the underlying assets bears little or no relation to the funding amounts raised, argues Qaedi (2010), one of the interviewees for this research. Also, as these are not true-sale structures, any non-liquid assets can be used. Therefore, IFIs typically raise short- to long-term funds from bank and non-bank customers, who tend to be price sensitive, relatively unstable (except those from the public sector) and concentrated, as depicted by Table 3.3. Deposit concentration is generally a significant risk factor for IFIs.

It should be noted that IFIs' funding bands remain imbalanced. Between deposits in their various forms (qard hasan, PSIAs, murabahah, etc.) and Tier 1 capital, IFIs have so far had access to a limited number of alternative funding sources with different features in terms of priority of claims and thus cost. Only very few subordinated sukuk have been issued so far. Malayan Banking Berhad in Malaysia, for example, issued a junior sukuk eligible as Tier 2 debt under Bank Negara Malaysia's regulation. According to Marx (2010), who was interviewed for this research, bank securitisation, other Tier 2 instruments, Tier 3 short-term debt to cover the regulatory capital charge of market risk, as well as plain vanilla and innovative hybrid capital notes, are non-existent in the Islamic financial industry. One of the reasons behind such a vacuum in the wide – but often grey – area between deposit and core capital of IFIs lies in the fact that a number of Shari'ah supervisory boards have been uncomfortable so far with the concept of differentiating between priorities of claims of various classes of stakeholders in the case of liquidation, adds another interviewee, Chowdhury (2010).

IFIs' capital management strategies therefore tend to be stretched. Allocation of economic capital to business units using risk-adjusted return-on-capital methodologies, for example, is barely applied, except in a handful of well-advanced institutions globally. However, even in the conventional universe, the allocation of economic capital to business units is still limited to a relatively small number of institutions that adopt more sophisticated risk management techniques. Therefore, it is not surprising that advanced approaches for economic capital computation have not so far been widely adopted by IFIs in emerging markets. Capital allocation tends to be inefficient at this stage, although this is not disadvantageous to a large extent as: (i) capitalisation ratios are high, and capital is not scarce in the geographies where IFIs are most active (typically in the Gulf region); (ii) asset yields are wide enough to serve record Return on Equity; and (iii) actual yields on equity far exceed shareholders' required rates of return (Moody's, 2008b).

In the longer run, and after the current financial tsunami, competitive pressure and massive losses will drive margins down. In addition, customers will become more educated about the concepts and principles underlying IBF and will tend to be less willing to accept lower returns on their deposits and switch more naturally to PSIAs, driving IFIs' funding costs up. Finally, capital has become scarcer given the recent losses and bailouts in the banking sector. All of these elements could easily change the nature of the IFIs' profitability equation, with lower net returns directed toward more demanding shareholders. A solution to the conundrum would be to let capitalisation ratios dwindle gradually to protect returns to shareholders while building assets more efficiently above targeted hurdle rates (Visser, 2009). Another option is to look for alternative financing vehicles like hybrid instruments, various classes of PSIAs and securitisation. Although debt obligations can be traded only at face value under Shari'ah law, this does not apply to the trading of assets, which opens the potential for the use of securitisation of assets such as leases (Visser, 2009). However, significant legal hurdles need to be overcome before securitisation can become a feasible source of funding for Islamic banks.

As a fact, capital is a very expensive way of funding. Islamic banks, particularly in the GCC, therefore engage in higher-risk/high-yield transactions to make up for the expensive funding via capital and consequently keep shareholders satisfied with high returns. Those IFIs forced themselves, unintentionally, up the risk curve instead of diversifying their risks. This makes the balance sheet of Islamic banks quite polarised, with high real estate assets. This led Islamic banks to a high concentration risk, on both sides of the balance sheet. A typical balance sheet structure of many Islamic banks displays high exposure to properties on the assets side; and limited funding sources with high reliance on short-term liabilities and capital on the other side. This is a very unfavourable funding continuum that has led Islamic banks to a vicious circle of risks: one risk creating the next.

ALM in Islamic banking: theory versus practice   In theory, IFIs should be less exposed to asset–liability mismatch than their conventional counterparts. This comparative advantage is rooted in the ‘pass through’ nature of Islamic banks, which act as agents for investors/depositors and pass all profits and losses through to them (Greuning and Iqbal, 2008). In addition, the risk-sharing feature of Islamic finance plays a critical role. Following the theoretical model, any negative shock to an Islamic bank is absorbed by both shareholders and investors/depositors. On the other hand, depositors in the conventional system have a fixed claim on the returns of the bank's assets, irrespective of the bank's profitability on its assets side. In other words, holders of PSIAs in the Islamic system should share in the bank's profits and losses alongside shareholders, and are exposed to the risk of losing all or part of their initial investment. This contractual agreement between the IFI and the PSIA holders should be based on a ‘pass through’ mechanism in which all profits and losses are passed to the investors. Thus, the problem of asset–liability mismatch should not exist. Some regulators have recognised this and require these assets (generally 50% risk-weighting) to be included in capital adequacy calculations and the reserves as Tier 2 capital (FRSGlobal, 2009). Greuning and Iqbal (2008) argue that this type of financial intermediation contributes to the stability of the financial system. Because of the nature of contracts both on the assets and liabilities sides on the balance sheet, IFIs are often less vulnerable to external shocks and less susceptible to insolvency. Chapter 5 covers in detail how the Islamic financial system could act as a panacea for economic woes if its fundamentals are genuinely applied.

The challenge to Islamic banks is to determine the rights and obligations of PSIA holders vis-à-vis shareholders, especially when various types of Shari'ah-compliant deposit accounts are offered, so as to ensure the required disclosures and transparency in the distribution of profits and the sharing of risks (IFSB, 2007).

Lowe (2010), one of the interviewees in this study, explains that from an analytical perspective, PSIAs should not be classified as equity-like liabilities, despite their (theoretical) loss-absorbing characteristics. PSIAs are rather considered as more debt-like liabilities. The rationale behind this treatment of PSIAs as liabilities with no capital benefits is that, from an economic and practical perspective, PSIAs:

1. Are not permanent capital, as they tend to be very short-dated (with maturities typically below one year);
2. Can be withdrawn before maturity, provided that the PSIA holder gives up their contractual return to be earned at maturity;
3. Have no voting rights; and
4. In practice, are very rarely allowed to absorb losses.

However, in practice the challenge is where there is a clear differentiation between PSIA holders and equity holders. Can IFIs avoid combining shareholders' and PSIA holders' funds, as the theory would suggest? The liabilities of Islamic banks may – in common with assets – have very different profiles and need careful management. The biggest issue remains the position of PSIA. Juristically, PSIA are a form of limited term equity rather than debt claims on the bank, and therefore losses relating to the assets they fund should not affect the bank's own capital. However, Islamic banks are not immune from runs or panic withdrawals, and PSIA holders typically have the right to withdraw their funds at short notice, forgoing their share of the profit for the most recent period and also their share of any losses that might have arisen, explains Kailani (2010), who was interviewed for this research.

Visser (2009) strongly opposes PSIAs by arguing that they involve a moral hazard problem, as they might give the bank an incentive for risk-taking and for operating with very little of their own funds. Depositors will have to take the brunt if investments go sour, just like equity investors in a conventional investment company, only they have no say in the appointment of management. They only thing depositors can do is to shift their funds to other banks, but they may not always have sufficient information to do so in time. He adds that this moral hazard problem was cited as one reason by the Rector of Al-Azhar University in Cairo in his 2002 fatwa for declaring interest-bearing banking deposits halal. Visser (2009) obviously misses the point that regulators and Shari'ah boards will not allow IFIs to misuse PSIAs, and that IFIs put the utmost importance on avoiding any jeopardy to their reputation.

Engel (2010), one of the interviewees for this research, adds that unrestricted PSIA funds will generally be combined with those of the bank's shareholders who may have quite different risk appetites, as PSIA holders are generally looking for a safe investment, similar to deposit account holders in conventional banks. In practice, the treatment of the fund-combining issue is handled differently. Shamil Bank of Bahrain has so far applied a strict distinction, for management account and return computation purposes, between assets financed by shareholders' funds and what the bank calls ‘unrestricted investment accounts’. Conversely, Kuwait Finance House – like most IFIs – does not explicitly segregate classes of liabilities and prefers a more flexible and convenient way of computing a total gross return on assets, and then applying both a musharakah and mudarabah fee to isolate returns to PSIA holders (Moody's, 2008a).

