Chapter 17

Managing Risk in Islamic Financial Institutions

In This Chapter

arrow Appreciating the importance of risk management

arrow Walking through the risk management process

arrow Determining why Islamic firms face certain risks that conventional firms don’t

arrow Identifying the risks at play in conventional and Islamic finance

arrow Reading up on risk management standards in the Islamic finance industry

All business organizations face risks, which can range from the loss of a loyal customer to the failure of the entire operation. Data corruption or theft, lawsuits against the company, fines, penalties, loss of competitive advantage, negative media attention, public liability . . . the types of risk that a company may face are seemingly endless.

Financial institutions, including those in the Islamic sector, face certain risks that are specific to their industry. Islamic financial firms encounter an additional set of risks that relate to their adherence to Islamic law (see Chapters 1 and 2).

As the Islamic finance industry matures, the professionals in it must be diligent about managing risk. In this chapter, I identify the primary risks for Islamic financial institutions and offer some insights into the art of risk management: the process of identifying, assessing, and minimizing or controlling risk. Risk management is a crucial element of corporate governance, a topic I cover in depth in Chapter 15.

Realizing the Business Necessity of Risk Management

Senior managers at financial firms must prioritize risk management, which isn’t an easy job. Risk exposure can come from many places, including the market in which a firm does business, the firm’s own operations, credit defaults, and liquidity problems. And risk exposure for financial institutions is greater today than it has ever been. Here are just some of the reasons:

check.png The financial industry develops and sends to market some pretty complicated, innovative, and unproven instruments.

check.png New kinds of financial institutions have emerged, such as Internet-based banks and forex (foreign exchange) trading companies.

check.png Financial markets in general remain fairly unstable after recent global financial crises.

check.png Government regulations are changing in response to these financial crises.

check.png Innovations in technology continually alter the way financial transactions are conducted.

check.png All financial transactions are done through electronic platforms, which operate at lightning speeds and sometimes demand lightning-fast decisions.

check.png Competition among financial firms has increased.

check.png New economies are being developed, which means that new financial markets are being created.

remember.epsThe key goals of risk management for any financial institution are to protect against unpredictable losses, stabilize earnings, and maximize earnings in the long run.

realworldexample.epsWhat happens when risk management practices are lax? Consider just two examples that illustrate the potential consequences:

check.png In 1995, Barings PLC, which was one of the oldest banks in the United Kingdom, declared bankruptcy after a single employee lost U.S. $1.3 billion of the bank’s money in derivatives trading.

check.png In 2004, National Australia Bank lost Australian $360 million because of unauthorized spot trades on foreign currency.

In truth, the financial crisis that crippled economies all over the world in late 2007 and throughout 2008 occurred in large part because so many financial firms suffered from a weak risk management culture as well as inefficient management, insufficient liquidity, and poor corporate governance.

Knowing Where the Buck Stops: The How and Who of Risk Management

Islamic and conventional financial institutions alike need to have appropriate risk management procedures in place to avoid unfortunate, unforeseen events. In broad terms, the risk management process for any individual, group, or company involves the following steps:

1. Identify the risk.

2. Measure the risk.

3. Reduce the risk.

4. Monitor the risk.

5. Report/control the risk.

remember.epsWhat each of these steps entails depends on the specific types of risks you’re talking about. The rest of this chapter provides more details on how to manage various types of risk.

As I explain in Chapter 15, a company’s board of directors and senior management are ultimately responsible for mitigating risk. But every Islamic financial institution has a specific risk management department that works on identifying and measuring risk and developing policies and procedures to manage that risk. A risk management department is staffed by a risk manager and risk officers.

Larger organizations may feature different corporate structures for their risk governance departments. Here are some possibilities:

check.png One risk management committee: A large organization may have a risk management committee as part of its board committee structure. This committee oversees the risk management department.

check.png Two risk management committees: Some mega organizations — Kuwait-based Gulf Finance House, for example — have two different levels of risk management committees: one committee at the board level and another at the senior management level.

check.png Group risk committees: In this structure, subcommittees exist for different kinds of risks; each has its own responsibilities. For example, you may find three different subcommittees for liquidity risk, market risk, and operation risk. The subcommittees report to a group risk committee, which reports to a risk committee board, which reports to the board of directors. (Whew!)

