Risks Unique to Islamic Finance - dummies

Risks Unique to Islamic Finance

By Faleel Jamaldeen

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. Islamic financial institutions face some risks that conventional financial firms don’t, including equity investment risk, displaced commercial risk, rate of return risk, and sharia noncompliance risk.

Equity investment risk in Islamic finance

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:

  • The background and business plan of the managing partner or management team

  • 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).

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.

The 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:

  • 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.

  • 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.

  • 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.

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

Rate of return risk in Islamic finance

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.

Even 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.

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.

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

  • 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.

  • 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.

  • 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.

    Islamic scholars make their decisions based on their interpretations of source materials, 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.