The practice is therefore different from the theory, and the means of determining shareholder's share is not always transparent. Notwithstanding such practical differences among IFIs in both combining funding sources and computing returns, ‘displaced commercial risk’ is always at stake, giving birth to various mechanisms of smoothing returns. Although displaced commercial risk is a unique risk to IFIs, it is discussed in this section because it forms an essential part of ALM for Islamic banks.

Displaced commercial risk   Displaced commercial risk is indeed a term reflecting the risk of liquidity suddenly drying up as a consequence of massive withdrawals should the IFI's assets yield returns for PSIA holders lower than expected, or worse, negative rates of profits. It is the transfer of the risk associated with deposits to equity holders. This arises when under commercial pressure banks forgo a part of profit to pay the depositors to prevent withdrawals due to a lower return (AAOIFI, 1999). Displaced commercial risk implies that the bank, although it may operate in full compliance with the Shari'ah requirements, may not be able to pay competitive rates of return as compared to its peer group Islamic banks and other competitors. Depositors will again have the incentive to seek withdrawal. To prevent withdrawal, the shareholders will need to apportion part of their own share in profits or even equity to the PSIA holders.

As demonstrated below, the practice of smoothing investment returns through profit equalisation reserves (PERs), IRRs and active management of mudarib fees is a very common feature of IFIs to avoid random, business and confidence-driven liquidity crises. As a matter of fact, a negative return on PSIAs would not constitute a breach of contractual obligations, as PSIAs are supposed to absorb losses other than those triggered by misconduct or negligence, and therefore this would not be considered a default. Nevertheless, default might be subsequently triggered by the very tight liquidity conditions the IFI would face in the case of massive runs on deposits. While this is in keeping with the risk-sharing principles encouraged by Islam, it remains to be seen how such account holders would react to losses on their accounts.

Some banking regulators have taken the view that this practice of smoothing returns results in a modification of the legal attributes of the PSIA such that Islamic banks have a ‘constructive obligation’ to continue smoothing returns. This means that the practice of smoothing becomes obligatory, and unrestricted PSIA holders effectively have the same rights as conventional depositors according to Chowdhury (2010; Chowdhury was interviewed for this research). Kailani (2010) explained, during the interview for this research, that a typical problem in Western countries with highly developed markets is the legal definition of a ‘bank’ as a ‘deposit-taking institution’ – deposits having the legal status of debt contracts and being ‘capital certain’ – whereas Islamic banks accept deposits as PSIAs, which cannot be capital certain as the Shari'ah does not permit this.

Unfortunately, insofar as both Islamic banks and their supervisory authorities in some countries consider unrestricted investment accounts to be a product designed to compete with, and to be an acceptable substitute for, conventional deposits, profit smoothing in such an environment may be considered an inherent attribute of the product rather than a means of deliberately avoiding transparency and market discipline, especially if it is combined with in-substance capital certainty (Archer and Karim, 2007). This undermines an important inherent characteristic of risk mitigation within Islamic banking, as discussed in Chapter 5.

Managing displaced commercial risk efficiently is a dynamic exercise   Thun (2010), one of the interviewees for this research, explains that traditionally there are a number of lines of defence against displaced commercial risk: IRRs and the bank's mudarib fee tend to absorb expected losses; PERs are used to cover unexpected losses of manageable magnitude; and, ultimately, shareholders' funds stand against unexpected losses with a higher net impact. Figure 3.6 shows how Islamic banks use these lines of defence to ensure stability.

IRRs are built from periodic provisions for expected statistical losses, which come as a deduction from the asset portfolio, in the same way that loan-loss reserves are deducted from conventional banks' loan books. IRRs are gradually built from the periodic provision charge equivalent to the expected losses attached to IFIs' investment portfolios, transiting through the IFI's income statement. Should actual losses be in line with IRRs, there is limited likelihood that displaced commercial risk would materialise into a bank run and thus into a liquidity crisis. Indeed, returns to PSIA holders would not be negatively affected. IRRs are generally deducted from income distributable to PSIA holders after the PERs are accounted for, and after the mudarib fee is captured by the IFI (Thun, 2010).

Reducing mudarib fees to protect returns to PSIA holders remains a management decision. PSIAs are the combination of a musharakah contract (whereby PSIA holders and shareholders bring funds to the banking venture) and a mudarabah contract (whereby the IFI's managers allocate PSIA holders' funds to various asset classes on their behalf). Therefore, the IFI is eligible, under the mudarabah contract, for a mudarib (management) fee, which typically constitutes 20–40% of asset yields net of PERs. In case asset yields deteriorate beyond levels absorbable by IRRs, the IFI's management team, in line with the board's formal approval, could reduce management fees ex post, which it can do contractually (although unilateral increases of mudarib fees are strictly forbidden). This is viewed as a gift of the bank to PSIA holders to earn their loyalty across the cycle (Chowdhury, 2010). Typically, mudarib fee reductions tend to apply when unexpected losses (beyond expected losses handled by IRRs) are manageable one-offs. When exceeding a certain threshold, losses would be covered by PERs (Thun, 2010).

PERs, a grey area in the capital continuum, collectively belong to PSIA holders for smoothing their returns. PERs are accounted for before any computation of the mudarib fee or IRRs. PERs are extracted from gross asset yields. Their purpose is to provide an excess return to PSIA holders in periods where assets have performed worse than expected, and therefore when yields on PSIAs might be lower for a given IFI than for its Islamic and conventional peers. PERs collectively belong to present and future PSIA holders, although past PSIA holders (who might not be current or future customers of the IFI) may have contributed to building them (Putz, 2010; one of the interviewees). This is in line with the principle according to which the various stakeholders of an IFI are subject to collective solidarity. PERs, being a future claim of PSIA holders on the bank, are not part of capital in accounting terms, and thus are not subject to distribution to shareholders (Greuning and Iqbal, 2008). From a regulatory perspective, however, the treatment suggested by the IFSB is very subtle, particularly in Western jurisdictions; just like the treatment of PSIAs for the computation of capital adequacy ratios of IFIs under Basel II, which is explained in detail in Chapter 4.

Smith (2010), Senior Analyst–Financial Institutions at Fitch Ratings and one of the interviewees for this research, explains that shareholders' funds constitute the ultimate line of defence against displaced commercial risk. Ultimately, should IRRs, mudarib fee cuts and PERs be insufficient to protect depositors from excessive volatility regarding PSIA returns, shareholders can lawfully use their own capital to compensate for possible losses or PSIA holders' opportunity costs. Shareholders' funds have in the past been used to compensate holders of investment accounts, such as in 1998 for Dubai Islamic Bank PJSC and in 1990 for Kuwait Finance House. In both cases, PSIA holders suffered no losses.

Mahlknecht (2009) argues that an extreme example of displaced commercial risk is the International Islamic Bank for Investment and Development in Egypt, which distributed all of its profits to IAHs and nothing to shareholders from the middle to late 1980s. In 1988 the bank distributed to its depositors an amount exceeding its profits, and the difference appeared in the bank's accounts a ‘loss carried forward’. The practice of forgoing part or all of the shareholder's profits may adversely affect the bank's own capital, which can lead to insolvency in extreme cases.

In short, although in theory there should be no mismatch between assets and liabilities of an Islamic bank, current practices have introduced distortions that expose banks to asset–liability mismatch risk, especially when they have no liquid assets with which they can hedge such risks. Greuning and Iqbal (2008) believe that IFIs should standardise how to deal with displaced commercial risk, and that the rights of PSIAs should be clearly stated and explained to all depositors. They suggest that the profits should be deducted only from long-term depositors, who are more likely to be exposed to such risk, and not from short-term depositors, who are not exposed to it.

Operational Risk

Historically, operational risk has been defined as all risks other than market, credit and liquidity risk. However, the BCBS (2006) has narrowed this definition within Basel II by stating that operational risk is “The risk of loss resulting from inadequate or failed internal processes, people or systems or from external events.” This definition includes legal risk, but excludes strategic and reputational risk.

Operational risk has been recently recognised and has been gaining prominence in risk-related research. It is now part of the integrated risk management framework of all financial institutions, which typically increases with the scope and size of activities of a bank but can be mitigated by a sophisticated risk management function and systems. The major components of operational risk are people, processes, technology and external events (usually catastrophic). People risk includes human error, lack of expertise and compliance, and fraud. Process risk includes risks related to different aspects of running a business, which may include regular business processes, risk related to new products and services, inadequate controls, etc. (Akkizidis and Khandelwal, 2007).