Seeing How Risk Management Is Different for Islamic Financial Firms

An interesting feature of Islamic finance — aside from (but related to) the need to remain sharia-compliant — is that risk and return are shared between the firm and its fund providers. In a conventional firm (which guarantees returns to its depositors and investors), only the institution bears the risk; no risk is transferred to the fund providers. That means, at least in theory, that an Islamic financial institution’s risks are lower than those faced by its conventional counterpart. But Islamic firms actually face additional and unique risks (which I describe later in this chapter) that may balance the scales.

Conventional financial institutions are exposed to five broad types of risk: credit, market, liquidity, operation, and reputation. (I explain these risks in more detail in the later section “Grappling with Generic Risks.”) Islamic financial institutions face these risks, too, along with a slew of concerns that most conventional firms do not, such as equity investment risk, displaced commercial risk, rate of return risk, and sharia noncompliance risk.

Financial firms must devote a lot of time, attention, and money to risk management if they want to stay in business. But as I explain in Chapter 15, you can’t simply cut and paste conventional corporate governance techniques into the framework of an Islamic financial institution. This discrepancy is due in large part to the shared-risk principles of Islamic contracts that provide the basis for Islamic financial products and to the relative youth of the Islamic financial industry compared to the conventional system. The following sections explain these issues in more detail.

Sharing risk with stakeholders

Stakeholders in Islamic financial institutions are generally more aware of risk than their counterparts in conventional firms are. As a result, they demand that their banks, mutual fund companies, and other financial organizations approach each transaction with an eye toward reducing risk. (Conventional customers and investors don’t — and very likely can’t — make such demands from their financial firms.) This heightened awareness among stakeholders in the Islamic financial sector exists for a couple of key reasons:

check.png Profit and loss sharing: Islamic banking products (such as savings accounts) and investment products are based on contracts that call for profit and loss sharing between the customer and the institution. I explain these types of contracts in detail elsewhere in the book, including in Chapters 6 and 10. When a customer knows from day one that her principal will be returned and her investment rewarded only if the contract activity is profitable, she parts with her money fully aware that her decision carries risk, and she expects her investment partner (the financial institution in this case) to take certain precautions with her money.

check.png Sharia-compliance: To be sharia-compliant, Islamic financial transactions can’t involve interest, gambling, speculation, or prohibited industries. Depositors and investors often seek out Islamic firms precisely because of this fact, but they’re also aware that adhering to sharia principles constricts the firm in some ways. Sharia compliance amplifies certain financial risks, and I explain two such risks in the following section.

Playing catch-up with the more established conventional system

Because of the relatively short history of the Islamic financial industry and certain restrictions established by sharia law, Islamic financial institutions can’t always mitigate their risks as well as conventional financial institutions can. The Islamic capital market is simply less developed than its conventional counterpart, which means that not many options exist (yet) to help Islamic firms mitigate liquidity risk.

For instance, conventional capital markets help financial firms reduce their liquidity risk by offering certain financial instruments, such as short- or long-term debt instruments and derivatives. But these instruments are generally off-limits for Islamic firms because they aren’t sharia-compliant.

In addition, Islamic financial firms don’t have access to the same hedging techniques that conventional firms use. In fact, few hedging techniques are available for Islamic firms at this time, and sharia scholars disagree on whether they’re sharia-compliant. I discuss this topic in Chapter 11, where I explain the fledgling Islamic derivatives market.

As Islamic institutions continue developing innovative product lines to better compete in the global financial markets, risk management will only become more important.

Grappling with Generic Risks

Although conventional and Islamic financial institutions are both subject to credit, market, liquidity, operational, and reputational risks, the nature of these risks may differ between the conventional and Islamic sectors. I describe the differences in this section.

