CHAPTER 1
Introduction: Research Background and Motivation

Risk knows no religion

—Michael Ainley, Head of Wholesale Banking, FSA (2007)

Was Michael Ainley right when he assumed that risk management is similar across different cultures and religions, in this case Islamic and conventional banks? Are Islamic banks just like any other bank that provides financial services, and hence have similar risk management requirements?

The subject of risk management in Islamic banking has many facets. On the surface, the frequently repeated story that Islamic banks are more resilient than conventional ones is attractive in a world torn by a financial tsunami. Unfortunately, at least in the current form in which Islamic banking is practised, this is not entirely true. The assumption at one point early in the crisis was that the Islamic market would be entirely unaffected and would sail through the crunch; and people thought that the financial crisis would be the lift-off platform for Islamic banks. On the contrary, the crisis exposed a number of areas in Islamic banking that needed to be dealt with.

This study examines different aspects of risk management issues in Islamic banking. At the heart of this book is the question of whether Islamic banks are more or less risky than their conventional peers. A review of the existing literature does not provide a clear-cut answer to this question. The majority of the relevant literature gives conflicting views using theoretical arguments rather than a formal empirical analysis. The question is clearly an empirical one, the answer to which requires feedback from the market place. The study thus attempts to fill this gap in the empirical literature on risk management in Islamic banking through a survey-based questionnaire and in-depth interviews.

The difficulties afflicting conventional financial markets since mid-2007 have led to more attention being paid to Islamic alternatives. While the modern Islamic finance industry is still young, it has been growing rapidly for several years, largely on the back of an oil-fuelled economic boom in the Middle East. Much demand came from non-Islamic investors who were simply attracted by good investment opportunities. With awareness of the industry rising, Islamic banks have expanded their operations, especially in the core markets of the Middle East and South Asia, but also in newer markets with substantial Muslim populations, including Sub-Saharan Africa and parts of Europe.

At the same time, risk management is receiving increased attention everywhere due to the financial crisis, and risk management products and methods for Islamic banking and finance (IBF) are certainly a hot issue. The market turmoil of the past few years has triggered a wide-ranging reassessment of the global financial system and a need to understand the causes that led to a financial crisis of a severity not seen since the Great Depression. One of the main areas of attention has been the failure of many financial institutions to manage their risks adequately. In most cases, the industry debate has focused on pure risk management failures, particularly the shortcomings of risk models in measuring risks accurately, without addressing the broader issue of how risk is managed at the highest macroeconomic levels and how the whole financial system is based on greed and lack of morality. Since then the credit crunch has afforded advocates of Islamic finance an opportunity to emphasise Shari'ah principles relating to debt and risk, finding a receptive audience beyond the Muslim world. For Islamic financiers, highly complex structured products such as subprime and toxic assets were seen as unacceptable because they were so far removed from their underlying assets.

There appears to be great potential for further growth in Islamic banking, which is still at a relatively early stage. However, there are also a number of challenges associated with developing a new industry with a different approach to risk management. It is notable that although Islamic banks were unscathed by the subprime crisis, many have since suffered from the negative effects of the broader recession, including a collapse in property prices in Dubai, where many Gulf Islamic banks had substantial exposure. The first sukuk defaults occurred in 2009 from two Gulf-based corporate institutions: Kuwait's Investment Dar and Saudi Arabia's Saad Group; others followed shortly after.

This research provides an up-to-date overview of current market practices, issues and trends in risk management for Islamic banks. It focuses on practical applications and discusses a wide range of unique risks faced by Islamic banks from the perspective of different ranges of practitioners. The book asserts that the weaknesses of many financial firms in managing their risks have to be looked at in a comprehensive fashion. The root drivers of the prevailing financial system have to be challenged and replaced by a more transparent and ethical alternative.