Lowe (2010) argues that operational risks are rather difficult to measure and manage because these risks become apparent only once a problem arises. He stated that risks associated with operational risk could include:

1. Internal fraud. For example, intentional misreporting of positions, employee theft, and insider trading on an employee's own account;
2. External fraud. For example, robbery, forgery, cheque kiting and damage from computer hacking;
3. Employment practices and workplace safety. For example, workers' compensation claims, violation of employee health and safety rules, organised labour activities, discrimination claims and general liability;
4. Clients, products and business practices. For example, fiduciary breaches, misuse of confidential customer information, improper trading activities on the bank's account, money laundering and sale of unauthorised products;
5. Damage to physical assets. For example, terrorism, vandalism, earthquakes, fires and floods;
6. Business disruption and system failures. For example, hardware and software failures, telecommunication problems and utility outages; and
7. Execution, delivery and process management. For example, data entry errors, collateral management failures, incomplete legal documentation, unapproved access given to client accounts, non-client counterparty misperformance and vendor disputes.

The wide range of activities included in operational risks make it difficult to apply a standard model to all organisations and hence there is a lack of universally accepted standard models. Banks often use internal audit ratings, quality self-assessments, operational risk indicators or Key Risk Indicators (KRIs) such as volume, turnover, rate of errors, income and loss volatilities, etc.

Operational risk in Islamic banks   IFSB Principles, as in Box 3.6, introduce the risk management strategy for operational risk management.

Operational risk is considered high on the list of risk exposures for Islamic banks. A survey by Khan and Ahmed (2001) shows that the managers of Islamic banks perceive operational risk as the most critical risk after mark-up risk. The survey found that operational risk is lower in the fixed-income contracts of murabahah and ijarah, and higher in the deferred sales contracts of salam and istisna'a. The relatively higher rankings of these instruments indicate that banks find them complex and difficult to implement.

An internal control problem cost Dubai Islamic Bank USD 50 million in 1998 when a bank official did not conform to the bank's credit terms. This resulted in a one-day run on the bank's deposits to the tune of USD 138 million, representing around 7% of the bank's total deposits at that time (Greuning and Iqbal, 2008).

It is argued that operational risks are likely to be significant for IFIs due to their specific contractual features. Moreover, Islamic products are less commoditised and require more tailoring and oversight, and this leads to substantial overheads and higher operational risk. One of the interviewees in this research, Lowe (2010), asserts that a number of small IFIs have allowed their businesses to grow rapidly without a proper organisational infrastructure in place. He listed some specific aspects of Islamic banking that could raise the operational risk of Islamic banks:

1. Cancellation risks in the nonbinding murabahah and istisna'a contracts;
2. Failure of the internal control system to detect and manage potential problems in the operational process and back-office;
3. Potential difficulties in enforcing Islamic contracts in a broader legal environment;
4. Need to maintain and manage commodity inventories often in illiquid markets;
5. The monitoring of PLS arrangements cannot easily be standardised; and
6. Potential costs and risk of monitoring equity-type contracts and the associated legal risk.

People risk and the scarcity of qualified human resources is the most striking weakness of the whole industry (Brown et al., 2007). In fact, scarcity of talent might impede, for a while, the growth dynamics of Islamic banks. There is a clear, identifiable and sometimes quantifiable shortage of skilled managers, officers and clerks in the Shari'ah-compliant financial universe. Not only is the industry growing fast, triggering pressure on existing staff to absorb increasing volumes, but a number of new entrants are also entering the arena: markets like Bahrain, Qatar, Saudi Arabia, the UAE, Malaysia and Singapore, among others, have witnessed the incorporation of a large number of new IFIs announcing authorised capital of unprecedented size. Newcomers must be staffed and newly trained employees are scarce because education, training and experience take time to build exploitable competences (Mahlknecht, 2009). The easiest and most effective way to quickly staff freshly instituted organisations is to acquire them from existing banks, creating visible pressure on the labour market in the entire industry. Risks including management discontinuity, excessive growth of personnel expenses, innovation disincentives and lack of experienced staff might all damage an IFI's capacity to build competitive advantages, and ultimately its market position, reputation and business model.

On a positive note, several professional qualifications in Islamic finance have been created in different regions over the last few years. This should ease the pressure on the industry in the medium term. It is necessary to create a pool of highly qualified professionals with in-depth knowledge of not only the Shari'ah and its objectives, but also Islamic and conventional finance and financial engineering. Directors and senior management of Islamic banks too should be required to attend such courses.

Technology risk is another type of operational risk that is specifically high for Islamic banks. It is associated with the use of software and telecommunications systems that are not tailored specifically to the needs of Islamic banks. Like any other business, Islamic banks require bespoke software; given the nature of business the computer software available in the market for conventional banks may not be appropriate for IFIs. Compliance with Shari'ah rules requires management information systems that are scarce and expensive to develop. The currently available systems are less robust than those in conventional banks; they are either bespoke systems or ones that have been modified to handle Islamic products. There are few systems that have been specifically designed for the use of Islamic banks and are in widespread use (Brown et al., 2007). Santhosh Bhat, one of the interviewees for this research but whose interview was not included in the final sample, stated that “the most critical features of any Islamic banking software is the automation of profit pooling, which is the calculation of weighting and distribution of profit to the depositors according to the Shari'ah-compliant distribution method”. The latest systems and technologies as used in conventional banks are often not used by Islamic banks.

Documentation risk is higher for Islamic banks than for conventional banks partly as a result of the lack of standardisation in the contracts and also because any deficiencies in the documentation could make the contract unenforceable (Moore, 2009).

In short, given the newness of Islamic banks and their unique business model, operational risk can be acute in these institutions. Therefore, the three methods of measuring operational risk proposed by the Basel II Accord have to be adapted considerably if they are to be applied to Islamic banks. This is explored in detail in Chapter 4.

Displaced Commercial Risk

As discussed in the section ‘Asset–Liability Management’, Displaced Commercial Risk is a risk unique to Islamic banks that stems from their ALM practices.

Shari'ah Non-Compliance Risk

Shari'ah non-compliance risk is related to the structure and functioning of Shari'ah boards at the institutional and systemic level. This risk could be of four types, which are strongly correlated and linked:

Lack of standardisation risk   The Shari'ah is subject to interpretation, particularly in the field of economic and financial transactions known as the fiqh al-muaamalat. Therefore, from one market to another, from one school of thought (madhab) to another, and even from one Shari'ah scholar to another, the fine line between what is considered lawful at any point in time and what is not considered lawful can be so thin that fatawa may differ substantially. This difference in the interpretation of Shari'ah rules results in differences in financial reporting, auditing and accounting treatment. For instance, while some Shari'ah scholars consider the terms of a murabahah or istisna'a contract to be binding on the buyer, others argue that the buyer has the option to decline even after placing an order and paying the commitment fee, explains Al-Ghamrawy (2010), Managing Director at Al Baraka Bank-Egypt and one of the interviewees for this research. Differing attitudes toward hedging techniques such as forwards, futures and options provide another example of a large divergence of opinion that does not benefit the industry (IFSB, 2007).

These differences can be partly attributed to the presence of the Shari'ah board, which governs and guides the banks regarding the conduct of Islamic banking. The Shari'ah board interprets various products and situations based on the Qur'an, Sunnah and fiqh (Islamic jurisprudence). There are four classical schools of Islamic thought, namely Hanafi, Maliki, Shafi'i and Hanbali, which have specific presences in different parts of the world, and hence the Shari'ah rulings differ based on the different schools. China and Turkey are more influenced by the Hanafi; in a large part of Africa Maliki is followed; Indonesia and Malaysia have large numbers of followers of the Shafi'i school; and Hanbali appears to be followed in Saudi Arabia (Akkizidis and Khandelwal, 2007). These four schools represent most of the commonly accepted rulings of Islamic jurisprudence. The interpretations of Shari'ah scholars can be based on one or more schools of though and hence can have impact on the conduct of the Islamic banking.

Multiple factors are considered before the Shari'ah board provides a ruling on a particular case. This multiplicity of methods of financing has been a prime reason for the lack of standardisation of products, processes and policies. It did not hamper the growth and development of Islamic banking, but has resulted in some confusion among the followers of Islamic banking. This has direct effect on risk management for Islamic banking. Also, due to the multiplicity of interpretations of situations, progress in developing specific legislation for Islamic banking has been slow. Malaysia, Pakistan and Bahrain have developed specific legislation dealing with Islamic banking, whereas most of the other countries offering Islamic banking are using conventional banking legislation with some modifications for Islamic banking along with Shari'ah rulings (Akkizidis and Khandelwal, 2007).

