Risk Management for Islamic Banks

Recent Developments from Asia and the Middle East

Imam Wahyudi, Fenny Rosmanita, Muhammad Budi Prasetyo, Niken Iwani Surya Putri

• Publisher: Wiley
• Year: 2015
• ISBN:
  9781118734452
• Edition: 1
• Topic: Business
• Subtopic: Islamic Banking & Finance
• Index: Business

Gain insight into the unique risk management challenges within the Islamic banking system

Risk Management for Islamic Banks: Recent Developments from Asia and the Middle East analyzes risk management strategies in Islamic banking, presented from the perspectives of different banking institutions. Using comprehensive global case studies, the book details the risks involving various banking institutions in Indonesia, Malaysia, UAE, Bahrain, Pakistan, and Saudi Arabia, pointing out the different management strategies that arise as a result of Islamic banking practices. Readers gain insight into risk management as a comprehensive system, and a process of interlinked continuous cycles that integrate into every business activity within Islamic banks.

The unique processes inherent in Islamic banking bring about complex risks not experienced by traditional banks. From Shariah compliance, to equity participation contracts, to complicated sale contracts, Islamic banks face unique market risks. Risk Management for Islamic Banks covers the creation of an appropriate risk management environment, as well as a stage-based implementation strategy that includes risk identification, measurement, mitigation, monitoring, controlling, and reporting. The book begins with a discussion of the philosophy of risk management, then delves deeper into the issue with topics like:

• Risk management as an integrated system
• The history, framework, and process of risk management in Islamic banking
• Financing, operational, investment, and market risk
• Shariah compliance and associated risk

The book also discusses the future potential and challenges of Islamic banking, and outlines the risk management pathway. As an examination of the wisdom, knowledge, and ideal practice of Islamic banking, Risk Management for Islamic Banks contains valuable insights for those active in the Islamic market.

Part One

Introduction

Chapter 1
Principles of the Islamic Financial System

Islamic finance is an integrated social, economic, and financial system based on a set of principles that brings a positive motive for economic activity, balanced between material and spiritual needs and between personal and societal interest. Among those principles are balance between work and reward, equal treatment of humans, responsibility over self and society, fairness in scale and measurements, the principle of coexistence, prioritization of the interest of other people and society over one's self-interest, and freedom of conscience.

The initial purpose of the modern financial industry's intermediation is to assist the economy and from it the distribution of resource within society. But then, this purpose encounters obstacles in the form of “bourgeois appetites,” democratic politeness, and individual work ethic. These three forces cause humans, as economic agents, to never be satisfied with the resources that they already own, and propel the mechanism of financial manipulation to create “high-powered money,” ending in excessive risk-taking behavior. The combination of these three powers supports the idea of individual freedom and achievement, but abandons the idea of the economic agent's part in social responsibility. Islam recognizes the three powers as nafs, a catalyst for economic activity and the progress of civilization that can only aid in achieving prosperity when coupled with institutional reform and a mechanism to check the morality of the actions of humans in its execution. Islamic financial institutions arise as entities that are trusted to have a strategic function for institutional reform in the direction of prosperity as well as priority in the real sector, complemented with an ethical oversight mechanism through syari'ah principles that grounds operations and transaction activity.

Islamic Financial Contracts: The li-tabarru' Contract versus li-tijari Contract

Based on the purpose or reason of a contract's formation between two people or more, financial contracts can be divided into three. First is the contract for the purpose of generating profit, called li-tijari. Every party in the contract is aware that they or their cosigners enter into the contract for the purpose of acquiring personal gain for themselves through the contract. Usually there is a bargaining and negotiating process, either bilaterally or multilaterally, on the specifications of the contract, such as the terms for price, quality, and quantity of the object; the ratio; the timeframe of settlement; the time of delivery; the time of payment; and the like. With this awareness, all sides have willingly accepted the risk inherent in the contract and have no regrets if the realization of the contract is different from their expectation. In mu'amalah, there are many examples of this sort of contract, like sale (bay'), rent or lease (ijarah), partnering in business (syirkah), the cultivation of agriculture (musaqat), and so forth. Islam allows anyone to enter a transaction with the intention of gaining profit as in the various contracts mentioned, as long as the contracts are made properly and are also executed properly. The profits gained from these contracts are incomes that are lawful and good, for they are gained by the efforts of one's own hand.

