Dissertation Presented in partial fullfulment of the requirements of The Manchester MBA.

1. The University of Manchester
Manchester Business School
Risk Management in Islamic Financial Institutions
Mohamed Abdulla Ebrahim
Student registration number: 7396184
This dissertation is submitted in partial fulfilment
of the requirements for the degree of
Master of Business Administration.
0

2. A. DECLARATION
This work has not previously been accepted in substance for any degree
and is not being concurrently submitted in candidature for any degree.
Signed……………………………………………….
Mohamed Abdulla Ebrahim
Student number: 7396184
Date 4th April 2011
STATEMENT 1
The dissertation being submitted in partial fulfilment of the requirements
for the degree of MBA
Signed……………………………………………….
Mohamed Abdulla Ebrahim
Student number: 7396184
Date 4th April 2011
STATEMENT 2
This dissertation is the result of my own independent work/investigation,
except where otherwise stated. Other sources are acknowledged by
footnotes giving explicit references. A bibliography is appended.
Signed……………………………………………….
Mohamed Abdulla Ebrahim
Student number: 7396184
Date 4th April 2011
STATEMENT 3
I hereby give my consent for my dissertation, if accepted, to be available for photocopying,
interlibrary loans and for electronic access, and for the title and
summary to be made available to outside organizations.
Signed……………………………………………….
Mohamed Abdulla Ebrahim
Student number: 7396184
Date 4th April 2011
1

3. B. ACKNOWLEDGEMENTS
I would like to dedicate this work to Caliph/Imam Hassan Ibne Ali (A.S) fifth (5th) and last of
the Rightly Guided (Rashidun) Caliphs, the essence of whose life‟s work was to preserve the
unity of the Ummah of his grandfather the Prophet Mohamed (PBUH), the cost of which
included his abdicating from the role of Caliph to preserve this unity. One of his sayings which
inspires me and which I would like to share is “Teach others your knowledge and learn the
knowledge of other, so you will bring your knowledge to perfection and learn something you
did not know.”
I would like acknowledge the support and contributions of my family and friends who
influenced, encouraged and supported me to do this excellent MBA. I would like to mention the
contribution of my mother Late Mrs. Shirin Ebrahim, who pushed me to pursue excellence,
loved me unconditionally and inspired me to follow the path to actualise my talents and dreams.
I am thankful to two of my former employers during whose employ I started and completed the
process of attaining the Manchester MBA, namely Ernst & Young, Mombasa, Kenya, and
Credo Investments FZE, Dubai, UAE under whose employ I completed most of the academic
coursework and allowing leave me to attend the workshops as and when required.
I would like to record my appreciation to Dr. Antony Merna for his supervision of the project
and the support he provided during the course of completing this dissertation.
I am responsible for anything controversial in the dissertation, which is not meant to undermine
any school of thought/individual, as its objective is to increase knowledge.
Mohamed Abdulla Ebrahim
April 2011
2

4. C. ABSTRACT
Islamic finance (Capital Markets, Banking and Insurance) has emerged from a niche financial
market to the mainstream of finance. The geographic market, clientele served, products base and
volume of funds have grown significantly. Furthermore, the players have increased and now
include not only pure Islamic institutions but also hybrid players (conventional bank with
Islamic Finance windows). Therefore, not understanding the unique risks of the Islamic Finance
model (risk sharing and risk pooling) can cause a failure of the model igniting a financial crises
with a ripple effect on the Islamic faith. Hence, managing these unique risks is extremely
important.
Purpose / Perceived Value
To increase the academic knowledge base on Risk Management in Islamic Financial Institutions
and hope some useful insights would be obtained which in turn would lead to improvement in
risk management practices in Islamic Financial Institutions. This would explore the subject of
corporate risk management in the context of Islamic Financial Institutions, which are run on the
Islamic legal and economic system, which prohibits Riba (interest), avoids Gharar (uncertainty),
avoids Maysir (gambling or excessive speculation).
Methodology
Review material on risk management, Islamic finance and risk management in Islamic financial
institutions and their basis in academic and professional knowledge already written on. Analyse
disclosures in annual financial statements of three Islamic Financial Institutions and apply these
against a Risk Management framework. Carry out a Linkedin based pilot research survey on
Risk Management practices in Islamic Financial Institutions.
3

5. TABLE OF CONTENTS
S/No Title/Chapter From To
Page Page
Cover page 0 0
A Acknowledgements 1 1
B Declaration 2 2
C Abstract 3 3
1 Introduction 5 10
2 Risk Management 11 17
3 Islamic Finance 18 26
4 Importance of Risk Management in Islamic Financial Institutions 27 38
5 Analysis of Risk Management disclosures in Financial Statements 39 51
6 Analysis of responses from Linkedin pilot survey questioner 52 58
7 Conclusions and Recommendations for Further Work 59 62
8 Bibliography 63 63
4

6. Chapter 1: Introduction
1.1 Background
Risk Management is gaining momentum as a subject and a professional discipline in its own
right as distinct from Corporate Governance, Internal Audit/control, Financial Reporting and
Regulatory compliance to which it is closely aligned with. This has become pertinent as the
recent global financial crises (late 2007 to 2009) which has caused the deepest recession since
the Great depression which started in 1929 and continued to throughout the 1930‟s, has been
seen widely as a failure of financial institutions to manage the risks they undertook while
transacting business.
Islamic Finance has been one of the fastest growing segments of the financial sector. At one
time a common fallacy was Islamic Finance was less riskier than conventional finance, due to
the maxims of “al-kharaj bil dhaman and al-ghunm bil ghurm”, which basically propagate the
principle of „no risk no gain‟, very much underline the recognition of risk elements in Islamic
finance. (Zaid Ibrahim & Company)1. This dissertation shall endeavour to reflect the view that
Islamic Finance is simply different with its own unique set of risks which are neither more or
less riskier than other forms of finance.
A study undertaken by the International Monetary Fund (Cihak and Hesse, 2008)2 provides
empirical evidences which verify that Islamic finance is not necessarily more or less risky than
conventional finance. The study points out, that by having profit-loss sharing financing, this
shifts the direct credit risk from banks to their investment depositors. However, it also increases
the overall degree of risk of the asset side of banks‟ balance sheets, because it makes Islamic
banks vulnerable to risks normally borne by equity investors rather than holders of debt.
It was also pointed out that, because of their compliance with the Shariah, Islamic banks can use
fewer risk hedging techniques and instruments (such as derivatives and swaps) than
conventional banks. However, it is interesting to note that because of this prohibition against the
use of derivative products and short-selling activities in the form used by its conventional
counterparts, Islamic finance were largely shielded from exposure to „toxic assets‟ such as those
arising from collateralised debt obligations (CDO) and credit default swaps (CDS). But all is
was not well when the dust settled as Islamic Finance institutions like the Kuwait based Global
Investment House was technically in solvent.
1
Demystifying Islamic Finance – Correcting misconception, advancing value propositions Zaid Ibrahim & Co.
2
Islamic Banks and Financial Stability: An Empirical Analysis Martin Čihák and Heiko Hesse (2008) IMF working paper 0816
5

