Economic Efficiency of Islamic Financial Institutions Part II

Posted on 13th December 2015 by Muhammad Ayub and Camille Silla Paldi,;

Section 4         Alternative Policy Options and Steps

 4.1      Proper Risk Management: A Necessity

Risk management (RM) serves several important functions, including implementation of strategy, development of competitive advantage; measure of capital adequacy; aid to decision making, aid to pricing decisions, reporting and control of risks, and management of portfolio of transactions. According to the IFSB’s guidelines on risk management (2005), the main risk categories facing IFIs include credit risk, market risk, liquidity risk, operational risk, Shariah compliance risk, equity investment risk, rate of return risk and displaced commercial risk. IFSB subdivided the risk management practices into ‘Risk Policy and Environment’, ‘Risk Measurement’ and ‘Risk Mitigation’. Basel II, and subsequently Basel III tended to establish more market discipline along with risk weighted capital requirements on banks to reduce the probability and severity of future crises. Basel III combines micro and macro prudential reforms to address both institutional and system level risks. It focuses on the most problematic risks like trading book exposures, counterparty credit risk, derivatives and other securitization activities implying that its spirit seems to be moving away from the complex hybrid products.

While Shariah encourages proper measures for safeguarding the resources and wealth of the societies as also of individuals, it draws a clear line between halal and haram and recommends avoiding doubtful things and activities[1]. Quran also warns that the ‘LIMITS’ (Hudood) set by Allah Almighty must not be breached (2:187). Risk-free returns stemming from riba and gharar that add no value to the wealth of the society tend to breach the ‘LIMITS’ set by the Almighty. The expresses permission of forward sale (bai al-salam) with specific conditions as imposed by the Holy Prophet (pbuh) himself, implies that "ambiguity" and "uncertainty" has to be differentiated from normal business risk for earning valid profits and avoidance from invalid gains.

Risk structure of financial institutions has close relevance with capital adequacy structure as required by the Basel for ensuring solvency and stability of global finance. To be considered adequately capitalized, Basel requires international banks to hold a minimum total capital equal to 8 percent of risk-adjusted assets.  Investments in exotic instruments could further heighten vulnerability of the IFIs. This is why, the IFSB indicated in its amended capital adequacy standard that as Islamic finance is closely linked to real assets, it is less prone to credit bubbles, and Islamic banks do not engage in highly speculative trading. However, as commodity prices could change, Islamic banks need to build up countercyclical capital buffers in good times as per the provisions of Basel III. It is incomprehensible, however, that the IFSB also indicated how to calculate the exposure to derivatives like profit rate swaps, the replica of interest rate swaps in conventional finance.

4.2       Available Risk Management Tools

Having conceded the point that proper risk management is a pre-requisite for a successful business, and Islam encourages both cooperative and managerial styles of risk management to avoid losses to life, limbs and property, the approach, the strategy and the processes of risk management need to be changed to make the financial sector a facilitator for real sectors of the national and global economies.  During last three decades, emphasis in global finance has shifted from balance sheet risk management to off B/S risk management, relying heavily on financial derivatives. For IFIs, balance sheet risk management is still vital due to prohibition of exotic financial derivatives.

The main rationale for using the derivatives is said to be risk management and hedging from the potential losses.  But distinction has to be made between the real business risk and the external risks created and traded without any accompanying real assets or projects. The internal risk that shariah allows to be managed by observing some general rules may be the credit risk, market risk, liquidity risks and the operational risks.  Such risks can be measured by applying various tools and techniques and managed keeping in view the nature of the transactions and the risks involved. It may involve proper reviewing, monitoring, communication, and regular feedback at all steps which are all Shariah neutral measures and hence allowed to be used. 

The principles of Islāmic finance offer different possibilities to manage risks other than just replicating the complex derivatives and conventional hedging products. The seminal source of injustice, exploitation and instability is the creation of purchasing power, money and credit irrespective of the availability and potential of goods and services. As Islamic financial institutions have to avoid interest, gambling and all such returns that accrue without taking due risk and making value addition, they must abstain from such financing / investments that are not backed by the useful assets or real economic activity. Creating private money by the banks by dint of fractional reserve system, or the central banks’ money issued to finance fiscal deficits without any increase in the goods and services in an economy could be the destabilizing factors for Islamic finance as in the case of conventional finance.