Minimizing credit risk

Credit risk can arise in a financial institution if an individual or business entity fails to meet a financial obligation he or it previously agreed to honor. Whether the failure of fulfillment occurs because the obligator doesn’t want to fulfill its obligation or because it can’t, the financial firm loses money.

In a conventional financial institution, credit risk can arise if a borrower fails to pay a loan, whether that borrower is a lessee, a mortgage customer, or the issuer of a debt instrument (such as a corporate bond). Conventional institutions set up credit policies to avoid such events and to mitigate their effect through the firm’s retained earnings.

Islamic financial firms also have obligators or debtors: individuals and business entities who utilize Islamic financial instruments. These instruments may be equity-based (using contracts such as mudaraba and musharaka) or asset-based (using contracts such as murabaha, ijara, salam, and istisna). Here are the risks associated with each group of Islamic financial instruments:

check.png Equity-based instruments: The risk with equity-based products is that Islamic firms may lose their advance or principal. Both mudaraba and musharaka contracts are based on financial partnerships, which means the Islamic firm depends on the customer to fulfill his end of the bargain.

In a mudaraba contract, the Islamic firm puts up the capital but doesn’t have the right to participate in managing the economic activity being funded. As a result, information asymmetry exists; the firm can’t monitor any related risks, and its capital is jeopardized if its partner mismanages the activity.

The musharaka contract allows the Islamic financial firm to participate in the management of the venture being funded, but the firm still depends on its working partner (the customer) for proper management. If the partner is negligent or engages in misconduct, the firm potentially loses its advance capital.

check.png Asset-based instruments: The risk to a financial institution when asset-based products are involved is that customers may default on installments.

With investment instruments, such as those based on murabaha and ijara contracts, customers are expected to pay back money to the Islamic firm in deferred payments. The risk that they’ll miss payments exists. In the case of salam and istisna instruments, the credit risk can arise if the asset or project being funded isn’t delivered; nondelivery results in financial loss for the firm.

To mitigate credit risk, Islamic and conventional financial firms use the same tools:

check.png Requesting credit reports: Ideally, a legitimate credit agency issues a credit report on a potential borrower. If an agency-provided credit report isn’t available, the firm may check the customer’s profile with other financial institutions or use its own internal credit risk appraisal system to determine risk and decide whether to enter a financial agreement with a prospect.

check.png Being cautious with credit approvals: An effective internal control system (see Chapter 15) may require that all credit requests go through a credit approval board.

check.png Managing credit through asset collateral: For asset-based instruments established on contracts such as murabaha, the asset itself is taken as collateral.

check.png Monitoring project or asset activity: After credit is approved and a contract is signed, the firm monitors the progress of whatever activity it’s financially supporting and watches for signs of trouble.

check.png Diversifying credit: By entering contracts with representatives from various industries and sectors, the firm avoids problems if a single sector (such as real estate or a specific commodity) takes a dive.

realworldexample.epsIn its 2009 annual report, Bahrain-based Al Baraka Banking Group notes that its risk mitigation policies include periodic collateral verification conducted by an independent assessor. The allowed collateral assets are ships, aircraft, cars, fleets, railcars, and satellites. The group doesn’t accept any assets that are depreciable for less than five years or any perishable assets. Also, all assets must be insured to qualify as collateral.

Keeping market risk in check

Market risk incurs because of adverse movements in benchmark rates, foreign exchange rates, and commodity and equity prices that may influence the economic value of assets. Here, I explain each category of market risk.

Interest/margin risk

In conventional finance, the equivalent to margin risk is interest risk; conventional institutions can be affected by adverse changes in the absolute interest rate. For example, if a bond holder has a bond with a 7-percent fixed interest rate and the market interest rate increases to 10 percent, the bond holder can’t take advantage of the interest rate increase. (The bond holder faces an opportunity cost.)