7. 1.2 Aim and Objectives
The aim of this dissertation is to explore the theory and practice of risk management in the
context of Islamic Financial institutions, which is a fast growing segment of the financial sector.
Islamic Finance is no longer a niche confined to Muslim countries in the Middle East, it is part
of mainstream finance, with London vying with Dubai and Kuala Lumpur to be the Capital of
Islamic Finance. It is believed that a lot of written material is available on both Islamic Finance
and Risk management but much less on Risk Management practices in Islamic Financial
institutions. Its aim is to show that Islamic Finance is neither more riskier nor less riskier than
conventional finance, it is simply different.
The Islamic Finance model is based on social justice as articulated in the Holy Quran and the
traditions, acts and sayings of Prophet Muhammad (PBUH). This system prohibits Interest-
Riba, excessive risk taking “Gharar” (Uncertainty, Risk or Speculation) is also prohibited and
dealing only in activities considered Halal. In essence it is based on universal ethics flavored by
a religious outlook.
Objectives
 To look at Islamic Finance and the unique risks it poses due to its principles and nature.
 To understand how these risks differ from risks in conventional finance,
 To review how these risks are currently being addressed
 How these practices can be improved.
1.3 Literature Review
The literature review would include among others the following sources
a) Published research on both Risk Management and Islamic Finance by international
organisations and professional firms like IMF, Ernst & Young etc.
b) Published books on Corporate Risk Management and Islamic Finance
c) Publication of articles on Islamic finance, Risk Management on the internet/websites.
d) Published articles related to Risk Management in Islamic Finance in Magazines.
6

8. 1.4 Research Methodology
To achieve the stated aims and objectives, the research methodology to be as follows:-
a) Questioner on Linkedin to Professionals and advisors working in Islamic finance on risk
management practices in Islamic Financial Institutions. The questions would be based on a
risk management model i.e. how risk identification takes place, and how these risks are dealt
with or should be dealt with in their opinion. This questioner will give an insight in current
practices in Risk Management and elicit opinion on the way forward. The following
questions will be put forward to be answered by the respondents.
Part 1 based on the Risk management cycle3 (Smith, 1995) comprises of the following
questions related to each component in accordance with your knowledge and experience
related to risk management practices in Islamic Financial institutions (IFI):-
1 Identification of Risks/Uncertainties
How are potential risks identified in the IFI you are familiar with?
Is there a formal process of recording potential risks?
Who is responsible for tracking risks undertaken by the IFI (CRO, FD, CEO, CFO)?
Are risk specific to a individual major transactions separately identified?
2 Analysis of Implications
How are the implications quantified?
Are risks quantified in accordance with how often they occur?
Are risks quantified as to severity i.e. potential of loss or impact on IFI?
To whom are these reported i.e. to the Board of directors or executive management?
3 Response to minimize risk
The following are the typical responses to minimize risk for an entity, please indicate in
your opinion the percentage of occurrences the particular response is chosen? Total 100%
Risk Avoidance (declining transaction)
Risk reduction (maybe by syndication)
Risk transfer (hedging or insurance)
Risk retention (accept the risk)
4 Allocation of appropriate contingencies
How is the desirable/acceptable level of risk determined?
How are resources allocated to ensure the overall risk level is acceptable?
Are contingency plans put place should the risk materialize?
If yes, how are these communicated to the members of the organization?
3
Corporate Risk Management – Tony Merna and Faisal F Al Thani 2nd edition 2010
7

9. Part 2 Objective is to elicit opinion on way forward on improving the practice of risk
management in Islamic Financial Institutions.
 In your opinion is the state of risk management practice adequate for the needs of the IFI,
you are familiar with?
 In your view what are the three key improvements that should be made to make the risk
management process better?
The following are the Global Top 10 risks as Identified in The Ernst & Young Business Risk
Report 2010 4(2009 rank in brackets), please rank the risks in your opinion as they apply to
Islamic Financial Institutions:
1. Regulation and compliance (2)
2. Access to credit/funding (1)
3 Slow recovery or double-dip recession (No change)
4. Managing talent (7)
5. Emerging markets (12)
6. Cost cutting (No change)
7. Non-traditional entrants (5)
8. Radical greening (4)
9. Social acceptance risk and corporate social responsibility (New)
10. Executing alliances and transactions (8)
b) Analytical synthesis of publicly available information regarding risk management in Annual
Reports of the following three Islamic Financial Institutions Meezan Bank (Pakistan), Al
Baraka Banking group (Bahrain but operating through out the Middle East and North
African region) and Khaleej Takaful - Insurance (Dubai) .
1.5 Limitations of the Research
The research is limited to the responses of members of Linkedin groups with interest in
Islamic Finance and to the publicly disclosed information in Annual Financial Statements of
the three selected Islamic Financial Institutions. Hence it will not be having information on
detailed risk management practices in the selected Institutions and in other Islamic Financial
Institutions. The opinion on the way forward will be limited to the views of the respondents
of the questioner.
4
The Ernst & Young Business Risk Report 2010
8

10. 1.6 Scope of Dissertation
The scope of the dissertation will be to explore the risk management practices in Islamic
Financial Institutions, by reviewing the currently published literature and responses on Risk
Management practices and propose a way forward to improve these practices. This will be
structured in chapters as described below:-
Chapter 2 - Risk Management
This will Introduce Risk Management, exploring what risk management can achieve to enhance
value to a business. Then I will introduce the concept of risk and uncertainty. Thereafter the risk
management process/cycle. Finally the available tools and techniques used to mitigate, share or
transfer risk.
Chapter3 – Islamic Finance
This chapter will introduce the reader to the background and general principles governing
Islamic Finance. Then each section will look at the different general products of Islamic Finance
which includes Islamic Banking, Islamic Insurance – Takaful and Islamic Capital markets.
Chapter 4: Importance of Risk Management in Islamic Finance
This chapter will attempt to identify risks unique to the Islamic economic model, the threats
posed by risks peculiar to Islamic Finance, how to deal with these risks identified,
Islamic financial instruments which may be considered both to aggravate risk and to
mitigate risk depending on the context.
Chapter 5: Analysis of Risk Management disclosures in Financial Statements
This chapter will present the analysis of the risk management disclosures in the financial
statements of Meezan Bank based in Pakistan, Khaleej Takaful an Islamic insurance company
based in Dubai, United Arab Emirates and Al Baraka banking group headquartered in Manama,
Bahrain but having a pan Arab base operating through various subsidiaries in Middle East and
North Africa region.
9

11. Chapter 6: Analysis of responses from Linkedin questioner
This chapter will analyse the responses from the Questioner for members of Groups on Islamic
Finance on Linkedin and CIMA Islamic Finance forum on their perception of Risk Management
in Islamic Finance Institutions and the Questioner for people working in Islamic Financial
institutions and are members of groups in Linkedin and CIMA Islamic Finance Forum. I shall
then endeavour to synthesis the findings of the analysis and suggest on the way forward to
improve practice of risk management in Islamic Financial Institutions.
Chapter 7: Conclusions and Recommendations for Further Work
This chapter will present a summary of the dissertation, its findings and draw conclusions. It
will also attempt to suggest the way forward to improve risk management practises in Islamic
Financial Institutions. Lastly it will make recommendation for further work in this area
especially the interplay between corporate governance and risk management in Islamic
Financial Institutions.
10