Any system that claims to be shunning interest and gharar must choose an alternative money creation and currency system that structurally eliminates interest and other exploitative returns as Islām, Catholic Church and other divine religions so require[2]. While Corporate Social Responsibility (CSR) is being discussed in the global finance, it’s more a pre-requisite for the IFIs that they must make it a part of their business. Taking one step ahead, they need to adopt stakeholders approach to include society and all its segments among the beneficiaries, and expand the scope of CSR to include the banking and finance sectors so that they are made to observe economic, ethical, legal, social and philanthropic responsibilities.  (Ayub M. 2015a).

Accordingly, the practitioners need to focus on choosing the truly compliant and the most adequate risk management tools that broadly include rahan (collateral), personal guarantee, pledge, hamish jiddiyah, promise, agency, khayyārāt (option to rescind any contract), parallel forward transactions like in salam, takāful, shart al jazā’ī in istisnāetc.  The non-systematic risks can be mitigated by ensuring cost effectiveness, by providing requisite training to the practitioners, by resorting to suitable takāful policies, by choosing good clients, by adopting suitable capital budgeting and by prudent and Sharī‘ah compliant liquidity management policies.

In addition to the permission for managerial types of risk management techniques, encouragement for the cooperative risk management measures is evident from the Holy Prophet’s approving the historical systems of al-nahd (النهد) (partnership in the provisions on mutual cooperation basis) and liking his 'ash`ari Companions who put forward a mutual help concept and practiced it in their life as explained by Imam Nawavi in Sharah Sahih Muslim16/62 :) (cf: JIBM, June 2013). Accordingly, IFIs in various areas and jurisdictions may establish risk study and awareness centres and cooperative risk management pools to be funded by their contributions for payment of claims of defined losses.

4.3       Effective Regulation, Implementation, Clarity & Surveillance Needed

Islamic banks need to adopt better management skills and operational systems to mitigate the risks of losses in their business. In addition to risk and capital structure management, providing for strong internal and external controls may create a more stable risk mitigation system. EY World Competitiveness Report 2013 indicated the weak risk culture a hindrance to sustainable growth of Islamic banking. Furthermore, effective regulation of the Islamic banking industry requires change in approach of the structural institutions and the regulators.

4.4       Developing Secondary Market for Islamic Finance Instruments

The dichotomy that exists between the objective of Shari’ah compliance and the need to compete in a conventional system can also be relieved through creation of an active secondary market for Islamic finance instruments. IFIs may exchange funds among themselves on the basis of mudaraba  instead of strengthening the interest based system by way of tawarruq and other ruses and this cannot be accomplished except with efforts of the regulators and global structural institutions like IDB, AAOIFI, IFSB and Shariah advisory and consultancy firms operating at broader levels.  Such means of obtaining liquidity could be through Tradable Inventory Certificates (Kahf and Maha M. Khan, 2015), securitization of both short and long term Islamic financial contracts and by developing Shari’ah approved liquid secondary market for these securitized instruments  (Vogel and Hayes 2006: 238).  The increased liquidity provided by such a market would relieve pressure on banks in fulfilling their liquidity function and lessen the pressure for risk mitigation while at the same time lowering the levels of required capital. 

5          Conclusion

The paper discussed that Islamic finance is fast on growth and innovations but slow on establishing its credibility. The practitioners as also the regulators generally think that by using synthetic and exotic products like organized tawarruq, financial derivatives and the returns swap procedure what some call “Sharī´ah Conversion Technology, they attract customers, but in reality they lose them in the long term (Ethica 2014). This emphasis on form over substance has led to abuse of Shariah principles to justify the contracts which undermine the objectives of the Shariah (Wajdi 2009). It has stopped journey of financial system to real sector economy to help resolve serious problems facing the economies. It seems that the tendency of a few Islamic scholars to lean towards conventional products has perhaps misled Islamic banking professionals in the wrong direction. A recent IMF Working Paper draws such conclusion while discussing the impact of Islamic finance, In theory, Islamic finance is resilient to shocks because of its emphasis on risk sharing, limits on excessive risk taking, and strong link to real activities. Empirical evidence on the stability of Islamic banks, however, is so far mixed. While these banks face similar risks as conventional banks do, they are also exposed to idiosyncratic risks, necessitating a tailoring of current risk management practices (Hussain M; WP/15/120).