This variation is not only time-consuming and costly but it also leads to confusion about what Islamic banking really encompasses and therefore hinders its widespread acceptance. It also makes it difficult for regulators – especially in non-Muslim countries – to understand the idea of Islamic banking. Consequently, regulators tend to be restrictive in granting licences for Islamic banks. The same applies to investors and customers, who sometimes find themselves reluctant to invest in Islamic banks because of their confusion about the concept and its specific products.

The curious case of Investment Dar Company (‘TID’) v. Blom Development Bank may have some significant implications for the Islamic finance industry. Blom Development Bank of Lebanon had placed various ‘funds’ with TID of Kuwait, pursuant to a wakala arrangement. TID became distressed during the course of 2008/09 with the onset of the credit crunch and announced a restructuring. In May 2009, it defaulted on the profit/coupon of its USD 100 million sukuk issue, and since then there has been much confusion regarding the status and progress of the restructuring. TID then argued that the previously executed wakala arrangements with Blom Development Bank did not actually comply with Shari'ah principles; hence, all related agreements should therefore be considered ultra vires (or void). The court issued a summary judgment ordering payment of the capital amount but not the anticipated profit required, which necessitated consideration at a full trial. Chowdhury (2010) hence states that “It is widely felt that the application of Shari'ah compliance as a commercial and defensive legal tool undermines the credibility and ethical ethos that underpins Islamic finance.”

Shari'ah arbitrage risk   The competitive dynamics of IFIs, together with lack of standardisation, could enhance Shari'ah arbitrage, itself a component of Shari'ah-compliance risk. IFIs compete head on with conventional banks, but they also position themselves as contenders within the Islamic financial industry, sometimes internationally, if not globally. The different Shari'ah interpretations give rise to Shari'ah arbitrage, which is the risk of resort to the most liberal interpretation of financial Islam for business purposes (Visser, 2009). Therefore, Muslim investors and originators might be tempted by Shari'ah arbitrage. Shari'ah arbitrage might also lead an IFI to crowd itself out of the market because it may not be considered sufficiently Shari'ah-compliant by its constituency, the final decision-making body as to Shari'ah compliance, which is beyond the reach of any fatwa. This could be damaging from a macro-industrial perspective, should the whole Islamic financial industry be overly heterogeneous to the point where fragmentation becomes unavoidable and durable (Yaccubi, 2010).

Non-compliance risk   Chowdhury (2010) argues that the relationship between an Islamic bank and its customers is not only that of an agent and principal; it is also based on implicit trust that the bank will respect the desires of its customers to comply fully with Shari'ah. This relationship is what really distinguishes Islamic banks from their conventional counterparts and it is the sole justification of their existence. If the bank is unable to maintain this trust, by not being Shari'ah-compliant, it risks losing the confidence of its customers. This could severely damage the creditworthiness of an IFI. For instance, Muslim depositors might withdraw their funds from a bank, triggering a liquidity crisis. Retail customers that are mainly attracted by the Islamic nature of a bank might also stop requesting loans from this institution, triggering a downturn in profitability.

Wilson (2002) argues that what distinguishes IFIs from their conventional counterparts is not only the unique products they have on offer but also the commonality of their client base, who all have been attracted to IFIs because they provide products compatible with Shari'ah, which the clients themselves respect and believe in. The high level of trust between IFIs and their clients reduces the risks of moral hazard. Therefore, IFIs should ensure transparency in compliance Shari'ah and place this issue at the top of their priorities.

Shortfall of scholars   This is an industry-related rather than an organisation-specific risk. There are few Shari'ah experts in commercial law and finance law. Most scholars who go on to specialise as academics do so in fields such as theology or history, while those who specialise in practical subjects become experts on the laws of zakah, marriage and divorce, or inheritance (Selvam, 2008). The industry is no longer able to produce qualified scholars at the required rate, particularly due to the long and arduous process involved, which includes learning the finer points of modern capital markets. It could take up to anywhere between 10 and 15 years for a person to qualify as a Shari'ah scholar and sign off on a fatwa due to the extensive training and guidance required to become an established scholar, according to Chowdhury (2010). He also stated, “There are only a few scholars who combine knowledge of the Shari'ah with an understanding of the working of modern finance… I personally know several scholars who have written advanced academic dissertations on subjects dealing with the classical jurisprudence of commerce and transacting.” However, as Sheikh Yusuf Talal DeLorenzo (cited by Selvam, 2008) states “their knowledge is theoretical, these scholars are of no practical use to modern Islamic finance.”

Another obstacle is mastering the language of communication needed in the financial realm. Shari'ah scholars need to be conversant in both Arabic, the language of the Shari'ah, and English, the main language of modern finance. “Most scholars are not fluent in English and the Islamic finance industry in dominated in the English language at the moment,” adds Kailani (2010), another interviewee.

The strategy consultant firm Funds@Work (2009) carried out research on the landscape of Shari'ah scholars. The results, as depicted in Figure 3.7, show that among 271 organisations researched (including banks, mutual funds, insurance companies and private equity funds), there were 180 scholars with 956 positions; this remains an important challenge with various risk implications. If this shortage of Shari'ah scholars is not reversed, Islamic finance may not grow as quickly as it could.

It should also be noted that the shortage of skills applies not only at the scholarly level, but also in the wider industry as discussed earlier.

Reputational Risk

Historically, reputational risk used to be considered a subset of operational risk; however, convincing arguments have been put forth over time to distinguish reputational risk from operational risk and to highlight the sole significance of the former. According to Askari et al. (2009), a survey conducted by PricewaterhouseCooper (PwC) in early 2004, showed that of 1400 CEOs taking part in the study 35% identified reputational risk as either ‘one of the biggest threats’ (10%) or ‘a significant threat’ (25%) to their business growth prospects. Reputational risk is the most critical risk for IFIs, because the total loss caused by reputational damage can well extend beyond the bank's liquidation value and affect the whole industry for generations, regionally, internationally and even globally. Once a bank's reputations has been damaged or tainted, restoring market confidence is extremely challenging. Nevertheless, all Islamic banks in a given market are exposed to such risk. Close collaboration among financial institutions, standardisation of contracts and practices, self-examination, investing in customer awareness, and establishment of industry associations are some of the steps needed to mitigate reputational risk. “Reputational risk is certainly a major issue for a growing industry like Islamic banking and finance” said Richard Thomas (2009), Managing Director of Global Securities House.

Reputational risk for IFIs can occur at different levels. First, as a matter of image, loan foreclosure and security realisation, described as a relative strength of Islamic banks, are double-edged swords. Taking into account the expected take-off in mortgage lending especially in the GCC countries, the question of loan foreclosure and collateral seizing may be critical going forward. An IFI can hardly feel comfortable in the case of a Muslim family defaulting on the financial obligation pertaining to its primary residential property. In a number of jurisdictions, such a scenario would immediately trigger legal action leading the (conventional) bank to take full ownership of the collateralised property, at the expense of the borrower, who would be forced to relocate to an alternative, often smaller, home. According to Smith (2010), one of the interviewees for this research, in the context of the Muslim societies where IFIs are most active, it would be quite damaging for the IFI's ‘ethical’ reputation to leave a Muslim family homeless for the sake of profit, and then to sell the seized property post-foreclosure on the secondary market, since real estate Islamic finance presents itself as an ethical alternative to conventional banking. Therefore, should mortgage financing pick up in a number of Islamic jurisdictions, reputational risk management would call for a number of mitigating mechanisms like mutual takaful attached to housing loans.

Reputational risk can also arise from the fact that Islamic finance is a relatively young industry, and a single failed institution could trigger negative publicity for other banks in the industry, affecting their market share, profitability and liquidity. For example, Islamic Bank of Britain (IBB) has been suffering since its inception in 2004 from the negative publicity about Islamic banking among British customers caused by the collapse of the Bank of Credit and Commerce International (BCCI) in 1991 and the withdrawal of Al Baraka Bank from the UK market in 1993.¹ It took IBB's management tremendous effort to overcome the damage caused to trust in Islamic banking in the Western world.