12. Chapter 2: Risk Management
2.1 Introduction
This chapter will give a background to risk management and its development as a discipline.
Thereafter it will look at the relationship between risk and uncertainty, from which the
dissertation will discuss the risk management process, finally it will discuss the tools and
techniques used. Risk Management has numerous definitions usually based on the context in
which it is being discussed among these are:
“Risk management is formal process that enables the identification, assessment, planning and
management of risk.” 5(Merna and Al Thani 2010)
COSO ERM defines enterprise risk management as a process designed to identify potential
events that may effect the entity, and manage risk to be within its risk appetite, to provide
reasonable assurance regarding the achievement of entity objectives. The process is effected by
an entity‟s board of directors, management and other personnel, applied in strategy setting and
across the enterprise. 6
ASNZ 4360 states that risk management is an integral part of good business practice and quality
management. The standard further specifies that risk management means inter alia identifying
and taking opportunities to improve performance as well as taking action to avoid or reduce the
chances of something going wrong.7
The Institute of Risk Management in its risk management standard says Risk can be defined as
the combination of the probability of an event and its consequences (ISO/IEC Guide 73). In all
types of undertaking, there is potential for events and consequences that constitute opportunities
for benefit (upside) or threats to success (downside). Risk Management is increasingly
recognised as being concerned with both positive and negative aspects of risk. Therefore this
standard considers risk from both perspectives.8
The common theme arising from the various definitions are that risk management is a
management process to deal with uncertainties faced by any entity, threats to its resources and
its consequences, as it chooses the opportunities presented by its operating environment, to
increase the value of the entity.
5
Corporate Risk Management 2nd edition Tony Merna and Faisal F Al Thani
6
COSO ERM
7
ASNZ 4360
8
A Risk Management Standard - http://www.theirm.org/publications/documents/ARMS_2002_IRM.pdf
(Assessed 26 February 2011)
11

13. 2.2 Risks faced by an Islamic Financial institution
Common risks faced by an Islamic Financial Institution are shown in Figure 2.1 (author‟s own)
below:
Risks faced by IFI’s
Credit Risk Price Risk Profit Rate Risk Pure Risks
Liquidity Risk
Commodity or Exchange
Damage to assets Legal Liability
Asset Price Risk Rate Risk
Price risk is the context of an Islamic Financial Institution is that the value of the underlying
commodity or asset which forms the basis of the contract between the Islamic financial
institution and the financed party will vary from the original price. The exchange rate risk arises
when the rate of exchange fluctuates for its funding and also financing transaction.
Credit risk is the uncertainty of the financed party being unable to meet its obligations to the
Islamic Financial Institution as and when they fall due. This is a speculative risk undertaken
with an objective of a gain, with the possibility of a loss.
Profit rate risk is the risk that the profit generated from partnership contracts will not be as
envisaged or the profit rate indicated to the institutions investment account holders will not be
sufficient or balanced. Furthermore, some investment account holders benchmark this profit rate
with interest rates offer by conventional banks, and can move their funds to conventional
financial institutions.
Liquidity risk arises due to two main reasons, firstly the inherent mismatch been the term of the
source of funds (deposits which are mainly short-term) and the destination of the funds (project
funding which are mainly long-term) and secondly the risk that the funds raised by the Islamic
Financial Institution from the Capital markets in form of Sukuk‟s and expected to be repaid and
at that point in time there is no appetite from buyers to purchase the new issue.
Pure risks are risks for which there is potential for only a downside and is best exemplified by
damage to owned assets or property and legal liability due to being sued by third parties like
customers and employees among others.
12

14. Key Drivers of Risk- Figure 2.2
(Adapted from A Risk Management Standard – Institute of Risk Management)
Externally Driven
Financial Risks Strategic Risks
Foreign Exchange Risk Competition
Interest Rate Risk/Profit rate Customer Changes and Demands
Credit Risks Industry Structure Changes
Liquidity and cash flow Research and product development
Internally Driven
Accounting controls Products and Services
Information systems Legal Contracts
National Culture and Regulations Property destruction
Operational Risks Hazard Risks
Externally Driven
13

15. 2.3 The Concept of Risk and Uncertainty
Risk is simply defined as a probability of a loss or gain. One situation is riskier than another if it
has a greater expected loss or a greater uncertainty (defined as the variability around the
expected loss).9 Therefore risk is linked to the quantum of loss or profit (risk reward ratio) i.e.
the probability of an event occurring causing either a gain or loss and how much the gain/loss
varies from the expected outcome which is an average.
Business inevitable has to undertake risk in its daily activities as perfect information is a myth.
Risk is usually thought of in respect of a negative event happening, the probability of it
happening and the quantum of the loss when it occurs. Uncertainty is said to exist in a business
transaction whereby the decision-makers lack complete knowledge, information or
understanding of the proposed transaction and its possible consequences.
In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established the
distinction between risk and uncertainty.10“Uncertainty must be taken in a sense radically
distinct from the familiar notion of Risk, from which it has never been properly separated. The
term "risk," as loosely used in everyday speech and in economic discussion, really covers two
things which, functionally at least, in their causal relations to the phenomena of economic
organization, are categorically different. The essential fact is that "risk" means in some cases a
quantity susceptible of measurement, while at other times it is something distinctly not of this
character; and there are far-reaching and crucial differences in the bearings of the phenomenon
depending on which of the two is really present and operating. ... It will appear that a
measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an
unmeasurable one that it is not in effect an uncertainty at all. We accordingly restrict the term
"uncertainty" to cases of the non-quantitive type.
9
Risk Management & Insurance 2nd edition Harrington and Niehaus
10
http://en.wikipedia.org/wiki/Risk accessed on 26 February 2011
14

16. 2.4 The Risk Management Process
Risk Management deals both with insurable as well as uninsurable risks and is an approach
which involves a formal orderly process for systematically identifying, analysing and
responding to risk events.1 (Merna & Al Thani 2010).
A diagrammatic representation of the Risk Management Process Figure 2.3 adapted from A
Risk Management Standard by the Institute of Risk Management4
Organisation’s Strategic Objectives
Risk Assessment
 Risk Analysis
- Risk Identification
- Risk Description
- Risk Estimation
Modifications  Risk Evaluation Formal Audit
Risk Reporting: Threats and Opportunities
Risk Treatment
Th
Residual Risk Reporting
Monitoring
Definitions
Risk Assessment: Is the overall process of risk analysis and risk evaluation.
Risk Reporting: Threats & Opportunities to Board of Director & affected Business Managers
Risk Treatment: Is the process of selecting and implementing measures to modify the risk.
Residual Risk Reporting: to its stakeholders on a regular basis setting out its risk management
policies and the effectiveness in achieving its objectives
Monitoring: This process provides assurance that there are appropriate controls in place for the
organisation‟s activities and that the procedures are understood and followed.
15