This research combines conceptual frameworks with ‘hands-on’ practical perceptions of risk management in Islamic banking in a pioneering piece of research that Shari'ah scholars, policy-makers, practitioners, academics and researchers will find of relevance and a motivation to conduct further research in this vital but under-researched area. Although a few Shari'ah opinions are included in the book, religious and Shari'ah discussions are beyond the scope of this research.

SYSTEMIC IMPORTANCE OF ISLAMIC BANKING AND FINANCE

Islamic finance is the fastest-growing sector in the financial industry at present. Launched to reconcile the financial with the theological needs of a global community of 1.5 billion Muslims, Islamic finance today offers a broad and sophisticated range of products and services. Double-digit growth rates for Shari'ah-compliant assets over the past decade have naturally driven Islamic financiers to look beyond historical boundaries to explore new territories, both within and outside the Muslim world.

The increasing international interest in Islamic finance is a reflection of the success that this industry has achieved during its short history. Moreover, Shari'ah principles that place emphasis on providing economic added-value to stakeholders, and aim to create equivalence in benefits and costs, free from harmful speculation, are gaining more attention and better understanding globally. Several Western supervisory bodies are incorporating amendments to their supervisory and regulatory legislation to allow for Islamic institutions and Shari'ah-compliant products, which will reinforce the role of Islamic finance globally. Nowadays, in European, American and most Western markets, financial institutions are offering more products and services to cater for Islamic finance. Moreover, a great number of financial institutions in Gulf Cooperation Council (GCC) countries and in Asia are managing funds of over USD 300 billion and are encouraged by their markets to provide Islamic financial services (Moody's, 2011a).

Islamic banking, being the main sub-sector within the Islamic finance industry, has been pioneering this exponential growth. According to Moody's (2011a), the total assets held by Islamic banks globally amounted to more than USD 1 trillion by the end of 2010. While Islamic banks have been hit by the economic downturn, they have been considerably less affected than most conventional banks. This is mainly because, unlike conventional banks, the Islamic banks have not been exposed to losses from investment in toxic assets, nor have they been highly dependent on wholesale funds. Furthermore, Islamic instruments are highly useful alternative investments for the diversification of portfolios, as they have low correlation to other market segments, allow the selective underweighting of particular sectors, and seem to be relatively independent of even market turbulences like the subprime crisis. As a consequence, the increasing standardisation of derivatives and sukuk, as well as the growing liquidity and organisation of the Islamic capital market, offers many opportunities to innovative investors.

With such a background, it is obvious that Islamic banks have come a long way. The future of these institutions, however, will depend on how they cope with the rapidly changing financial world. With globalisation and the information technology revolution, the scope of different financial institutions has expanded beyond national jurisdictions, particularly for investment and wholesale banks. As a result, the financial sector in particular has become more dynamic, competitive and complex. There has been unprecedented development in computing, mathematical finance and innovation of risk management techniques. Moreover, the financial crisis is likely to challenge the global risk management foundations. All these developments are expected to magnify the challenges that Islamic financial institutions (IFIs) face, particularly as more well-established conventional institutions have begun to provide Islamic financial products. IFIs need to equip themselves with the up-to-date management skills and operational systems to cope with this environment. One major factor that will determine the survival and growth of the industry is how well these institutions manage the risks generated in providing Islamic financial services.

The last three decades have witnessed a shift of focus in the development of Islamic banking. The original objective of the 1960s and 1970s of developing an interest-free financial system is no longer the primary objective for Islamic bankers. The current core issue is to develop an Islamic financial industry which does not suffer from the weaknesses of the conventional banking system, particularly after the current credit crisis. Thus, the focus has shifted to risk management and mitigation, financial engineering, innovation and providing common standards in Islamic finance.