More broadly, reputational risk might stem from the misconception that IFIs, through zakat and other charitable donations, might be close to violent militant groups. In order to avoid even the perception of such involvement, IFIs, particularly in the aftermath of 9/11, have materially invested in know-your-customers (KYC) and anti-money laundering (AML) systems in order to enhance their processes and procedures for the early detection and reporting of doubtful and fraudulent transactions, sometimes at a heavy cost. For example, in 2006 there was US state enforcement action against Doha Bank's Islamic banking arm in its New York branch relating to insufficient anti-money-laundering controls and systems. In April 2009, Doha Bank paid a fine of USD 5 million, which was imposed by two US government agencies: the Financial Crimes Enforcement Network and the Office of the Comptroller of the Currency. The post 9/11 environment necessitates the attention of IFIs to reputational risk due to the increased scrutiny and regulations to which they are subject.

Finally, if an Islamic bank is viewed as non-Shari'ah-compliant this could break the trust of its retail, corporate and even money market customers. This could trigger a liquidity crisis as devout Muslim depositors might withdraw their funds.

Askari et al. (2009) highlight that, although there has not been a major failure of an Islamic bank in more than 30 years, there have been instances of failures of financial institutions claiming to offer Islamic financial products, for example, Ihlas Finans of Turkey in early 2001, The Islamic Bank of South Africa in 1997, and Islamic investment companies in Egypt in the 1980s.

Accounting Standards

In a relatively immature and fragmented Islamic banking industry, there is a need to establish an adequate infrastructure, including the setting up of uniform accounting standards. Until recently, IFIs had developed their own standards in cooperation with their domestic regulators. However, this resulted in a lack of comparability between the financial statements of different institutions in different countries. The need is now widely recognised to provide users of financial statements with more meaningful, transparent and comparable information on the financial performance of the reporting entity.

AAOIFI has made some progress in developing a level playing field among Islamic banks, preparing a common set of accounting standards and developing consistent auditing standards and banking practices for those institutions, as well as starting to create a benchmark for Shari'ah compliance. Accounting standards issued to date reflect the adoption of conventional accounting practice, amended to reflect the nature of Islamic banking and incorporating compliance with Shari'ah doctrines (Mahlknecht, 2009).

AAOIFI and IFSB have played pioneering roles in designing key accounting, risk management, auditing and reporting standards for IFIs. They have complemented these with Shari'ah standards for contracts and governance, and have built awareness of major risk and prudential issues in Islamic finance. However, the pace of adoption of standards is slow. Also, considerable challenges remain to upgrade the standards and develop new ones in order to support the rapid innovations in the industry, and to align the accounting and auditing standards more closely with the evolving regulatory standards. AAOIFI and IFSB standards are still under refinement and are not mandatory; and hence are still not used by several IFIs.

Eglinton (2010), Director of Banking and Capital Markets at Ernest & Young and one of the interviewees for this research, adds that consistency is of great importance and significantly different treatments of the same item can and do occur; this makes it difficult and potential confusion arises relating to the treatment of investment accounts. Should these be on or off balance sheet? Are they with or without recourse? Differing treatment of investment accounts can have significant implications for capital adequacy calculations and liquidity requirements. Income recognition (cash or accrual) at inception, receipt or ultimate repayment and expense recognition (deducted from profit apportionment) are also important issues as different treatments can have a significant impact on reported profitability.

Despite AAOIFI's efforts, its standards are not mandatory because of the overriding need to comply with domestic regulatory requirements, with the exception of a handful of countries, such as Bahrain and Sudan, where banking supervisors require Islamic banks to comply with the AAOIFI standards.

Most countries use the International Financial Reporting Standards (IFRS) or US GAAP standards for their accounting, or some close local adaptation. These have limitations for good transparency of the operations of Islamic institutions and may lead to very poor disclosure of important aspects of their operations. However, many regulators believe that they need one set of accounting rules to be applied by all banks in their jurisdiction and so they are reluctant to depart from this practice.

AAOIFI has, however, continued working closely with regulators and the International Accounting Standards Committee in order to encourage adoption of its standards. An increasing number of institutions produce financial statements that conform to both IFRS and AAOIFI standards (Moore, 2009). Eglinton (2010) adds that “This may be the way to go, especially as AAOIFI has never wanted to reinvent the wheel but has stated that its standards should be used to give more appropriate presentation only when IFRS is not suitable.”

Fiduciary Risk

Fiduciary risk is derived directly from the PLS feature of Islamic finance, and is closely interlinked with corporate governance risk. AAOIFI defines fiduciary risk as “being legally liable for a breach of the investment contract either for non-compliance with Shari'ah rules or for mismanagement of investors' funds” (Moore, 2009). As fiduciary agents, IFIs are expected to act in the best interests of investors, depositors and shareholders. If and when these objectives diverge from the actions of the bank, the bank is exposed to fiduciary risk.

Fiduciary risk can lead to dire consequences. First, it can cause reputational risk, creating panic among depositors, who may rush to withdraw their funds. Second, it may require the IFI to pay a penalty or compensation, which may result in a financial loss. Third, it can have a negative impact on the market price of shareholders' equity. Fourth, it can affect the bank's cost of and access to liquidity. Finally, it may lead to insolvency if the IFI is unable to meet the demands of current IAHs (Greuning and Iqbal, 2008).

In this context, information disclosure facilitates market discipline and enables different stakeholders to protect their own interests by allowing depositors to withdraw their funds, shareholders to sell their shares, and regulators to take necessary actions in case of mismanagement or misconduct (Greuning and Iqbal, 2008).

In its Exposure Draft on Risk Management, the IFSB gave some examples of how fiduciary risks may arise; these do not appear in the final standard but give a useful indication of the sort of risks that can arise (Moore, 2009):

1. A critical aspect of IFIs' activities relates to the potentially large availability of funds available by current account holders, whereby, as a result of the inappropriate management decision, IFIs may increase disproportionately their investment portfolios' returns by excessively leveraging these funds without due regard to risks arising from sudden and unexpectedly high levels of withdrawals from current accounts.
2. Where IFIs manage and invest various funds in longer-term investment projects, investment funds received over a more prolonged period may be commingled inappropriately. For example, if funds provided by more longstanding investors are invested in a troubled project, there is a risk that the IFI could use other IAH funds received later on to invest in the same project in the hope that the project may be salvaged. Distortions may arise when the IFI reports an attractive return to longer standing fund providers when they are in fact being paid out of funds paid in by more recent investors.
3. The reinvestment of profits (rather than their distribution to investors) may give rise to unfair advantages to the IFI, which may thereby extend the period of a poorly performing investment. This may unfairly increase the exposure of incoming IAHs to losses, which may have already existed prior to their investment.
4. The risk of conflicts of interest exists where poorly performing assets and/or restructured assets of the IFI may be transferred by the IFI's management from on balance sheet to off balance sheet accounts where the restricted IAH would bear the risk of loss. Such misapplications of funds could result in the investment risk being removed from the IFI's balance sheet but, based on an agency contract, the IFI may earn fees inappropriately on the investment management and would not share in any eventual losses recorded after the transfer.
5. When purchasing assets at a very low price, IFIs may ‘park’ them in a subsidiary or related company and, when the opportunity arises, sell them to the IAH at a higher price.
6. Other internal and operational issues may not be directly related to IAHs' investments but may give rise to exposure to losses for IAHs. For example, the risks derived from such elements as an excessive allocation of expenses and the hiring of less experienced staff affect the quality of investment performance and oversight.

Moore (2009) argues that these indicate some of the ways in which a less than scrupulous management could manipulate returns to suit their purposes. There appear to be many ways management might conceal their errors, and lack of transparency means that their actions would be hard to discover.

Corporate Governance Risk

Corporate governance has a particular importance for Islamic banks because of the unique nature of their stakeholders. All banks, as a result of their role in national and local economies and financial systems, have a broader group of stakeholders than other institutions have. But in the case of IFIs, the group is even wider as PSIA holders and Shari'ah boards must be added (Moore, 2009).

Deposits in conventional banks are, by definition, capital protected. Depositors also often have the comfort of deposit insurance schemes and the comfort that banks can turn to the lender of last resort to fend off any temporary problems. Regulators and supervisors do not want to see depositors lose money as it could have dire consequences for the whole financial system. However, the same protection is not offered to PSIA holders, particularly unrestricted PSIAs. Here, not only do the account holders have no say in how their money is invested, it is often also commingled with the bank's own funds. It is easy to see that situations could arise where there is a conflict of interest between shareholders and PSIA holders, while management may have a third agenda. This might be in the area of risk appetite or in the share of profits that would be allocated to the different parties. While shareholders can make their wishes heard through the board of directors, PSIA holders have no such voice. Assets can be transferred between unrestricted PSIAs, shareholders' equity and other funds; and as disclosure requirements have stood, only management need to know what happened or why it happened (Moore, 2009).