17. There are two major dimensions of a loss exposure are the loss frequency and loss severity.
Loss frequency is measured by probability of the occurrence of an event based on past
experience. Loss severity is measured by maximum possible loss and expected loss. Hence
classification of risk in accordance with these two dimensions is the starting point in managing
risk. In the view of business it is sensible to focus on exposures to risks rather than the potential
upside. The key exposures to risk in any organisation are physical asset exposures, legal liability
exposures, human resource exposure and financial asset exposures.
2.5 Risk Management Tools and Techniques
There are two major categories of risk management tools and techniques used by risk
professionals to analyse risk namely Quantitative techniques and Qualitative techniques, which
are applied to the dimensions of loss exposures. Qualitative techniques seek to compare the
relative significance of risk faced by an enterprise in terms of the consequences to it.
Quantitative techniques and tools attempt to determine absolute value ranges, using statistical
tools like probability distributions to quantify probable outcome.
Qualitative Techniques for risk management include Brainstorming, Assumption Analysis,
Delphi, Interviews, Hazard and Operability Studies (HAZOP), Failure Modes and Effect
Criticality Analysis (FMECA), Checklist, Prompt list, Risk Registers, Risk Mapping,
Probability Impact Tables, Risk Matrix Chart, Project Risk Management Road Mapping.
Quantitative techniques for risk management include Decision Trees, Controlled Interval and
Memory Technique, Monte Carlo Simulation, Sensitivity Analysis and Probability-Impact Grid
Analysis.
Other techniques include Soft Systems Methodology, Utility Theory, Risk attitude and Utility
Theory, Nominal Group Technique, Stress Testing and Deterministic Analysis, Tornado
Diagram, Country Risk Analysis and Political Risk Analysis.
Risk Control techniques include Risk Avoidance by not undertaking the activity which can lead
to a loss, Loss Control which include Loss prevention (reducing the frequency of losses) and
Loss reduction (reducing the severity of losses), Risk Separation this reduces the probability
that several losses will at the same time , Risk Combination/pooling increases the predictability
of losses through the law of large numbers and Risk Transfer which can include transferring the
cause of the risk, transferring the risk itself, transferring the cause of the risk and transferring the
consequence of the risk through insurance.
16

18. Contracts can be used to mitigate or transfer risk like insurance contracts for hazard (pure risks
like theft, fire etc), derivative contracts (options, forwards, futures and swaps) to mitigate
against financial risks like commodity prices, foreign exchange risks, interest rate risks and
contracts where risk is transferred to the counterparty through legal clauses.
The choice of the technique whether to assess the risk or alter the risk depends on the context of
the situation, availability and the resources including time and money to the organisation.
Hence, there is no one set of techniques to ensure universal applicability.
2.6 Summary
Risk management should be embedded within the organisation through the strategy and budget
processes. It should be highlighted in induction and all other training and development as well
as within operational processes e.g. product/service development projects. The Board has the
overall responsibility for determining the strategic direction of the organisation and for creating
the environment and the structures for risk management to operate effectively. There should be
a risk champion on the board to ensure the board is aware of the risks under taken by the entity
and decide whether these are acceptable. Business unit managers s have primary responsibility
for managing risk on a day to-day basis, hence risk management should be a regular
management-meeting item to allow consideration of exposures and to reprioritise work in the
light of effective risk analysis. The same awareness of risk issues is also required for those
involved in the audit and review of internal controls and facilitating the risk management
process and includes both the internal audit function and external auditors.
17

19. Chapter 3: Islamic Finance
3.1 Introduction
Islamic finance constitutes the fastest growing segment of the financial system in the world.
Modern Islamic banking started about three decades ago, the number and reach of Islamic
financial institutions worldwide has risen from one institution in one country in 1975 to over
300 institutions operating in more than 75 countries (El Qorchi, 2005)11. In Sudan and Iran, the
entire banking system is currently based on Islamic finance principles. However the roots of the
Islamic Banking system goes back back through time to the profit and loss sharing principles in
the Code of Hammurabi in the 18th century BCE. Over the centuries, philosophers and
theologians alike have debated the issues surrounding justness of exchange and the charging of
interest. Charging of interest is long seen as damaging to individuals as well as the economy by
the majority of theologians and philosophers. Even the Christian Holy Bible and Jewish Holy
Torah forbid Usury. This chapter will explore the general principle of Islamic Finance, briefly
going into the sources of Islamic Law without going into the details of the various schools of
thought which are contentious issues even among Islamic scholars depending on whether they
are Sunni or Shia, region from which they come from (scholars from some regions are more
liberal than others). There are Islamic Scholars who have approved derivative s contracts
(forward, swaps and options), while other scholars consider these as unlawful. An example
would be HH Prince Karim Aga Khan IV Imam to Nizari Ismaili Shia Muslims, direct lineal
male descendant of the Prophet Mohamed (PBUH) and widely respected in the Muslim
community worldwide has a different opinion on the interest which is not usury therefore not
“Riba” which is prohibited in the Quran, hence he has significant interests in conventional
banking institutions both in the developed and developing world, which is significantly altering
the economic lives of people living in those countries. In the other end of the Shia spectrum lies
the Mustali Ismaili Shia Muslims, in whose view even instalment sale contracts where the
current cash price and instalment sale price differ is considered unlawful and profit loss sharing
without the investor being actively involved in the business is prohibited, This based on the
principle, all earnings have to be from the individuals sweat, law of one price and avoidance of
excessive profit. Then it will give a bird‟s eye view of Islamic Banking, which is a banking
system that is based on the principles of Islamic law and guided by Islamic economics. Two
basic principles behind Islamic banking are the sharing of profit and loss and, significantly, the
prohibition of the collection and payment of interest. Collecting interest is not permitted under
Islamic law.
11
IMF Working Paper WP/08/16 Islamic Banks and Financial Stability: An Empirical Analysis
Prepared by Martin Čihák and Heiko Hesse
18