Banking, in all its forms, contains risks that pose a challenge to all stakeholders. Islamic banks, like their conventional counterparts, are financial institutions which provide services to depositors and investors on the one hand and offer financing to companies, the public sector and individuals on the other. They are therefore subject to many risks that are similar to those confronted by conventional banks. There is a growing concern that the risk management practices of Islamic banking are not keeping pace with the global financial market. The rapid growth of Islamic banking on all fronts calls for proactive responses to risk management issues. In addition, Shari'ah-compliant banks have their own unique set of risks that differ from those borne by conventional banks. In principle, there is a range of activities through which Islamic banks can work in different ways that enable them to provide funds. These activities are adapted to meet the Shari'ah principles that govern Islamic banking, the most important of which is the principle of risk sharing.

Managing risk especially in the current perilous times is no easy task. The events of mid-September 2008 challenged financial institutions' preconceived ideas of how to view risk. Until 15 September 2008, few bankers would have thought a systematically important and highly rated financial institution such as Lehman Brothers could have failed, let alone failed as quickly as it did. Risk management in Islamic banking is a hot issue as little is yet understood on many aspects, with IFIs facing significant challenges in measuring and managing risks. Effective risk management in Islamic banking therefore deserves priority attention because the future of Islamic banks will largely depend on how they manage their unique set of risks. So far, Islamic banking has been free-riding on financial theories and instruments developed within the context of the conventional debt- and interest-based system. Unless the Islamic banking industry develops its own genuine risk management architecture, it cannot achieve the dynamism of the Islamic finance system, which provides the security and viability needed for a more resilient financial system than the debunked Wall Street model.

RESEARCH AIMS, OBJECTIVES AND QUESTIONS

This research attempts to fill the gap in the empirical literature on risk management in Islamic banking. It recognises upfront that Islamic banking offers its own unique approach to risk management. Following a structured approach, first, the research aim and objectives were identified, and then research questions were developed within the context of the broader objectives.

The aim of this research is to explore and analyse the risk and risk management practices in the Islamic banking industry through the perceptions and opinions of participants drawn from the banking and finance industry. In doing so, this research maps out attitudes toward risk in the IBF industry and locates perceptions of the various stakeholders on risk management-related practices in the industry.

In fulfilling the identified research aim, the following specific objectives are developed:

  1. To ascertain the fundamental principles underlying risk management in Islamic banking and the unique risks facing IFIs;
  2. To investigate the effect of different control variables like region, country, respondent's position, nature of financial institution, nature of operations, and accounting standards on the participant's perception of the nature of risks, risk measurement, and risk management and mitigation approaches of IFIs in comparison to those of conventional banks and with reference to the market conditions in which IFIs operate;
  3. To evaluate the applicability of Islamic Financial Services Board (IFSB) Standards and Guidelines with respect to risk management and capital adequacy, and how the Guidelines could operate in a Basel II (and potentially Basel III) era;
  4. To investigate the real roots of the recent crisis with a view to drawing some lessons for IFIs;
  5. To examine the dichotomy between the theory and practice of Islamic banking; and
  6. To explore the next chapter for risk management in Islamic banking.

The following specific research questions are developed to address and investigate the broader research objectives:

  1. What are the top risks facing IFIs?
  2. What is the risk appetite associated with each Islamic finance contract?
  3. Does risk management in Islamic banking differ from conventional banking?
  4. Are Islamic banks more or less risky than their conventional peers?
  5. Are Basel II (and potentially Basel III) standards suitable for Islamic banking?
  6. What are the appropriate capital requirement levels for IFIs?
  7. Is Islamic banking actually more resilient than conventional banking?
  8. Could the recent crisis have occurred under an Islamic banking system?
  9. How developed and significant is hedging to Islamic banking?
  10. Is there divergence between the current practice and moral principles of Islamic banking?
  11. How does the future look for Islamic banking? What strategies should IFIs follow?

In answering the research questions, the impact of various categories of respondents and their profile indicators on risk perception are also investigated.

RESEARCH HYPOTHESES

Based on the dichotomy that exists between theory and practice in analysing risk management in Islamic banking, this research aims to explore and study the opinions and risk perceptions of various groups of Islamic banking professionals with the aim of answering the identified research questions.