The Muslim investors are becoming distrustful of sharī´ah compliant investment products: “They feel they are being given conventional products with Islamic labels”.  “Islamic financing is also subject to high judicial risk, as clients may turn to Shari’ah courts that rule on a case-by-case basis, as well as seek redress in regular courts” the IMF W/P cautions. A clear lesson is that IFIs have to avoid speculative exposures and all means for earning money on money. It is possible only if they abide by the rational principles of Islamic finance that ensure sustainable growth and halal returns, though lesser than the short term excessive and cyclical returns as experienced by the global finance industry during the last two decades.  However, they can use such conventional tools that do not conflict with the Shari’ah principles that may, inter alia, include internal rating systems, risk reports, internal control systems, external audits, maturity matching, and GAP analysis (Hussain; WP/15/120).

Sharī´ah compliance is the basic cause of coming into being of Islamic finance institutions and their ultimate objective; if it is not taken care of, there would be no need for any separate system within the conventional finance. Implementation of Islamic finance principles determines the level of Shariah compliance, in letter, in spirit, in both letter and spirit, or sometimes none of them. Financial derivative do not involve genuine sale / purchase and even the subject matter, except notionals, making shariah compliance doubtful even in legal sense; what to talk of the Maqasid. The ban on selling which one doesn’t have or on selling before possession implies that consequent upon a sale agreement, delivery has to be given and possession taken, implying that settling only the differences in prices is against the rules for valid transactions. Al-Bashir (2008: 299) concludes his book ‘Risk Management in Islamic Finance: An Analysis of Derivatives Instruments in Commodity Markets’ by contending that the forward, futures and options contracts in currencies, interest rate and stock indices are not permissible in Islamic law due to the clear involvement of ribā or excessive risk which is a form of gharar. He accepts the possibility of shares and commodities based derivatives and this is the area in which Islamic finance experts may explore on the basis of cushion provided by the Shariah by way of salam principles. Al-Bashir contends that development of a viable Islamic future market is possible if we adapt the conventional commodity forward contracts on the basis of salam principles. In this context he validly refers to the resolution of the Jeddah based Islamic Fiqh Academy [No. 107 (1/12) 23–28 September 2000] which maintained in its rejection of the forward contract in commodity that “if the subject matter in the forward contract is a commodity that need manufacturing, the transaction must fulfill the conditions of ’istiṣnāʿ. If does not need manufacturing, then the price must be paid in the spot and the transaction must fulfill the conditions of salam. However, if the price is not paid at the spot, the transaction will be illegal because it is a kind of baiʿ al-kāli bi al-kāli. On the other hand, if the transaction is just a promise and not binding upon either parties or at least one of   them, it will be permissible”.

Proper risk management involves and requires a clear policy and process of decision making, transpar­ency, properly availing the opportunities for profit, and overseeing the performance of the personnel involved along with accountability. For the IFIs, the risk of Shari'a non-compliance is also important and needs to be taken care of in addition to the common credit, liquidity and operational risks. It is imperative that the Shariah scholars and financial engineers abandon the practice of justifying non-Shari’ah compliance for commercial reasons and instead devote their intellect to deciphering the tools and products that are available in the Shari’ah. The dichotomy between developing Shari’ah based products and competing in the conventional market can be resolved by strengthening the regulatory regime(s), creating secondary market for Islamic finance, implementing Shari’ah based risk mitigation techniques, and strengthening internal and external controls and Shariah certification SOPs and procedures.  Banks may also diversify financing and investments for the purpose of risk mitigation.