Second is the contract that is made with the purpose of giving reward, aid, or assistance to other people; this is called the li-tabarru' contract. This type of contract is usually entered by those who are in need, have lived through a catastrophe, or are under problems that cause them to need the assistance of others. In this contract, negotiation or bargaining is rarely found except in payment terms and due date, where both are related to the ease preferred by the party in need. Because of this, Islam loathes anyone who exploits the opportunities that arise from other people's needs for personal gain or profit, material or immaterial, through any assistance rendered. Among the examples are loan or debt (qardh), entrustment (wadhiah), representation (wakalah), borrowing or lending (dayn), transfer of debts between debtors (hawalah), etc. In qaidah fiqhiyah, it is said, “every loan receivable that generates benefit/gain, then it is usury” (Asy-Syairazi, Al-Muhadzdzab: 1/304). Included in this group of contracts is a contract of guarantee over debts or loans, like third-party guarantees (kafalah) and asset-backed guarantees (rahn).

It is hoped that by knowing the division of financial contracts and by executing them consistently, one can avoid various forms of usurious transaction. For example, when one is interested in helping others who need capital for business, but is still at the same time interested in turning a profit, then the li-tijari contract can be used, like murabahah or ijarah. In both of these contracts, the capital owner can receive profit in the form of sales margin or rental fee, and the entrepreneur receive working capital in the form of fixed assets without having to expend money at the beginning. Other than that, by understanding the purpose for financial contracts, the parties involved can realize their position within the contract and their rights and responsibilities.

Principles of Islamic Finance

Risk sharing as a principle of justice is embodied in Islamic economy. Every economic agent involved in financial transactions, consciously or unconsciously, directly or indirectly, should complement each other and the system. All parties, without exception, can access money and other resources in the economy. The result is a “multiplier effect” that appears to drive the economy and improve the welfare of the community, not just the individual. All of these are summarized into three Islamic finance principles: universal complementarity, justice and equity in al-hisba, and abolition of riba.

Universal Complementarity

Both conventional and Islamic financial institutions function with the purpose of creating a system to enhance the efficiency of resource allocation and distribution in society by providing financial services to bridge the gap between the parties with excess funds on hand and those needing funds, thus setting in motion continuous economic growth. The basic difference between the two is that an Islamic financial institution must be free from all forms of usury, gambling (maysir), uncertain or doubtful elements (gharar), swindling (tadlis), injustice and coercion (ikhraha). Islamic financial institutions divide risk and profit fairly between different economic actors, both when there is a surplus of funds as well as when there is a deficit of them. This division of risk is a manifestation of the principle of economic fairness and implemented among the participants in the profit–loss sharing scheme. Every economic agent involved in a financial transaction, aware or not, directly or indirectly, should complement each other's absence of skill or function. Thus, everyone, without exception, can access the money in circulation and the available resource. Of course the multiplier effect that can be generated will mobilize the economy and improve the society's prosperity, not just the individual ones. When every element in the society is considered as an economic agent (producers and consumers, government, households, and industry) with complementary functions needed to achieve societal prosperity, the loss of individual business opportunity is a loss to society.

Justice and Equity in Al-Hisba

Among Islamic financial contract schemes, the profit-sharing instrument is considered to be most representative of Islamic finance's character. This scheme is dependent on the proportion (nisbah) agreed upon, based on the comparison between the opportunity cost of capital and the expectations of profit or loss of business. In Islamic finance, pricing is not determined by conventional standards (e.g., the capital asset pricing model [CAPM], market interest rate, etc.), but from the comparison of the function of satisfaction of capital to individual satisfaction and, on an aggregate level, a comparison to the economic surplus of every economic agent.

Abolition of Riba

Other than the two principles, there is at least another that must hold in the implementation of Islamic finance; the principle of removal of usury (riba). It must be understood that the marginal rates of substitution will be different among economic agents. This difference should be reflected in the lack of a “unified interest rate” as a reference for opportunity cost. In the allocation of return, it should be based on the division of investment roles along with the risk distributed among them. With that, every business opportunity will have a unique rate of return. In the end, this practice will consistently move in the direction of the removal of usury, which is the removal of a predetermined rate of interest between economic agents. In other words, economic agents will share risks and returns based on the actual performance of an investment. Aside from the way that usury is a form of injustice and is as such unlawful in Islam, the removal of usury is an implementation of the principle of fairness in measurement or scales. Every economic agent receives a different r...