20. Thereafter, we shall take a peek into the world of Islamic insurance – Takaful, which is based
on risk pooling and sharing rather than risk transfer. Takaful is where members contribute
money into a pooling system in order to guarantee each other against loss or damage. Takaful is
based on Islamic religious law, and is based on the responsibility of individuals to cooperate and
protect each other. Lastly, it will explore Islamic Capital Markets products the most well know
is the Islamic bond called a Sukuk. Since interest is prohibited Sukuks must be able to link
the returns and cash flows of the financing to the assets purchased, or the returns generated from
an asset purchased. This is because trading in debt is prohibited under Sharia. As
such, financing must only be raised for identifiable assets. It can be compared to a sale,
lease/rent and buy back transaction in conventional finance.
3.2 Islamic Finance general principles
The guiding principles of Islamic Finance are based on Islamic Law (Sharia) as documented in
the Holy Quran and promulgated in the Sunnah (Hadith - sayings and living habits/acts of
Prophet Mohamed (PBUH), which are universally accepted by all Muslims. Different schools
of jurisprudence both Sunni and Shia place different level of emphasis on secondary sources
like Ijma (consensus of Scholars), Ijtihad (independent legal reasoning), Qiyas (analogical
deduction), Aql (use intellect to find general principles applicable in the situation from the Holy
Quran and Sunnah ), saying and acts of Shia Imams who are descendents of Prophet Mohamed
–PBUH according to Shia beliefs they are responsible for guiding the Muslims ummah and
interpreting the Holy Quran according to the changing time and space, Urf (common practices
of a given society not addressed in the Holy Quran and Sunnah) and Al-Maslaha Al-Mursalah
(Maliki Sunni) "underlying meaning of the revealed text in the light of public interest". 12
Islamic Finance is based on the prohibition of interest ("Riba"), excessive uncertainty
("Gharar") and gambling ("Maysir" or "Qimar"). Being Sharia compliant also means that the
funding should not be for the purposes of haram (prohibited activities) like pornography,
building a brewery or casino or a pork farm etc. Judaism and Christianity also prohibit usury
(interest) in their religious texts the Torah and Bible respectively. Holy Quran commands honest
fulfilment of all contracts (al-Maidah: 1); prohibits the betrayal of any trust (al-anfal: 27);
forbids the earning of income from cheating, price manipulation, dishonesty or fraud (an-nisa‟a:
29); shuns the use of bribery to derive undue advantage (al-baqarah: 188); and promotes clarity
in contracts to minimise manipulation from dubious ambiguity (al-baqarah: 282)
12
http://en.wikipedia.org/wiki/Sources_of_Islamic_law (accessed 14th March 2011)
19

21. 3.3 Islamic Banking
The roots of Islamic banking goes to the time of the establishment of the Islamic Arab empire -
the Caliphate which conquered vast areas in Middle Central Asia, North Africa and parts of
Europe in the 7th Century, where systems of payments and finance were required which
included Qardan Hasannah (interest free loan), Hawallah (promissory notes/ bills of exchange),
a currency (Dinar), Waqf (trusts), to facilitate trade and mercantilism and pay the employees of
the Islamic state. However, this dissertation shall focus on modern Islamic banking, which is
based on the following concepts - Definitions adapted from FAS 1 issued by AAOIFI13:-
Mudarabha - A partnership in profit between capital and labour. It may be conducted
between investment account holders as providers of funds and the Islamic bank as a
mudarib. The Islamic bank announces its willingness to accept the funds of investment
amount holders, the sharing of profits being as agreed between the two parties, and the
losses being borne by the provider of funds except if they were due to misconduct,
negligence or violation of the conditions agreed upon by the Islamic bank. In the latter
cases, such losses would be borne by the Islamic bank. A Mudarabha contract may also
be concluded between the Islamic bank, as a provider of funds, on behalf of itself or on
behalf of investment account holders, and business owners and craftsmen.
Salam : - Purchase of a commodity for deferred delivery in exchange for immediate payment
according to specified conditions or sale of a commodity for deferred delivery in exchange for
immediate payment.
Murabaha : - Sale of goods with an agreed upon profit mark up on the cost. Murabaha sale is
of two types. In the first type, the Islamic bank purchases the goods and makes it available for
sale without any prior promise from a customer to purchase it. In the second type, the Islamic
bank purchases the goods ordered by a customer from a third party and then sells these goods to
the same customer. In the latter case, the Islamic bank purchases the goods only after a customer
has made a promise to purchase them from the bank.
Musharaka : - A form of partnership between the Islamic bank and its clients whereby each
party contributes to the capital of partnership in equal or varying degrees to establish a new
project or share in an existing one, and whereby each of the parties becomes an owner of the
capital on a permanent or declining basis and shall have his due share of profits. However,
13
Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)
http://www.aaoifi.com/aaoifi/Definitions/tabid/209/language/en-US/Default.aspx (accessed 14 March 2011)
20

22. losses are shared in proportion to the contributed capital. It is not permissible to stipulate
otherwise.
Istisna’a : - A contract whereby the purchaser asks the seller to manufacture a specifically
defined product using the seller‟s raw materials at a given price. The contractual agreement of
Istisna‟ has characteristic similar to that of Salam in that it provides for the sale of a product not
available at the time of sale. It also has a characteristic similar to the ordinary sale in that the
price may be paid on credit; however, unlike Salam, the price in the Istisna‟ contract is not paid
when the deal is concluded.
Ijarah and Ijarah Wa Iktana:- A lease agreement (similar to a hire purchase agreement)
whereby instead of lending money and earning interest, the Islamic bank purchases the asset and
rents it to the party requiring the asset and earns rental income. In ijarah wa iktana the renter
agrees to buy the asset at a nominal price at the end of the contract, in ijarah there is no such
agreement to purchase the asset.
3.4 Islamic Insurance – Takaful
Takaful is an Arabic word meaning guaranteeing each other. An Islamic insurance
(Takaful) industry observing the rules and regulations of Islamic Sharia law has
developed in recent years, which in common with Islamic banking avoids interest,
excessive uncertainty and gambling. However this concept has been practiced in various
forms for over 1400 years based on shared responsibility in the system of aquila as
practiced between Muslims of Mecca and Medina, which laid the foundation of mutual
assistance insurance – Takaful based on risk pooling and sharing today. Although some
Muslim scholars consider any form of insurance to be against the concept that Muslims
believe in God, who is the provider and sustainer of all and is based on the following
verse from the Holy Quran “Who, when a misfortune overtakes them, say: 'Surely we
belong to Allah and to Him shall we return'.". (Sura Al-Baqara, Verse 156)
Takaful is based on the concept of social solidarity, cooperation and mutual
indemnification of losses of members. It is a pact among a group of persons who agree
to jointly indemnify the loss or damage that may inflict upon any of them, out of the
fund they donate collectively. The Takaful contract so agreed usually involves the
concepts of Mudarabah (partnership in profit), Tabarru´ (to donate for benefit of others)
and Ta-Awun (mutual assistance or sharing of losses) with the overall objective of
21

