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 that may balance the scales.

Conventional financial institutions are exposed to five broad types of risk: credit, market, liquidity, operation, and reputation. 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. 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.

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:

  • 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.

    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.

  • 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.

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.

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

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