Islamic financial firms avoid interest risk because they can’t participate in interest-based transactions. Here’s how their equivalent risk — called margin risk — works: Islamic financial instruments, such as those based on murabaha contracts, operate based on markup. Murabaha is a deferred-payment contract in which the customer buys an asset at cost plus a profit margin. The Islamic firm has to decide on the appropriate profit margin that allows it to earn money while remaining competitive in the market.

remember.epsIn conventional finance, firms rely on industry benchmarks when making decisions about pricing for profit margins. Islamic financial institutions have lacked the benefit of benchmarks designed with their specific industry sector in mind. (In late 2011, the Islamic Interbank Benchmark Rate [IIBR] was launched, but as of this writing it’s in an initial growth phase.) Firms often use the LIBOR (the London Interbank Offered Rate) or other conventional benchmarks to price their products.

Adverse changes in the benchmark rate create risk for Islamic firms. If the benchmark rate increases, for example, the firm loses the opportunity (on its existing contracts) to benefit from such increases. Again, the risk here is an opportunity cost.

Forex risk

Movements in exchange rates can have adverse effects on investment values that are based in foreign currency. This risk is common for both conventional and Islamic financial firms. Here are examples of how this risk plays out in an Islamic institution that’s involved in international transactions.

check.png Spot currency transactions: The bank and another party agree to buy one currency and sell another at a specific price on an agreed-upon date (such as two days later). If the currency rates change between the agreement date and the date of the actual transaction, the bank may lose money (or it may profit instead).

check.png International remittance in foreign currency: If an Islamic institution pays for services offered by a provider in another country, and it agrees to pay in the foreign currency, it faces the risk of a shift in currency value.

For example, say an Islamic bank in the United Kingdom agrees to pay a U.S. company for certain services, and the exchange rate is £1 = U.S. $2 when the bank and the company sign the contract. If the pound depreciates during the contract period and the rate at the time of payment is £1 = U.S. $1.60, the bank loses money because it must pay more pounds to fulfill its contractual obligation.

check.png Murabaha transactions: If a bank supports transactions, such as those based on murabaha contracts, in which the bank accepts receivables in foreign currency, it risks its actual income value due to changes in currency exchange rates.

For example, say an Islamic bank in the United States has a murabaha contract with a European company. If the U.S. dollar appreciates against the euro, the real receivable amount for the bank decreases at the time of payment.

Commodity price risk

The risk to financial institutions with regards to commodities is related to forward contracts, in which the institution pays in advance for a product delivered at a later date. In conventional finance, commodity risk may arise if goods purchased based on forward contracts can’t be sold at higher prices because of market conditions. As I discuss in Chapter 10, Islamic finance offers an alternative forward contract called salam. The difference between the conventional and Islamic product is that the Islamic contract requires full payment for the product upfront. Conventional products allow either full or partial payment to be made in advance.

remember.epsConventional firms use hedging techniques to mitigate this risk. In Islamic finance, the risk can be mitigated by using parallel salam contracts: When the Islamic institution enters a contract to purchase goods, it simultaneously enters a contract with a buyer for those goods. In this setup, the firm makes full payment to the seller or manufacturer for the goods to be available in the future. After the goods are delivered, the already-contracted buyer purchases them.

This hedging technique isn’t without its issues. For instance, suppose the seller fails to fulfill his commitment and can’t deliver the goods: The Islamic institution is on the hook with the buyer and has to purchase equivalent goods in the market, possibly at a higher price than it paid to the original seller. So again, the firm is exposed to risk.

Lessening liquidity risk

Conventional and Islamic financial firms both have to deal frequently with liquidity risk. Basically, financial institutions perform a balancing act with their liquid assets — cash and any assets that can be quickly turned into cash. If a firm has too few liquid assets, it runs the risk of not being able to meet its obligations when they’re due. If it has too many liquid assets, it loses the opportunity to earn profits on them.

remember.epsThe two most important fund providers for Islamic banks are current (checking) account holders and investment account holders. A current account holder may demand the return of his funds at any time. The investment account holder may be obligated to keep funds in the institution for a certain period of time, but he expects to receive those funds back (plus investment profits) at the end of the contract period. Liquidity risks may arise for an Islamic bank if the largest portion of its deposits sits in current accounts and short-term investment savings accounts.