Better risk management also requires better monetary management by the monetary authorities and the regulators to ensure that the human and material resources are diverted from speculative / exploitative activities to the real economy to help enhance wealth creation activities. The money or the purchasing power created at national and global levels must represent the present or the potential real assets in the spot and forward markets to ensure that all economic agents get return based on genuine risk-reward structures. The last but not the least is that the management and personnel of the IFIs should not become a part of the self-centered conventional business model, which "made it easier to operate in one's own narrow interests, without the usual feelings of empathy that alerts us to the pain of others and define us as humans." (Abdullah and Mirakhor, 2013). They must stick to some moral and rational principles to become flag bearers for prevention of harm to the human beings. Only then, we can persuade the global community to work for universal values for application of the ‘golden rule’ and equitable fair dealing[3]



 Abdullah, David Vicary and Abbas Mirakhor (2012); Moral Foundation of Collective Action against Economic Crime; paper presented at 30th International Symposium on Economic Crime; KL; September 3, 2012.

Ahmed, Habib (2011), Product Development in Islamic Banks, Edinburgh University Press, Edinburgh.

Ahmed, Habib and Tariqullah Khan (2007), ‘Risk Management in Islamic Banking,’ in M. Kabir Hasan and Mervyn K. Lewis (eds), Handbook of Islamic Banking (UK: Edward Elgar), 144 – 160. 

Al-Bashir, Muhammad al Muhammad al-Amine (2008); “Risk Management in Islamic Finance; An Analysis of Derivatives Instruments in Commodity Markets”; Brill’s Arab and Islamic Laws Series; Leiden and Boston.

Al-Suwailem, Sami Ibrahim (2006), Hedging in Islamic Finance, Occasional Paper No. 10, Islamic Research and Training Institute, Islamic Development Bank Group, Jeddah.

Archer, Simon and Rifaat Ahmed Abdel Karim (Editors)(2007), Islamic Finance The Regulatory Challenge, John Wiley & Sons (Asia) Party Limited, Singapore.

Arif, Mohamed, Munawar Iqbal and Shamsher Mohamed (2012), The Islamic Debt Market for Sukuk Securities, the Theory and Practice of Profit Sharing Investment, Edward Elgar, UK.

Auda, Jesser (2008); Maqasid al Shariah: A Beginner’s Guide; IIIT, London Washington. 

Ayub, M (2007); “Understanding Islamic Finance”; John Wiley and sons, London.

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Ayub, M; (2015a),“Financial Inclusion: Social Inclusion in its true perspective has to be the Target”, (Editorial); Journal of Islamic Business and Management, Vol.5; No. 1.

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Bateman, Milford and Ha-Joon Chang (2009), “The Microfinance Illusion” (University of Cambridge);  See also Milford Bateman, ed., Confronting Microfinance: Undermining Sustainable Development (Sterling, VA: Kumarian, 2011).

Bernardo Vizcaino (2015), IMF to include Islamic finance in surveillance; November, 11;

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Hussain M., Asghar Shahmoradi, and Rima Turk , IMF WP (2015); An Overview of Islamic Finance; WP/15/120  June;

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Jobst, A.A. and Juan Solé (2012); Operative Principles of Islamic Derivatives – Towards a Coherent Theory; IMF WP/12/63

Ismath Bacha, Obiyathulla (2004), ‘Value Preservation through Risk Management: A Shari’ah Compliant Proposal for Equity Risk Management,’ The European Journal of Management and Public Policy, vol. 3, No. 1 (65 – 83).

Kahf, Monzer and Mahah M. Khan (2015); Tradable Inventory Certificates: A Proposed New Liquidity Instrument; Islamic Economic Studies Vol. 23, No. 1, May, 2015 (1-31)

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[1] “What is lawful (halal) is evident and what is unlawful (haram) is evident, and in between them are the things doubtful which many people do not know. So he who guards against doubtful things keeps his religion and honour blameless, and he who indulges in doubtful things indulges in fact in unlawful things, just as a shepherd who pastures his animals round a preserve will soon pasture them in it. Beware, every king has a preserve, and the things Allah has declared unlawful are His preserves. …‏” (Bukhari, Vol 3, No 267). In another hadith, Prophet said that the person should leave what causes them doubt, for that which does not cause them doubt.

[2]As from 1971, money is created by making loans depending upon banks’ own reserve ratios and the discount rate, and through the purchase and sale of government securities by the central banks” (JIBM Editorial, June, 2015).

[3] For details on the need for such universal values, see: Abdullah, Daud Vicary and Abbas Mirakhor, ibid;

Posted on 13th December 2015 by Muhammad Ayub and Camille Silla Paldi

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