23. eliminating the element of uncertainty. Even though all Muslims believe in the will of
Allah who is the owner of everything and we are merely his stewards, the steward had a
duty to protect the assets given to him in trust by the owner, hence justification for a
Sharia compliant Islamic alternative Takaful to conventional insurance. This view point
for Takaful is justified based on the following Islamic jurisprudence sources14.
Basis of Co-operation Help one another in al-Birr and in al-Taqwa (virtue, righteousness and
piety): but do not help one another in sin and transgression. (Holy Quran Surah Al-Maidah,
Verse 2) and Allah will always help His servant for as long as he helps others. (Hadith Narrated
by Imam Ahmad bin Hanbal and Imam Abu Daud)
Basis of Responsibility The place of relationships and feelings of people with faith, between
each other, is just like the body; when one of its parts is afflicted with pain, then the rest of the
body will be affected. (Narrated by Imam al-Bukhari and Imam Muslim)
One true Muslim (Mu‟min) and another true Muslim (Mu‟min) is just like a building whereby
every part in it strengthens the other part. (Narrated by Imam al-Bukhari and Imam Muslim)
Basis of Mutual Protection: - By my life, which is in Allah‟s Power, nobody will enter Paradise
if he does not protect his neighbor who is in distress. (Narrated by Imam Ahmad bin Hanbal)
Key Elements of Takaful
Mutual Guarantee: Loss covered by donations of members in fund which pays out losses.
Ownership of Fund: Contributors are owners of fund, hence entitled to the profit.
Elimination of uncertainty: Donations are voluntary and no pre-determined benefits.
Management of Takaful Fund: Operator uses either Mudaraba (Partnership) or Wakala
(Principal Agent relationship ) contract to manage funds, which are Sharia compliant.
Investments Conditions: Avoids interest and haram (prohibited) activities for investment.
14
http://en.wikipedia.org/wiki/Takaful (accessed on 14 March 2011)
22

24. 3.5 Islamic capital markets
There are two major components of Islamic capital markets namely Sukuk‟s (Sharia compliant
bonds) and Islamic investment funds. Using the double entry sheet terminology the Sukuk sits
on the credit side of the balance sheet hence is a liability, while Islamic investment funds sit on
the debit side of the balance sheet hence an asset. Both the capital market instruments are
market traded on organised stock exchanges, with some restrictions on the tradability of debt
instruments.
Sukuk is the Arabic word for financial certificate, commonly analogous to a bond (promise to
pay) in conventional finance. It is asset based rather than asset backed to comply with sharia
requirements. The beauty of the Sukuk lies in asset securitisation, whereby future cash flows
emanating from an asset are converted into present cash flow. A sukuk can be created on an
existing asset and also on a future asset which is being created. The sukuk can be structured as
Sukuk Murabaha which constitutes partial ownership in a debt, Sukuk Al Ijara which is asset
backed, Sukuk Al Istisna which is project backed, Sukuk Al Musharaka which is business
backed or Sukuk Al Istithmar which is an investment. From a strict sharia perspective debt
certificates are not tradable at a price other than at par or face value, as any money generated
from holding money is considered interest which is prohibited, hence most sukuk instruments
are held to maturity. Therefore the secondary market although in exists but has limited trades.
An Islamic investment fund is a Sharia compliant fund which invests in halal activites, avoids
excessive uncertainty, avoid interest and is not overly speculative (gamble). These can be
structured as a mutual fund, a hedge fund or electronic traded fund (ETF).
The common types of investments funds are commodity funds, equity funds, murabaha
funds and Ijara funds.
Commodities funds generate profits by buying and reselling commodities. Due to the
restrictions on the use of derivatives, commodities fund make use of two types of contracts:
1. Istina‟a- It‟s a contract where the buyer of an item funds upfront the production of the
item. A detailed specification of the item as to be agreed before production starts and
the cost of production has to be paid in full when the contract is agreed.
2. Bay al-salam which is similar to a forward contract where the buyer pays in advance for
the delivery of raw materials or tangible goods at a later date.
Equity funds invest in equity shares of companies engaged in halal business activities. These are
similar to ethical investing funds.
23

25. Murabaha funds are similar to development funds, and use the „cost-plus‟ financing model,
where a fund will buy goods and sell them to a third party at a given price. The price is made of
the cost of goods plus a profit margin.
Ijara Funds acquire and keep ownership of an asset (real estate, machinery, vehicles or
equipment) and then makes profits by leasing it out in return of a rental payment. The fund is
responsible for the management of the assets and will earns a management fee. This is similar to
Real Estate Investments Trusts (REITs) and Energy Royalty Trusts (common in Canada).
3.6 Differences between Islamic Finance and Conventional Finance instruments
Sukuk and Bonds
Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) defines a
sukuk as being: “Certificates of equal value representing after closing subscription, receipt of
the value of the certificates and putting it to use as planned, common title to shares and rights in
tangible assets, usufructs and services, or equity of a given project or equity of a special
investment activity”. Hence, it is a mezzanine financial instrument that is neither debt nor
equity, created by a process of securitization of cash flow and ownership of an asset or project.
The sukuk holder shares in the cash flow generated by the asset and the disposition proceed of
the assets. A bond on the other hand is a contractually obligation to pay to bondholders, on
certain specified dates, interest and principal.
Takaful and Insurance
Takaful is based on the principles on mutual assistance and voluntary contribution in a pool of
funds to be shared among those in the group afflicted by perils or calamities, without guarantees
that the fund will be adequate of expectation that the operator will earn a profit. In conventional
insurance the insurer collects premium from the insured to cover expected payout and profit,
this is akin to speculation (Maysir) which is forbidden in Islamic Finance. The insurer pays
premiums to be covered for risks that may or may not materialize, this is uncertainty (Gharar),
which is also forbidden in Islamic Finance. Lastly, the premiums collected are invested to earn
interest (usury) which is forbidden in Islamic Finance.
3.7 Summary
The basic principles underlying the Islamic Finance concept are very similar to ethical
investing, co-operative arrangements, and mutual principles, very closely aligned to
conventional financial products but avoiding interest, excessive uncertainty and speculation.
24

26. Chapter 4: Importance of Risk Management in Islamic Finance
4.1 Introduction
Product complexity in Islamic Finance has increased as there is a trend to develop an Islamic
variant for most products in non-Islamic finance, but the pace in risk management practices has
not developed at the same rate. This has been attributed (Ahsan Ali, December 2009)15 to the
following:-
 Lack of Standardised product descriptions and attributes within Islamic Finance.
 Lack of understanding of Islamic structures and therefore, weak regulatory frameworks
within countries to manage Islamic Financial Institutions (IFIs).
 Limited data on Islamic transaction and low technological adaptability for technology-based
risk management models.
 Concentration of Islamic Finance institutions in emerging markets, where the risk
management techniques for both conventional and Islamic modes of financing lag the
developed markets.
Due to the above reasons it is (Ahsan Ali, 2009)15 postulated that Islamic Financial Institutions
are inherently riskier propositions than their conventional counterparts.
The above arguments can be countered by the following:-
 Standardisation of product descriptions, Islamic Finance Structures and accounting
attributes are taking places through the efforts of Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB).
However, having two bodies with similar objectives and membership of which is voluntary
by Islamic Financial Institutions creates confusion in the perception of the general public.
Furthermore, there is weak enforcement capability as these organizations do not have
credible sanctions mechanisms, to enforce application of standards set.
 Islamic Finance is no longer confined to the developing world as London and New York are
becoming major centers for Islamic Capital Market products, hence risk management
techniques are improving and technological developments will catch up.
 The data availability is increasing especially in Malaysia and Gulf markets, with
publications like Business Islamica, Gulf news quarterly and Global Islamic Finance.
15
Risk Management Integral to the Future of Islamic Finance – Article in Business Islamica December
2009
25