The IFSB produced its standard on corporate governance in December 2006. One of its proposals is that each IFI should establish a governance committee of its board, one of whose responsibilities should be to ensure that the interests of its PSIA holders are looked after (IFSB, 2006). In addition, AAOIFI has set governance standards for Islamic institutions that cover the appointment, composition and responsibilities of the Shari'ah board, one of which is to protect the interests of depositors and PSIA holders (Kailani, 2010). As such, this board is a critical governance body within the bank.

It has been suggested by many that the governance process would be significantly enhanced by allowing PSIA holders some representation on the board of directors and by an improvement in the transparency of financial reporting. Another proposal that has been put into practice by the Al Baraka Group is to have a separate investors' committee (Moore, 2009). However, the practicality of both proposals is questionable.

Corporate governance practices can have a material impact on the bank's risk profile, particularly in countries where such practices are weak. Islamic banks do not generally have robust corporate governance frameworks in place. However, in this they are no different from some of their local conventional peers. For instance, family ownership/majority ownership by a core shareholder group is seen in both segments of an Islamic country's banking system. Their prevalence weakens the rights of minority shareholders, may lead to unmerited appointments or promotion of family members, and could give rise to conflicts of interest between different stakeholders. The lack of genuinely independent directors is a shortcoming of emerging markets in general and impairs a board's ability to maintain accountability and provide strategic guidance.

The exposure of big family businesses is among the most important risks for Islamic banks and the GCC business environment in general. Saudi Arabia is a clear example: Ahmad Hamad Algosaibi & Brothers owes money to more than 100 banks. This family-owned company owned a Bahraini bank, the International Banking Corporation (TIBC), which defaulted on USD 2.2 billion of debt in early May 2009. In addition, Algosaibi had defaulted on some USD 1 billion of foreign exchange, trade finance and swap agreements, and was seeking restructuring of all its group obligations, which are reported to include about USD 2.5 billion owed to Saudi banks and hundreds of millions of dollars owed elsewhere. Closely connected with family ties, the Saad Group and its subsidiary Awal Bank, owned by Maan Al Sanea, were also restructuring debt: the Group owes banks at least USD 5.5 billion. The ripples from the Saad and Algosaibi defaults also extend into international waters, weakly in concrete financial terms but perhaps more lastingly in terms of sentiment. Both groups borrowed from foreign banks: Algosaibi took out a USD 700 million syndicated loan in May 2007 arranged by BNP Paribas and WestLB, while a USD 150 million borrowing in 2006 by Awal was arranged by Arab Bank, Gulf International Bank and Hypovereinsbank. The Financial Times reported on 11 June 2009 that several of the international banks with a relationship with Saad and Mr Al Sanea had closed down credit lines. It is hard to find an Islamic bank in the GCC or Europe without significant exposure to these entities. According to Damak (2010), who was interviewed for this research, gross loan exposure within the GCC to the Saad and Algosaibi Groups amounts to USD 9.6 billion for 30 banks in the six GCC countries. Such developments and incidents have resulted in questioning of the nature of corporate governance, if any, in the Middle East, as the two conglomerates were controlled by family members. This Saudi banking scandal is, on one level, a family affair.

The GCC Board Directors Institute, a Dubai-based non-profit that seeks to improve corporate governance standards, issued a report in 2009 highlighting the need for corporate governance reform in the six GCC member states – Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE. The report Building Better Boards notes that only 55% of GCC companies disclose the main executive positions of board members, compared with 100% in Europe, and only 32% of companies disclose other positions held by board members, compared with 97% in Europe. It urges a reduction in the number of boards on which directors serve; the appointment of strong audit, nomination and remuneration committees; efforts to attract more international directors to the boards of Gulf companies; and the promotion of greater corporate transparency (Townsend, 2009).

Thus, corporate governance risk in the GCC, where most Islamic banks reside, has become publicly exposed. Poor corporate governance imposes heavy costs. The need for additional efforts toward improved corporate transparency is paramount. As long as Gulf companies and banks restricted their activities largely within the region, there was little pressure to change those opaque practices. However, growing links with international markets and financial institutions are generating greater demands for reform. Changing corporate practices, however, will not be easy. Governance reform needs to be addressed against the cultural backdrop in the Gulf, which places great emphasis on reputation and discretion. Nevertheless, in recent years Bahrain, Dubai and Qatar have created financial centres that promote high standards of regulation and corporate disclosure, including the requirement to publish regular results under IFRS.

Regulatory and Tax Issues

As the nature of their operations is different, IFIs face different problems in respect of legal, regulatory and taxation rules. In order to foster stability in Islamic banking, there is a need to develop uniform regulatory and transparency standards that are tailored to the specific characteristics of Islamic financial products and institutions. This task, while taking into consideration the financial environment in each country, also needs adaptation of the international standards, core principles and good practices to the specific needs of IFIs. For example, IFIs have to purchase assets for onward sale or lease to their clients. As such, the levy of taxation and fees on their purchases leads to an uneven playing field for them compared with their conventional counterparts. To avoid such costs, IFIs in some jurisdictions resort to practices creating doubts with respect to Shari'ah compliance (Ayub, 2007).

Some regulations need to be amended before an Islamic bank can operate within a particular economy; an example is stamp duties in mortgaging transactions in Western markets. Since the Islamic bank purchases a product on behalf of a client and then resells it, double stamp duties should not be charged in such circumstances. Regulators in countries where both systems operate side by side should recognise the need to set up flexible regulatory and tax frameworks that could facilitate banking operations in line with the Shari'ah principles. Flexibilities granted by the Financial Services Authority (FSA) in Britain to accommodate the specific needs of Islamic banking are a welcome move; it is hoped that the process of adaptation of laws will continue in order to make London an international hub for the Islamic finance industry in coming years.

Legal Risk

Given the different nature of financial contracts, Islamic banks face risks related to their documentation and enforcement. As there are no standard forms of contracts for various financial instruments, Islamic banks prepare documentation according to their understanding of the Shari'ah, the local laws and their needs and concerns. Lack of standardised contracts along with the fact that there are no litigation systems to resolve problems associated with enforceability of contracts by the counterparty increases the legal risks associated with the Islamic contractual agreements (Khan and Ahmed, 2001).

There are special concerns for Islamic banks over the enforceability of contracts. Conventional banks use well-established products for which standard documentation has been developed over the years that is accepted globally. This gives comfort, despite any limitations that may exist in the legal systems of the countries where the banks operate. This is not the case for Islamic products as yet. If problems arise and cases go to court, there is considerable uncertainty as to the court's decision (Moore, 2009).

Furthermore, the legal environment in some Islamic countries tends to be ambiguous and has never been tested, which constrains the ability to enforce a contract, recover bad debts or realise collateral. For example, Chowdhury (2010) states that “in the GCC, the rule of precedent does not apply to court cases, and insolvency rules have not been tested before”. Dey and Holder (2008) explain that courts in the UAE and Saudi Arabia will generally not honour any provisions of a foreign legal system which are contrary to Shari'ah, public order, morals or any mandatory provisions of the local law.

A number of recent court decisions have proven that when it comes to resolving disputes arising from Islamic finance contracts, Shari'ah rules and principles do not necessarily apply. This is simply because, most often, the issues in dispute are not Shari'ah in nature, but rather specific to the civil and commercial rights and obligations as contracted by the parties. The precedent here is the case of Shamil Bank of Bahrain v. Beximco Pharmaceuticals Ltd in 2004, when the Court of Appeal ruled that it was not possible for the case to be considered based on principles of Shari'ah law (HMCS, 2009). There were two main reasons. First, there is no provision for the choice or application of a non-national system of law, such as Shari'ah. Second, because the application of Shari'ah principles was a matter of debate, even in a Muslim country.