Another factor to consider is that not all customers in Islamic firms are motivated to deposit their money because of sharia compliance; some may just like the firm’s higher returns or socially responsible investments. These customers may create liquidity problems if they’re attracted by new higher rates from other firms or find other products that meet their expectations regarding socially responsible investing.

Similarly, depositors who demand sharia-compliant financial services may jump ship if they have reason to believe the Islamic firm isn’t meeting this requirement. For example, if another, more conservative Islamic bank suggests that its products are more compliant, the first bank may find itself facing a series of withdrawals.

Other factors that affect liquidity risk include credit risk (which I discuss earlier in this chapter), a mismatch between a firm’s assets and liabilities, and factors outside the firm’s control, such as national economic problems or political unrest.

Mitigation tools that Islamic firms can use to minimize liquidity risk fall into two broad categories. Basically, instruments are designed to handle either regular or irregular demand of liquidity.

Covering regular demand

Regular demand — requests for funds to be returned to current account holders and investment account holders — is somewhat predictable. An Islamic bank keeps liquidity reserves in its central bank to meet regular demand (and also to fulfill any regulatory requirements that exist). The Islamic bank receives no interest from the central bank for this reserve; the contract between the two entities is based on qard hasan (an interest-free loan) or wadia (a deposit for purposes of safekeeping).

In addition, the firm can establish controls over its investment deposits that help it forecast cash inflows and outflows. (Penalizing in a sharia-compliant way for early withdrawal from an investment contract is one such control.)

Finally, an Islamic firm that is part of a financial group or has a parent company has contracts in place with those entities so that they can assist the firm with meeting regular demand for liquidity.

Dealing with irregular demand

Not surprisingly, irregular demand for liquidity is unpredictable, so the risk is more difficult to mitigate. To avoid problems from unexpected demands, a firm may utilize the Islamic interbank money market; but as of this writing, that resource isn’t yet well developed. A better contingency plan may involve the firm selling its financial instrument holdings.

In some cases, an Islamic firm may need to arrange a loan from another company in its group or its parent company to handle irregular demand for liquidity. If that’s not possible, it may need to secure a loan from its shareholders.

remember.epsRequesting emergency funds from the central bank or asking for a government bailout are the options of last resort. These avenues severely impact the reputation of the firm in question.

Managing operational risk

Operational risk refers to adverse effects (including potential losses) in a business because of failures in internal controls, technology, or people, or as a result of the regulatory or legal environment. (As I explain in Chapter 15, internal controls are policies and procedures adopted within an organization to protect its property and assets and to make its accounting system more accurate and reliable.)

Although all businesses face operational risk, financial institutions deal with more regulations than most and therefore face increased risk of failure to comply. In addition, Islamic financial institutions must ensure that their operations are sharia-compliant or else risk losing their customers’ loyalty.

Here are some examples of operational risk that are specific to the Islamic finance industry:

check.png Maintaining multiple contracts: Islamic financial instruments are formulated based on many Islamic contracts. A single transaction between an Islamic firm and customer may involve many legal documents. For example, a bank and customer enter an istisna (project financing) contract for a new office building. The contract states that the bank is the constructor for the client and will deliver the property by a certain date. But the bank itself doesn’t build anything. Therefore, it subcontracts to a construction company. If the subcontracted company fails to build the property, the bank is exposed to legal risk.

Other contract-related operational risk occurs because the Islamic finance industry is so new in many countries. When a country develops new regulations, the rules may involve taxation that applies to existing contracts (which were signed before the firm knew about this taxation). Such rules may be less favorable to Islamic firms than conventional firms simply because the conventional firms dominate the financial landscape.

check.png Lacking consistent best practices and benchmarks: Islamic financial institutions are operating in a young industry. Best practices and industry benchmarks are still being developed, so firms face the risk of making less-than-ideal decisions in some instances because of a lack of proven guidelines.