27. Risk management in Islamic Finance is driven by the principles of Islamic economics which are
derived from the Holy Quran and Sunnah of Prophet Mohamed (PBUH). Hence it is prone to
the usual risks faced by all financial institutions plus risks which affect primarily Islamic
Financial Institutions. The importance of the concept of risk management in Islamic Finance is
emphasised by the following verse in the Holy Quran and Saying of Prophet Mohamed (PBUH)
Further he said: "O my sons! Do not enter the capital of Egypt by one gate: but go into it by
different gates. However know it well that I cannot ward off you Allah‟s will for none other
than He has nay authority whatsoever. On Him do I put my trust and all who want to rely upon
anyone should put their trust on Him alone." (Surah Yusuf: Verse 67)
Prophet Muhammad noticed a Bedouin leaving his camel without tying it and he asked the
Bedouin “Why didn‟t you tie down your camel?” The Bedouin answered, “I put my trust in
God.” Muhammad replied, “Tie your camel and put your trust in God.”
In this chapter the author shall identify risks faced by Islamic Financial Institutions, look at risk
affected due to its economic model or how normal business risks uniquely affect them. Then the
author shall look at threats posed by these risks and consequently how those risks can be dealt
with. Finally it shall discuss Islamic Financial Instruments which are used in Islamic Finance
which mitigate certain risks but create a different type of risk for an IFI.
4.2 Identification of risks in the Islamic Finance economic model
Credit Risk
This is the risk whereby the borrower defaults on the loan. In the Islamic Financial Institution‟s
(IFI‟s) context this means the counter party defaults on its contractual obligation and the IFI has
to foreclose on the underlying asset, this becomes particularly challenging in the instance of
residential real estate instalment sale transaction, which would conflict with its responsibility to
society. It is important to note that IFI‟s generally have greater exposure to real estate than
conventional banks, where the bank becomes owner of the asset which according to IFRS this
needs to be incorporated on its balance sheet, which creates additional volatility in its reported
earnings. Furthermore greater focus on asset financing through Ijara (leasing) and Murabaha
(sale with profit mark-up), may cause a tendency to overlook credit worthiness and ability to
repay of the counterparty.
Market Risk
Hedging using conventional derivatives is restricted, as some scholars consider it to be Maysir
(gambling) which is prohibited, hence the possibility of a higher than normal margin risk
26

28. especially in fixed margin Murabaha (sale with profit mark up) i.e. mismatch between what is
earned on the assets and what is paid out on its investment accounts. These restriction leads to
artificial inflation of values of investment opportunities as too much capital is chasing too few
assets. Furthermore, IFI‟s run a higher foreign exchange risk on their balance sheets particularly
translation risk for banks with operation in multiple countries, which have to be consolidated as
per IFRS requirements, due to limited opportunities to hedge.
Operational Risk
IFI‟s have to ensure correct processing and sequential documentation for most of its
transactions, as any error invalidates the entire transactions and profit has to be donated.
Liquidity Risk
This is higher in IFI‟s as the secondary market for Islamic Capital market instruments is
underdeveloped, due to prohibition in sale of debt at a price other than at par. Thus most Islamic
Capital market instruments are held to maturity, which restricts the ability to realise cash when
required repay investment account holders, hence a minor run on an IFI can have a major effect
on its solvency, as it cannot access its central bank as lender of last resort.
Reputational Risk
This is higher in IFI‟s due to the risk of Sharia compliance requirements, while Sharia decrees
and decisions are not standardised or follow the principles of judicial precedence as in English
common law. Sharia boards are made up of scholars, who sometimes disagree on products lines
like Tawaruk (Shariah-compliant of finance through which loan finance is raised by buying
installments in local commodities that are owned by the bank) which is acceptable to certain
scholars and prohibited by others. The Sharia board of an IFI can be changed to get scholars
who are compliant to the wishes of the IFI‟s owners, hence they could be accused of “scholar
shopping or fatwa shopping” which has the potential to damage its reputation in the eyes of
Investment Account holders. This happened in Dubai during the recent global financial crises
when some real estate developers wished to change the underlying assets of instruments in a
process of consolidation of projects, which were considered unacceptable to certain scholars.
Furthermore, fatwa‟s issued by prominent scholars not on the IFI‟s Sharia board also tend to
influence behaviour of market participants.
27

29. Classical Islamic Law 16 classified risk in into three categories as follows:-
1. Essential risk and al-kharāj bi-dhaman, which can be roughly translated as „the profit belongs to
him who bears responsibility‟. This maxim encapsulates the concept of risk for return (al ghunm
bil ghurm). Parties who enter into an agreement are entitled to its benefit as long as there is
some form of associated risk. Without the risk, the transaction would not be shari‟a compliant.
Any condition to the contrary would make the transaction void, such as anything contrary to the
rule on a total or partial loss or decrease in value of an asset is on account of its owner). If one
requires a return of some form, then one should be able to take on the associated level of risk. In
an Islamic sales contract, the seller bears all the risks of loss of the asset until title is transferred
to the buyer who then in turn takes on the full risks, including risks of defect, damage or
depreciation arising thereafter. In an Islamic leasing arrangement, the lessor assumes all risks of
loss (not caused by the lessee) and the risks of maintenance and payments of taxes. Whereas the
lessee assumes the risks of rental payment, of any loss of profit and of under-utilisation
associated with the rental of the asset. In a mudaraba arrangement, the risk of loss, damage or
decrease in value of the mudaraba assets and capital is borne by the investor (rab al mal) as long
as there is no default, misconduct or breach by the investment manager (mudarib).
2. Gharar Katheer, which can be roughly translated as „excessive/gross uncertainty or speculation‟.
Muslims are strictly prohibited from entering into this second category of risks as such risks
make a transaction or a contract void from a shari‟a perspective. Whereas in conventional
finance, this is a form of tradable risk which can be separated and sold on, or, which can be
mitigated against. This form of risk is also known as gharar jaseem and it can be further
classified into the following sub-types of prohibited risks:
a. Risk in Existence (i.e., the sale of an non-existent item, such as crops, on a future basis);
b. Risk in taking Possession (i.e., the sale of a run-away camel or commodity / property that
has to be repossessed);
c. Risk in Quantity (i.e., sale price or rent being unknown in a sale or lease contract);
d. Risk in Quality (i.e., type, quantity or specifications of the subject matter of contract being
unknown); and
e. Risk in Time of Payment (i.e., a deferred sale without fixing the exact period).
16
Islamic Finance project Harvard Law School, Islamic Legal Studies Program, Harvard-LSE Workshop London
School of Economics 26 February 2009 Workshop on Risk Management: Islamic Economic and Islamic EthicoLegal
Perspectives on the Current Financial Crisis – A short Report Prepared by Husam El-Khatib Introduction by Zohaib
Patel.
28