To mitigate this risk, contracts have to be written very carefully to minimise potential disputes and state the governing law. At present, most Islamic finance contracts are governed by English law, and a few under New York law. There are also advantages in standardisation of documentation. However, local courts may not enforce an English legal judgment without re-examining the merits of the claim and may not recognise English law as the law of the contract, or only to the extent that it is not incompatible with local law and public policy. This would mean that the local courts could seek to reinterpret documents governed by English law as if they were governed by local law. They could therefore give effect to the documents in a manner not intended by the parties (Miller, 2008). For instance, around 110 banks from all over the world are currently struggling in courts trying to retrieve their money from the defaulting Ahmed Hamad Algosaibi & Brothers Group and the Golden Belt sukuk issued by Saad Group in Saudi Arabia. The ongoing litigation has proved that the ability to enforce English judgments in Saudi Arabia is almost non-existent, and that liquidation rules in the GCC are lagging behind.

Short Track Record

Modern Islamic banking has been in existence for only three decades and many products are less than a decade old. This is in addition to the fact that most Islamic banks are active in the developing world where transparency, corporate governance and risk management at large are still work in progress, or non-existent.

Credit Derivatives

In recent years derivatives have been increasingly taking an important role not only as instruments to mitigate risks but also as sources of income generation. They are one of the newest tools for managing credit risks. A derivative is an instrument whose value depends on the value of something else. In these instruments the underlying risk of a credit is separated from the credit itself and sold to possible investors whose individual risk profile may be such that the default risk attracts their investment decision (Ahmed and Khan, 2007). This can be done by packaging, securitisation and marketing credit risk exposures with a variety of credit risk features. Derivatives come in many guises, for example, futures, options and swap contracts (Davis, 2009b).

Futures are forward contracts of standardised amounts that are traded in organised markets. Like futures, options are financial contracts of standardised amounts that give buyers/sellers the right to buy/sell without any obligation to do so. A swap involves agreement between two or more parties to exchange a set of cash flows in the future according to predetermined specifications (Stremme, 2005).

Shari'ah and Islamic Derivatives

Discussion on Islamic derivative products is rare, and even what is available in the literature is not very favourable. In general, it is argued by many Shari'ah scholars that conventional derivatives are not compliant with the precepts of Shari'ah for various reasons.

First, they entail gharar (uncertainty in a contract or sale in which the goods may or may not be available or exist) and maysir (the forbidden act of gambling or playing games of chance with the intention of making an easy or unearned profit) and are therefore viewed in a similar way to gambling. For example, the argument is often put forward that the huge trading volume of derivative markets is indicative of extensive speculation, that the market attracts and accentuates speculative behaviour.

A second issue that causes uneasiness among fiqh scholars is the fact that a large portion of those trading in derivative markets have no intention of either making or taking delivery of the underlying asset; they are based on a system of margin calls without real movement of goods. Third, standard options, swaps and futures contracts stem from debt and are connected to the sale and purchase of debts and liabilities (Yaccubi, 2010). Shari'ah permits taking on risk only proportionate to the real value of the asset and not beyond the value of the real asset (Usmani, 2009). As a result, the scope for risk-transfer techniques in Islamic finance is limited at the present.

Derivatives also introduce a serious moral hazard to the financial matrix due to the nature of their structures. In some situations, a bank could benefit from the customer's default, as the bank makes profit from the Credit Default Swaps (CDS) it bought on this customer. In a creditor's meeting to help the customer, for example, this particular bank will have a hidden agenda of trying to make the customer default. This goes against the core principles of Islamic finance that promote the wellbeing of society.

While the OIC Fiqh Council has endorsed arbun under the condition that a time limit is specified for the option, the concept of arbun is merely acceptable to the extent of part payment after finalisation of the deal. Its legality as a separate sale (i.e. bai'al-arbun), detached from real transactions, is in general not approved by the Shari'ah scholars. Of the main schools of Islamic fiqh, only the Hanbali considers bai' al-arbun to be a valid legal contract (Ayub, 2007).

Kamali (2005) argues that commodity derivatives should be viewed under the broad scope of public interest or maslahah. In addition, Chapra (2007) debates that hedging has become an important instrument for the management of risks in the present international economic and financial environment where there is a great deal of instability in exchange rates as well as other market prices. He makes a suggestion to the fiqh jurists to review their position on currency hedging contracts. To explain his view, he assumes that a Saudi businessman places an order for Japanese goods worth a million dollars (Rls 3.75 million) to be delivered three months from now. If the exchange rate is 117 Yen per dollar, and if the exchange rate remains stable, Yen 117 million will become due at the time of delivery of goods. Since exchange rates are not stable, and consequently if the Yen appreciates over these three months by say 5%, the Saudi importer will have to pay Rls 3.94 million for the goods instead of Rls 3.75 million. The Saudi businessman will therefore incur an unforeseen loss of Rls 190,000.

Although recognising that the verdict so far is that hedging is not permissible, Chapra (2007) argues that this opinion is based on three objections: hedging involves gharar, interest payment and receipt, and forward sale of currencies. All three of these are prohibited by the Shari'ah. However, as far as gharar is concerned, the objection is not valid because hedging in fact helps eliminate gharar by enabling the importer to buy the needed foreign exchange at the current exchange rate. The bank, which sells forward Yen, also does not get involved in gharar because it purchases the Yen spot and invests them until the time of delivery. The bank therefore earns a return on the Yen that it invests for three months but also loses the return it would have earned on the Riyals or the dollars that were used to purchase the Yen. The differential in the two rates of return determines the premium or the discount on the forward contract. The second objection with regard to interest can be handled by requiring the Islamic banks to invest the Yen or other foreign currencies purchased in a manner permitted by Islam. There would not have been any interest, but rather profit earned on the investments. The third objection is, of course, very serious. Chapra (2007) argues that although Islam prohibits forward transactions in currencies, we live in a world where instability in the foreign exchange markets has become an unavoidable reality. It is very risky for businessmen as well as Islamic banks to carry unhedged foreign exchange positions on their balance sheets, particularly in crisis situations when exchange rates are very volatile. “If they do not resort to hedging, they actually get involved in gharar more intensively. In addition, one of the important objectives of the Shari'ah, which is the protection of wealth, is compromised unnecessarily” (Chapra, 2007).

Engel (2010) explains that derivatives will come for Islamic banks; it is just a matter of time. Today the closest structure is sukuk, with lease agreements and the transfer of ownership rights, but still a lot of work is needed. The Malaysian market is more liberal than the GCC market and the Islamic financiers in Malaysia are working hard on developing Islamic derivatives that would have a wide acceptance among Shari'ah scholars. Lowe (2010) adds that “if the scholars rule all derivatives haram, this would make hedging very difficult for Islamic banks”.

It is said that a wise man learns from others' mistakes; Islamic banking should learn from the painful experience of conventional banking in the over-use of derivatives. Derivatives should be used for hedging to reduce risks rather than for profit-generating purposes. The use should also be carefully controlled and audited by the individual banks and regulators. Judging derivatives should be made within context.

Islamic Hedging Tools

Islamic banking needs to move quickly toward viable hedging alternatives if it is to sustain the growth that it has enjoyed so far. However, Islamic banks are not using any equivalent of credit derivatives, as sale of debt is prohibited, almost by all scholars, except in Malaysia. With the dramatic improvement in financial innovation in Islamic finance, some endeavours have been successful in providing that a number of contracts exist in Islamic banking that could be considered a basis for derivative instruments within an Islamic framework. These are bai'salam, arbun, khiyar al-shart, wa'ad and dual murabahah.

Bai' salam   Bai' salam is similar to the conventional forward contract. However, the major difference is that in a bai' salam contract the buyer pays the entire amount in full at the time the contract is initiated. The contract also stipulates that this payment must be in the form of cash. The buyer in a contract therefore is an Islamic bank. Because there is full prepayment, this potential contract is beneficial to the seller. As such, the predetermined price is normally lower than the potential price. The price behaviour is certainly different from that of conventional forward contracts, where the forward price is typically higher than the spot price by the amount of the carrying cost. Credit or counterparty risks of forward and bai' salam contracts are therefore different. In a bai' salam contract, the risk would be one-sided because the buyer has fully paid, and therefore only the buyer faces the seller's default risk as opposed to both parties facing risk, as in a forward contract. In order to overcome the potential for default on the part of the seller, the Shari'ah allows the buyer to require security, which may be in the form of a guarantee or pledge (Noraini et al., 2009).

Visser (2009) adds that, instead of using forward contacts for swaps, as they have been traditionally utilised, one could also hedge price risks with the help of futures. Since the buyer of a future really wants to take delivery of a good and thus there is no speculation, futures contracts should be met with less disapproval. It should be noted that the Maliki school allows futures contracts to be traded, like they have always done for bai' salam contracts, but the Hanafi, Shafii and Hanbali schools do not.

