Islamic risk

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Shariah compliant banks generally face all of the same risks as conventional financial institutions, as well as several that are unique to Islamic finance.

Unlike conventional banks, Islamic banks share business risks with investors and borrowers. The fundamental difference between conventional and Islamic banking, from a risk perspective, is in the nature of risk sharing.

The profit sharing model in Islamic banking differentiates the nature of risk that the institution faces. This facilitates equitable distribution of profits and losses between depositors and banks or partners.

With returns on the depositor's investment offered on a profit sharing basis, they have an equal share in the business risks of the institution.

Similarly, financing based on Islamic tenets changes the nature of risks faced by Islamic institutions. While the conventional bank assures fixed rates on deposits, regardless of whether it makes profits or losses, the Islamic bank offers no such guarantees.

If the bank earns profits during the financial year, it offers depositors the agreed rates; conversely, if the year has brought in losses, depositors share the burden together with the bank. One of the most important risks unique to an Islamic bank is the risk of non-compliance with Shariah principles.

Finally, to quote from Al-Hawari, 1996, Islamic banks attach varying degrees of importance to the elements of capital, capacity, collateral, character and condition from that of conventional banks. The conventional bank may accord priority to the collateral, whereas the Islamic bank gives priority to the character of the customer.

The conventional bank is perhaps more interested in the capital and capacity, but the Islamic bank is focused on capacity rather than the capital. On the other hand, there may be some similarity between the conventional bank and the Islamic bank on the issue of priority attached to the security and soundness of a project submitted to the bank for financing.

Islamic banking - risks overview

In general, all risks faced by conventional banks are also relevant to Islamic banking organisations, and to a large extent the measurement of these risks and the mitigation techniques deployed are common.

The risks common to both conventional and Islamic banks include: liquidity risk, credit risk, market risk - both exchange and volatility, legal risk, and operational risk.

Risks unique to Islamic banks include: pricing risk under mark-up financing; commodity risk; ownership risk (assets owned as part of financing); reputation risk (for non-compliance with Shariah principles); counterparty risk in the case of Murabaha (declining to honour the 'promise to buy' agreement), Istisna (declining to honour the 'promise to accept the delivery' agreement), Salam (declining to honour the ‘supply on time and quality, quantity' agreement).

Risk compliance - current and emerging requirements for Islamic banks

The discussion herein excludes regular suspects such as compliance with Basel II, Sarbanes Oxley, IAS 39, IFRS, FAS 133, USA PATRIOT Act, Know Your Customer and Anti-Money Laundering; instead centring around environmental risk, information risk, and settlement risks.

To manage voluntary compliance standards for environmental practices, several organisations, including financial institutions, have adopted ISO 14000 standards.

Adhering to this standard implies outlining clear environmental goals and generating regular performance reports, though this is no guarantee of clean and efficient practices on the ground. The standard is about management systems and not about environmental pollution prevention.

Banks, including Islamic banks, must de-risk themselves by insisting that a corporate borrower is ISO 14000 compliant. ISO 14000 requires an organisation to establish an Environmental Management System (EMS) to accomplish the following: improve and monitor regulatory compliance, enhance internal management system efficiency, reduce waste, prevent pollution, and improve environmental performance.

ISO 14000 has legal implications that are not addressed in ISO 9000. It considers a broader array of interested parties, which includes banks, competitors, investors, ecosystems, lawyers, regulators, and suppliers.

Islamic banks, like other businesses, are potentially liable for environmental damage that their operations cause.

However, because banking operations are not pollution-intensive, pollution from their own operations is not the primary environmental concern, but their focus is on derived environmental liability through debt and equity transactions.

Poor environmental practices by banks' customers may reduce the value of collateralised property and/or increase the likelihood of fines or legal liability that reduces a debtor's ability to make payments to the bank.

Instances where banks have been held responsible and liable for contamination, where the banks held stakes in the form of secured interest are not uncommon (see cases involving Mellon Bank, Maryland Bank and Trust, and Fleet Factors Corporation).

In the US, several organisations have provided guidelines to banking and financial institutions to protect themselves from lender liability. These guidelines address the core of banks' environmental risk management practices.

Settlement risk management

Emerging standards and guidance issued to mitigate settlement risks are applicable to Islamic banks. Examples include Continuous Linked Settlement (CLS) and ISO 20022.

CLS eliminates the risk of paying one currency and failing to receive the other. With CLS, both sides of the trade are settled simultaneously on a Payment Versus Payment (PVP) basis. So, in effect, it is almost as final and certain as a domestic payment system.

CLS has far-reaching effects - not only because it eliminates settlement risk, but also because participants can significantly improve their liquidity management and reduce costs. CLS eliminates settlement risk, increases trading opportunities and reduces costly reconciliation.

Islamic banks can use CLS as a significant mitigation for settlement risk.

Prepared originally by the technical committee ISO/TC68 (as ISO 15022) dealing with banking, securities and related financial services, ISO20022 replaces the earlier standards - ISO 7775 and ISO 11521 and ISO 15022. Deemed mandatory by SWIFT, the new standard helps achieve straight through processing in financial transactions between organisations.

Apart from the traditional store and forward mechanism, the new standard aims at achieving straight through processing by online-real-time interaction with back end systems and with batch downloads and uploads.

Complex messages and business transactions can be handled with the new standard. The standard is significantly more business-oriented than the earlier message-oriented approach.

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