The following research hypotheses were formulated to determine the parameters of the research questions:

  1. The main risks facing Islamic banks are reputational risk, Shari'ah-non-compliance risk, asset–liability management risk, liquidity risk and concentration risk.
  2. Islamic bankers prefer mark-up-based contracts and shy away from profit-sharing contracts.
  3. Profit-sharing contracts are perceived as more risky than mark-up-based contracts.
  4. There is no substantial difference between risk management in Islamic banking and conventional banking.
  5. Capital requirement levels should be lower in IFIs than in conventional banks.
  6. Basel II was drafted with conventional banking very much in mind. IFIs should follow their own standards, e.g. IFSB Principles on capital adequacy.
  7. Islamic banking is more resilient to economic shocks than is conventional banking, but is not recession proof.
  8. Not many Islamic banks use the more technically advanced risk measurement and reporting techniques.
  9. The use of risk measurement techniques is less advanced among Islamic banks than among their conventional peers.
  10. Islamic banks use a number of risk mitigation tools that are intended to be Shari'ah-compliant and that are less advanced than those utilised by conventional banks.
  11. Most IFIs abandoned conservative risk management Shari'ah principles in favour of copying conventional structures.
  12. There is strong potential for Islamic banking provided that it goes back to its roots.
  13. Perceptions of Islamic and conventional bankers differ significantly, as Islamic bankers are more biased toward their business model, and vice versa.

The above hypotheses are further broken down into more refined sub-hypotheses for testing purposes later in this research; these are presented in the research methodology chapter (Chapter 6).

SIGNIFICANCE OF THE STUDY

This book has a particular significance as it attempts to provide a complete overview of risk management in Islamic banking. This makes it a valuable resource for both conventional and Islamic investors, as well as for IFIs, researchers, consultants and policy-makers who are faced with the increasing complexity of Islamic instruments. Risk management is receiving more attention all over the world due to the subprime crisis, and for most IFIs, risk management presents specific challenges.

The existing body of knowledge demonstrates that research on risk management in Islamic banking is still scarce. Globally there has been a significant increase in the literature on risk management over the past decade, especially during the past two years. This has emerged largely because of a combination of developments: first, there has been greater reflection on risk mitigation and management in the wake of frequent episodes of financial crisis; second, financial diversification and product innovation have brought new dimensions and types of risks to the forefront; third, the endeavours of the financial community to develop and innovate financial architecture have resulted in financial institutions facing different types of risk. Cross-segment mergers, acquisitions and financial consolidation have blurred the risks of various segments in the industry. However, these developments have revolved around the conventional banking system, benefiting incrementally from the financial engineering and innovation of esoteric products and structures. While Islamic banking has grown substantively in the last few years, appreciation of its risk architecture and profile is still evolving (Greuning and Iqbal, 2008).

Reflecting the increased role of Islamic finance, the literature on Islamic banking has also grown in the last decade. There is now a considerable amount of research on the topic of IBF; nevertheless there are still large gaps in the coverage of topics related to risk management. A large part of the literature focuses on Islamic finance contracts, structures, roots of Islamic finance, comparisons of the instruments used in Islamic and conventional banking, and the regulatory and supervisory challenges related to Islamic banking. This is to be expected because the initial focus of the whole Islamic finance industry was to create awareness of Islamic finance and its basic concepts among a riba-dominated financial world. Nevertheless, the last few years have witnessed a shift of focus in the literature on Islamic banking toward more specialised areas like capital markets, mergers and acquisitions, asset management, sukuk, structuring and product development, innovation and standardisation. There is, however, relatively little research conducted on risk management and capital requirements for Islamic banking; such research includes studies by Haron and Hin Hock (2007), Iqbal and Mirarkor (2007), Akkizidis and Khandelwal (2007), Grais and Kulathunga (2007), Greuning and Iqbal (2007), Mahlknecht, M (2009), Sundararajan (2007), and others as explored in Chapter 3.