Ahmed and Khan (2007) assert that by virtue of a number of fiqh resolutions, conventions and new research, the scope for commodity futures in Islamic finance is widening; the potential of futures contracts is tremendous in risk management and control. Kamali (2005) argues that if new technology can eliminate gharar in the contract, then it may be reconsidered by Shari'ah scholars. Futures contracts should not be branded as maysir as they serve an economic purpose – to reduce price risk. The implementation of a contemporary futures contract removes gharar, which is the basis on which these contracts are forbidden, and in the future they may prove to be instrumental in managing risks in Islamic banking, particularly commodity risks. He adds that Shari'ah scholars' requirement for the possession of assets prior to sale is in principle in order to avoid gharar, but this argument against futures does not hold water as delivery is guaranteed by the futures clearing house. Kamali concludes that futures contracts are Islamically permissible provided that they steer clear of haram commodities and of interest elements.

It should be mentioned that there are a few Muslim countries with futures markets: Indonesia (coffee and crude palm oil), Kazakhstan (wheat), Malaysia (crude palm oil, stick index and government debt), and Turkey (currency). In addition, there is some over-the-counter trading based on bai'salam in a number of Islamic countries, including Iran (Visser, 2009).

Arbun   Arbun is a contract whereby a buyer of goods makes an immediate down-payment of part of the price against future delivery. The buyer has the option to pay the balance, being the purchase price less the down-payment, at any time until a specified final purchase date. However, should the buyer choose not to buy the goods by the final purchase date, the down-payment will be forfeited. It is very similar to the call option in conventional finance. The main difference is that a call option is purchased by paying a premium which is not offset against the purchase price should the option be exercised, whereas the down-payment on an arbun purchase is part payment for the good or asset if the sale is effectuated (Visser, 2009). Islamic funds have successfully utilised arbun to minimise portfolio risks in what are now popularly known in the Islamic financial markets as the Principal Protected Funds (PPFs) (Ahmed and Khan, 2007). Further development should move toward credit risk mitigation by way of Islamic credit default swaps and the development of options under the arbun structure.

It should be noted that the Hanbali school is the most liberal in allowing arbun; other schools, in particular the Hanafi school, tend to be opposed to it (Yaccubi, 2010). They argue that the retention of a down-payment by the seller is akin to misappropriation of the property of others and hence is not permissible (Visser, 2009).

Khiyar al-shart   Khiyar al-Shart (option of condition) is a contract in which one or both parties to a contract (or even a third party) holds an option (embedded within the contract) to confirm or rescind the contract within a specified time contingent on the fulfilment of a stipulated condition. The contract has embedded options that could be triggered if the underlying asset's price exceeds certain bounds. The features of this contract in relation to its exercise are similar to a conventional put option. What differentiates the khiyar al-shart option from conventional options is that there can be no separate fee paid at the start of the contract in respect of granting the option right. Therefore, it is the delivery price of the underlying asset which includes an element that recognises the economic value awarded to the option holder in the contract. Ahmed and Khan (2007) argue that there are no fiqh objections to using non-detachable embedded options and that in Sudan such a contractual agreement has become a regular feature of the salam contract.

Wa'ad   Bai' salam, arbun and khiyar al-shart all involve bilateral binding contracts, whereas the rules are less stringent with a wa'ad contract. It is a promise whereby the party looking to hedge provides a unilateral binding undertaking to buy currency from a third party at a given price in the future. The third party is not under any obligation to act on the transaction when the offer to purchase is submitted, resulting in significant counterparty risk (Wyman, 2009).

Dual murabahah   In conventional terms a Dual Currency Deposit is a fixed deposit with variable terms for the currency of payment. Deposits are made in one currency, but repayment at maturity occurs either in the currency of the initial deposit or in another agreed-upon currency, depending on the occurrence of a trigger event. The ‘optionality’ is typically created by buying an option from the client. Rather than return the option premium to the client as a flat payment, it is embedded in the deposit and returned to the client as an enhancement to the deposit yield. This deposit creates foreign exchange rate risk for the investor and is therefore only suitable for clients with a specific view or risk appetite.

To replicate the above payoff and risk profile in an Islamic environment, Islamic banks combine commodity murabahah and wa'ad technology, enabling the bank to pay the customer an increased profit on the murabahah and settle the principal amount of the deferred price in a pre-specified different currency. Figure 3.8 provides a detailed explanation of how the dual currency murabahah can be used as a risk mitigation tool.

Further Risk Mitigation Provisions Inherent in Islamic Banking

IFIs have to absorb the risks that they cannot transfer or mitigate. This is done through the use of collateral, guarantees, loss reserves and provisions, allocation of capital through the Risk-Adjusted Return-On-Capital (RAROC) exercise, risk weightings, etc. Sundararajan and Errico (2002) argue that in addition to the traditional risk mitigants, the management of the risk-return mix, particularly of unrestricted PSIAs, could be used as a key tool of risk management. Appropriate policies toward PERs (and possibly IRRs), coupled with appropriate pricing of investment accounts to match the underlying risks, would improve the extent of overall risk-sharing by these accounts.

Also, under a PLS system the Islamic bank is subject to higher screening and monitoring, making the danger of insolvency lower, provided that PLS principles are rigorously applied. Managing the risk-sharing of IAHs through proper pricing, reserving and disclosure policies would greatly enhance risk management in Islamic banks.

Chapra (2007) argues that PLS might go a long way toward preventing financial crises, as it would substantially reduce the moral hazard problems associated with prudential supervision of banking, in particular the incentive given by deposit guarantees for high-risk lending and investment. In addition, it is argued that under PLS there would be more discipline in the system. Depositors would be more interested in the soundness of the banks and in the quality of the banks' assets, in order to prevent having to accept negative returns. Banks would also have a better incentive to be careful in selecting borrowers and projects.

The PLS feature of Islamic banking therefore provides an inherent risk management tool that could be of great help to banks and the whole system if properly implemented. Under capital allocation, the IFSB supervisory discretion formula is a step in the right direction as it acknowledges the risks assumed by PSIA holders and incentivise banks – through lower capital requirements – to adopt more PLS financing modes, as explained in Chapter 4.

In practice, however, the losses of Islamic banks are not shared with PSIA holders, and often a minimum yield on deposits is ‘implicitly’ guaranteed. As a result the potential benefits of PLS finance cannot be realised. According to Sundararajan (2007), available empirical evidence shows that in practice, because Islamic banks try to provide Shari'ah-compliant alternatives to conventional products, there is considerable smoothing of the profits paid out to the unrestricted IAHs, and correspondingly reduced sharing of risk between the bank and the holders of such investment accounts, with banks bearing the majority of the risk. The extent of this de facto departure from the risk-sharing principle for unrestricted IAHs varies between countries; in some countries banks are expected – though not legally bound – to bear virtually all of the asset risk, while in others it is simply a matter of competitive pressure. Under current practices, reserves are passively adjusted to provide a stable return to unrestricted IAHs, effectively not allowing any risk mitigation through investment account management. For example, many banks with sharply divergent risk profiles and returns on assets seem to be offering almost identical returns on unrestricted IAHs, and these are broadly in line with the general rate of return on deposits in conventional banks.

Moreover, most Islamic banks realise the risk management gaps in their current business models especially in the areas of liquidity and hedging. Therefore, Islamic banks traditionally have been holding a comparatively larger proportion of their assets in reserve accounts, resulting in higher buffers than conventional banks.

Finally, some constraints attached to the status of IFIs, as sellers and buyers of tangible goods – as opposed to conventional banks intermediating between cash inflows and outflows with different maturities – also have risk-mitigating benefits. One rule of the key principles of modern Islamic finance states that any financial transaction should be backed by a tangible, identifiable underlying asset. This is a powerful way for the IFI to secure, at least in principle, strong access to the collateral backing the transaction. In short, IFIs naturally have a high level of collateralisation on their credit portfolios, and thus are in a position to somewhat reduce their economic, if not regulatory, exposures at default. In addition, IFIs have in principle greater visibility in terms of the economic allocation of the funds they supply to borrowers. Indeed, contrary to a conventional financial institution where a customer is not obliged to disclose the purpose of its loan, the IFI finances the acquisition of an identifiable asset legal ownership of which belongs, in most cases, to the bank until full repayment is made.