check.png Requiring unique information systems: The information technology (IT) system in an Islamic financial firm must differ from those in a conventional firm because of the nature of its business. The Islamic firm needs an IT system that helps it ensure sharia compliance and allows it to be competitive. For example, the system must be able to calculate the zakat amount for investments (see Chapter 14) and comply with Islamic finance industry standards such as those set by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) or the Islamic Financial Standards Board (IFSB). (Zakat, or charitable giving by the wealthy, is one of the pillars of Islam; flip to Chapter 2.)

check.png Operating within the broader legal environment: Like conventional financial institutions, Islamic firms are regulated by their respective governments. But Islamic institutions often face stricter regulatory review of new products because that review includes the factor of sharia compliance. In other words, regulators consider sharia compliance when determining whether a product can move to market, and they may reject products based on compliance concerns.

check.png Demanding different skills from employees: Islamic financial firms need personnel — senior managers, sharia advisors, operational managers, risk managers, and product innovators — who are well-versed in the specifics of Islamic finance. Without them, the firm can’t innovate and meet the growing needs of its quickly expanding population of customers and prospects.

As I explain in Chapter 15, a firm’s senior managers and board of directors are responsible for developing proper internal controls to mitigate operational risk. For personnel-related operational risks, these internal controls must include the segregation of duties and responsibilities, the development of recruitment policies to suit the firm’s hiring needs, and a reporting structure that promotes efficiency and transparency.

Rising above reputation risk

Reputation risk refers to the declining corporate image of any financial institution, conventional or Islamic. If an entity doesn’t properly manage such a decline, the end result is bankruptcy. That’s because reputation risk can easily trigger liquidity, market, credit, and operational risk.

A decline in reputation may occur because of a weak corporate governance structure or failures within the business operation. In the case of an Islamic institution, poor sharia governance could be to blame; I discuss the specific risk factor of sharia noncompliance in the upcoming section “Avoiding sharia noncompliance risk.”

remember.epsA failing reputation for one financial firm may create a ripple effect. Customers who question one bank’s reputation may start to question the reputations of others. Especially in the Islamic financial industry, because it is so young, such a failure runs the risk of influencing public opinion about the entire Islamic financial sector.

Financial firms of all kinds can take the following steps to mitigate reputation risk:

check.png Create a strong, accountable, and transparent corporate structure (see Chapter 15).

check.png Define a well-structured corporate strategy with a long-term vision, mission, and goals.

Islamic firms can also establish a strong sharia governance body featuring qualified scholars (see Chapter 16).

Dealing with Risks Unique to Islamic Finance

To create value for their participants, senior management and boards of directors at Islamic financial institutions must take necessary steps to manage their unique risks. The following sections discuss risks that Islamic financial institutions face but that conventional financial firms don’t, including equity investment risk, displaced commercial risk, rate of return risk, and sharia noncompliance risk.

Examining equity investment risk

Islamic financial firms offer instruments based on equity investments. The two contracts generally used for these instruments are mudaraba (partnership) and musharaka (joint venture partnership). Equity investment risk arises because of a potential decrease in the fair value of the equity position held by the Islamic firm.

A firm’s equity participation can range from direct investment in projects or joint venture businesses to indirect sharia-compliant investment, such as in stocks. If the firm faces a decline in the value of its equity position, it can lose any potential return on its investments and may even lose its invested capital. This situation can trigger additional problems, such as credit risk and liquidity risk.

The Islamic firm can try to reduce equity risk by analyzing certain key factors, including the following, before entering a contract:

check.png The background and business plan of the managing partner or management team

check.png The projected legal and economic environment in which the project will take place

In addition, the firm must continue to monitor the investment after the contract is signed to avoid information asymmetry with its partner(s).

Coping with displaced commercial risk

Islamic financial institutions don’t provide fixed returns in exchange for their customers’ deposits or investments. Instead, people who provide funds expect to share profits and losses with the firm.

remember.epsThe shared-risk-and-reward scenario is nice in theory, but in practice, investors expect returns! If they don’t get them, they may move their money to other financial institutions. This becomes more likely as more Islamic banks and other firms enter the marketplace and sharia-compliant customers’ options increase.