Given the lack of sufficient research about risk management in Islamic banking, there is even less empirical research available in this vital area. A limited number of papers discuss risks in IFIs but they do so in academic terms instead of pragmatic analysis of data. On the other hand, empirical papers on Islamic banks focus on issues related to efficiency and financial stability, such as Yudistira (2004), Moktar et al., (2006) and Heiko and Cihak (2008). But risk management in Islamic banking has not been thoroughly analysed in an empirical fashion, with the exception of a handful of sources like the profound work done by Khan and Ahmed (2001), Noraini et al. (2009) and Mahlknecht (2009).

In addition, the previous studies on risk management in Islamic banking only highlight the issues without offering any feasible solutions. Therefore, this book is considered distinct, and departs from previous studies by offering practical and feasible recommendations to improve risk management architectures within Islamic banking. Moreover, this study provides a larger sample size within the wider populations in the Islamic banking industry, and includes a very well diversified sample of respondents (geographically, by background, by the nature of activities of their organisations, as well as by other control variables) to enable the researcher to obtain better findings by conducting significance tests on the differences between various groups. The survey findings are further enhanced by in-depth interviews with senior Islamic banking professionals, which allow more room for interviewees to express their views in a less formal and more open way than in the structured questionnaire. The interview sample is also well diversified.

Finally, while a few scholars have researched the practical implementation of risk management in Islamic banking, this book is the first of its kind to do so after the recent credit crisis. The book extracts empirical evidence from the perceptions of Islamic banking professionals and from the recent crisis to substantiate the research process and the findings of the research.

OVERVIEW OF THE RESEARCH METHODOLOGY

In responding to the research questions outlined above, this book undertakes a combination of two research methods: firstly, a comprehensive review of the existing literature and theory, and secondly, an empirical study to elicit opinions and perceptions in response to the theory which is discussed in the literature. Both quantitative and qualitative data analyses are used for this part.

In the first part of the research, the theoretical framework of this study was constructed through the literature review, which is presented in a series of chapters. The main literature sources were journals, conference proceedings, books, reports, theses and bank regulators' papers. Due to the fact that literature on risk management in Islamic banking is scant, information and quotations from interviews are used in the literature review to substantiate the argument. This may not accord with convention; however, this strategy helped to provide a better understanding by combining primary and secondary material on the subject matter.

The second part of the book is concerned with an empirical study which investigates the respondents' perceptions of risk management issues in Islamic banking. A survey technique using questionnaires is used in this context to obtain primary data from the target sample of bankers, financiers and Shari'ah scholars. The data was analysed using Statistical Package for Social Science (SPSS) software. In addition, semi-structured interviews are used to substantiate and compare the questionnaire findings. A detailed description of the research process is presented in Chapter 6.

OVERVIEW OF THE RESEARCH

This study consists of two major sections, namely background and empirical work. Chapters 2 to 6 are the foundational chapters for the following five; these latter form the empirical part of the book.

Following this brief introduction, the book continues with 10 closely interrelated chapters. There is unavoidably some overlap of discussion and cross-referencing. The overview of Chapters 2 to 11 is as follows:

  • Chapter 2 Principles of Islamic Banking and Finance reviews the existing literature, texts and other relevant reference materials. In order to understand the risks that IFIs face, this chapter first briefly discusses the nature of these institutions with the objective of providing an introduction to Islamic banking and its instruments; however, this is not intended to provide a detailed description of how Islamic financial products are structured. This chapter is divided into three sections: the first explains the basic tenets of Islamic finance and the most commonly used terms and contracts, the second discusses the important financial instruments available and the market size, and the third looks at the international standardisation bodies.
  • Chapter 3 Risk Management in Islamic Banks: A Theoretical Perspective commences with an overview of risk management in general. After defining and identifying different risks, specific issues related to risk management and mitigation in Islamic banking are discussed. Risks are classified into two main categories: risks which Islamic banks have in common with traditional banks as financial intermediaries, and risks which are unique to Islamic banks due to their compliance with the Shari'ah principles. The risk characteristics of Islamic products and the complexities of some of these are rigorously examined. This chapter is based on both academic desk research and practical views form the open interviews conducted.
  • As for Chapter 4 Capital Adequacy for Islamic Banks: A Survey, realising the significance of capital in today's Basel-dominated era, a designated chapter is allocated to analysing capital adequacy for Islamic banks. This chapter examines the need for capital and provides the rational and historical background of the Basel I, II and III frameworks. It then highlights the detailed analysis of credit, market and operational risks that has been given by the Basel II Accord. Proposed amendments to the Accord after the recent crisis and the proposed Basel III standards are discussed. The chapter then examines the applicability of the three Pillars of Basel II to Islamic banking. The chapter also signifies the link between the role of social responsibility of Islamic finance and market disclosure. This chapter further identifies the key role the Islamic Financial Services Board (IFSB) plays in the development of standards for risk management in the Islamic financial industry.
  • Chapter 5 focuses on Islamic Banking and the Financial Crisis. In theory, Islamic banks are more resilient to economic shocks than conventional banks. Sadly, close mimicry of Western products in the pursuit of easy profits caused Islamic banking to divert from the basic principles laid down more than 1400 years ago. Hence, Islamic banks are currently feeling the effects of the recession despite their limited exposure to higher-risk financial products. The recent crisis acts as a wake-up call; if Islamic banks learn the right lessons, they could bounce back strongly. This chapter combines evidence from the recent crisis with the principles discussed in the previous chapters to prove that the Islamic financial system, specifically with its different approach to risk, can act as panacea for economic woes.
  • Chapter 6 Research Framework and Methodology discusses the research strategy and methodology adopted for the data collection process. It presents in great detail the recommended research procedures by making reference to the various research methodology textbooks on the appropriate research process and technique to be used. The rationale and justifications for each of the tools and techniques used throughout this study are also presented. In addition, the chapter also presents more closely the refined research sub-hypothesis which is to be tested in the analysis chapter.
  • Chapter 7 Profiling Perspectives on Risk Dimensions in Islamic Finance: Descriptive Questionnaire Data Analysis takes the research to the market place by analysing data and presenting the results from a survey on risk management issues in IFIs. It includes a demographic profile analysis and also the core variables for the research. The purpose of this chapter is to give an overview analysis of the findings from the survey. The descriptive analysis benefited from a frequency analysis, which also includes the frequency percentage, mean and standard deviations value for each of the variables; this provides readers with grounding knowledge for the overall results.
  • Chapter 8 Analysing Perceptions of Risk and Risk Management Dimensions and Issues: Inferential Statistical Analysis presents further analysis of the views and risk perceptions of respondents using inferential statistical tools such as the Kruskal-Wallis test, factor analysis, MANOVA multivariate analysis of variance and the Chi-Square tests. The results of the analysis are discussed, interpreted and justified in great detail. The aim is to explore the results in as much detail as possible from the data in order to respond to the research questions.
  • Chapter 9 Exploring Perceptions of Risk and Risk Management Practices in Islamic Banking: Interview Data Analysis is an analysis of the semi-structured interviews conducted with a number of Islamic banking professionals from banking institutions, consulting and law firms, academia and rating agencies. A focused coding technique is used to analyse and sort the findings. This chapter represents the findings of the qualitative analysis.
  • Chapter 10 Contextualising the Findings: An Interpretative Discussion presents the overall discussion of the findings in Chapters 7, 8 and 9 by responding to each of the research hypotheses. The chapter provides an in-depth discussion of each of the hypotheses, and also makes cross-references to the theory and findings of previous studies in order to link together all the pertinent main findings in this study. The outcome of this chapter helps to derive the overall conclusions of the study.
  • The last chapter, Chapter 11 Conclusion and Research Recommendations, presents a summary of the major findings, recommendations and limitations, and offers suggestions for future research.
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