As a result, Islamic firms face displaced commercial risk; they’re forced to pay returns to fund providers even if the underlying assets don’t earn profits. The financial institution must smooth out what may otherwise be a bumpy road for depositors and investors.

Here’s how an Islamic institution can deal with this risk:

check.png It gives up a portion of its own profit and/or waives its fee from an investment, project, or asset so it can funnel that money into customer returns.

check.png It creates a fund called a profit equalization reserve by setting aside a percentage of previous years’ profits to use when investment returns dip too low (see Chapter 15 for information on this technique).

check.png It creates another fund called an investment risk reserve (again, funded by a portion of previous years’ profits) that allows the firm to recover investment losses in a given year (described in Chapter 15).

check.png It makes every effort to ensure that its investments are solid and poised to offer maximum returns.

Facing rate of return risk

Rate of return risk arises because of unexpected changes in the market rate of return, which adversely affect a firm’s earnings. In a conventional financial institution, returns are fixed; both the firm and fund providers know in advance what their returns will be. In Islamic firms, returns are uncertain and investors share both profits and losses with the institution.

remember.epsEven though investors in Islamic products understand the risks of products that are based on profit and loss sharing, they may react negatively — and possibly pull out their funds — if a firm’s returns are lower than market benchmark rates. When market benchmarks increase, an Islamic institution feels pressure to provide more returns than its asset earnings alone may merit. If the firm fails to respond to the market rate increase, that failure may lead to liquidity risk (because customers may withdraw funds too rapidly). If it responds to the market pressure, it creates displaced commercial risk and must take the steps outlined in the preceding section.

Avoiding sharia noncompliance risk

Sharia compliance is the reason Islamic financial institutions exist. If a firm isn’t adhering to sharia principles and guidelines, the impact can be severe. If one or more Islamic scholars indicate that an Islamic firm is veering away from compliance, its reputation will sink. (Flip to Chapter 16 for info on the folks who rule on sharia compliance.)

Very briefly, here’s what compliance with sharia principles looks like:

check.png Complying with minimum requirements from the start: An Islamic firm must do a few key things to distinguish itself from a conventional financial institution: avoid interest, gambling, and speculation; steer clear of investing in prohibited industries; and include a sharia board in its corporate governance structure.

check.png Keeping transactions and operations in compliance: Even if a firm starts out in compliance, its internal controls must ensure that transactions and operations are analyzed on an ongoing basis. A sharia board is responsible for conducting regular sharia audits to look for any possible noncompliance that may undermine the firm’s reputation.

check.png Developing compliant products: Every product developed by an Islamic financial institution must go through the institution’s sharia board for approval. When internal approval is secured, the product goes to outside regulators, who also consider its sharia compliance and may reject it if they have compliance concerns. The firm’s internal controls must outline this process carefully so that any product sent to regulators for consideration is, without a doubt, sharia-compliant.

remember.epsIslamic scholars make their decisions based on their interpretations of source materials (see Chapter 6), and interpretations differ. A firm’s internal sharia board may approve a new product only to have regulators reject it. Conversely, a firm’s sharia board may reject a product idea that is later approved by another institution. In these situations, a company’s stakeholders may ask for additional confirmation regarding a product’s sharia-compliance. This product development risk is unique to the Islamic finance industry.

Tapping into industry guidelines

The Islamic Financial Services Board (IFSB) is an international standard-setting organization for Islamic financial institutions. It issues principles and standards in corporate governance, risk management, and capital adequacy. If you plan to pursue a career related to Islamic finance, I encourage you to get familiar with all IFSB principles. (Check out Chapter 15 for details on this group.) To read specifically about risk management, check out the 2005 publication available online at

In addition, the Basel Committee on Banking Supervision (BCBS) is an international banking committee established to provide cooperation among, and improved supervision of, banks worldwide. This committee formulates standards and guidelines on best practices for banks around the globe. Although not all its standards apply to the specific needs of Islamic institutions, some do (because some of the risks for conventional and Islamic financial institutions are the same). If you want to find out more about the work of BCBS, visit

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