30. Involvement of any of the above types of risks make contracts of consideration or exchange
(aqood al muawadat) void with the unanimous opinion of the jurists. In contracts of gifts or
donations (aqood al tabarro‟at), the majority of jurists are of the opinion that these risks make
such forms of contracts void, with the exception of Maliki jurists who view risks in contracts of
gifts are permissible. From this Maliki opinion, contemporary jurists have derived that takaful is
permitted despite containing Risks in Existence, Possession, Quantity and Period.
These risks are deemed excessive and gross in nature as they fall into the categories of gambling
and speculation, being some of the causes for the current global financial crisis. Short sales for
instance are prohibited on the basis they fall foul of the rule on Risk of Possession; they involve
the sale of something (i.e., shares) which are not owned by the seller at the time of the initial
sale. Also, the sale and trading of debt falls foul of the above prohibited categories of risks as
such activities carry with them additional („gross‟) levels of risks, such as the possibility of non-
payment of the debt by the actual debtor.
An important corollary to the prohibition on excessive risk is that shari‟a does not permit a party
to intentionally take on such forms of excessive risks and then to hedge against those same risks
with the help of some form of hedging or risk management tool, irrespective of whether the
actual hedging/risk management tool is shari‟a compliant in itself or not.
3. The third category can be described as a level in between the former two. This can include a
variety of forms of risk, including market risk and operational risk. This is not a risk that is
part of a financing tool‟s inherent structure per se. Therefore, this type of risk can be
mitigated against or avoided.
4.3 Threats posed by risks peculiar to Islamic finance
Insolvency
The threat of insolvency is higher than average due by lack of liquidity in Islamic asset
instruments and securities due to an under developed secondary markets and lack of access to
central bank as lender of last resort in case of a run by investment account holders on the
Islamic Financial Institution. This happens because of the mismatch of maturity term between
Investment account deposits and the longer term financing arrangements. Also most
instruments are held to maturity due to prohibition on sale of debt other than at par, so when
there is a short-term liquidity crunch its effects are more severe unless its owners have funds
elsewhere to provide liquidity, which the usual response is to withdraw from other markets
causing a domino effect.
29

31. Reputational Damage to the Islamic Finance Brand/Segment
Due to the fragmented nature of Sharia decisions and decrees, which are developed
independently by scholars in different markets, without having judicial precedence
requirements, with some scholars from different schools of thought being more liberal than
other, widespread acceptance is difficult, especially for controversial issues. This prevents an
orderly development of standards of product development and financial reporting. A point to
note is that IFI‟s are required to confirm to the financial reporting framework of its country of
operation. A general fatwa by prominent scholar not on a particular IFI‟s Sharia board can
cause loss of credibility and confidence by the consumers if he makes a compelling argument in
public about a particular transaction or product developed and IFI and approved by its Sharia
board. This is a controversial issue for Islamic Credit card issuers (fixed fee based) and process
on changing underlying security for a sukuk or project funding transaction in the event of real
estate project consolidation on the crash in real estate market. This is compounded by lack of a
universally accepted body for determining mandatory product standards and financial reporting,
plus membership of AAOIF and IFSB is voluntary. In short the risk borne by an IFI is product
is approved by its Sharia board, but vocally disapproved by a leading scholar, causing a
reputational disaster in the perception of the public, aggravated if the scholar was a dissenting
former member of the Sharia advisory board.
Greater potential for volatility of reported earnings
IFI‟s financial statements if prepared and compliant with International Financial Reporting
Standards (IFRS) have to report financial instruments and assets using “mark to market”
principles, due to the requirement of ownership of assets which have to be reported on the
balance sheet and movement in value passing through the income statement, caused profits to
fluctuate more than conventional financial institutions. This aggravates during economic
downturn, as not only are the financial instruments subject to downward valuation, also losses
on assets which will eventually be sold to counterparties.
Operational Risk - Contracts
Islamic Finance transactions are subject to multiple contracts to make them compliant with
Sharia rules, the threat of misclassification of a transaction can lead to a requirement for
different type of contract which if missed would negate the entire transaction i.e. making it non-
Sharia compliant. This is further compounded by lack suitable trained finance personnel in
Sharia Law and Sharia scholars suitably trained in finance to structure Islamic Financial
transactions appropriately.
30

32. 4.4 How to deal with the risks identified
Insolvency
Insolvency caused by lack of liquidity in Islamic Financial Instruments and Sharia non-
compliance of short-term funding from lender of last resort (Central Bank) could be solved by
forming a supra-national body to bailout Islamic Financial Institution‟s funded by a voluntary
donation each year say 0.2% of the member institution‟s operating profits. This fund could also
be used to buy illiquid instruments from IFI‟s to finance short-term liquidity constraints, give
Qardan Hasanah (interest free good loan) to IFI‟s for their short –term liquidity needs, and
operated on a mutual assistance basis. It could also act as manager of last resort to protect
investment account holder‟s funds in case of eminent collapse of a member IFI. This measure
would have a positive impact on the credibility of the Islamic Finance market and improve its
reputation. Qardan Hassanah mentioned in The Holy Quran 'If you lend unto Allah Qardan
Hasanah , He will multiply it for you and He will forgive you, for Allah is the Most
Appreciative , Most Forbearing' (Verse 64-17)
Reputational Damage to the Islamic Finance Brand/Segment
A supra-national co-ordinating body (possibly formed by the merger of AAOIFI and IFSB with
unification of standards) which operates a global database of Islamic Financial products
approved by validly constituted Sharia advisory boards, irrespective of national, sectarian or
doctrinal bias, preferable based in a neutral International Financial Centre like London. This
body could also have a depository of experts on Islamic Law and Finance which could review
products developed which have been challenged by other scholars and considered acceptable by
others by giving an independent opinion (a form of judicial review). Financial reporting for
IFI‟s could benefit if the industry would petition the International Accounting Standards Board
(IASB) to consider issuing an International Financial Reporting Standard (IFRS) for IFI‟s.
Operational Risk – Contracts
This risk can be dealt with by having well reputed scholars on Sharia boards with persons with
knowledge of both Islamic Law and Financial knowledge and belonging to multiple schools of
thought or Islamic jurisprudence, to enable a diversified meaningful debate, when considering
Islamic Products. Furthermore more personnel working within IFI should be encouraged to be
certified by globally reputed Institutions like the Chartered Institute of Management
Accountant‟s17 Certificate in Islamic Finance qualification.
17
http://www.cimaglobal.com/Study-with-us/Certificate-in-Islamic-Finance/
31

33. 4.5 Islamic Financial Instruments/Transactions – Risk Mitigation and Risk Creation
Sukuk (Sharia compliant bond equivalents) and Ijara (lease or buy and rent contracts)
Islamic Financial Institutions that either issue or purchase Sukuk or enter into Ijara contracts are
investing in real assets. The return on these assets takes the form of rent, and is uniformly
spread over the rental period. The underlying asset provides additional security for the investor
and the productivity of the asset is the basis of the return on investment. The claim embodied in
Sukuk is not simply a claim to cash flow but an ownership claim. Hence, interest risk is
avoided and so is the risk of the fluctuation of the value of the borrowing (as selling of debt at a
price other than at par is forbidden), which mitigates the financial risk of the entity. However
the ownership claim has to be reflected in the balance sheet of the IFI which results in volatility
of earnings and balance sheet values due to mark to market rules required for most financial
reporting frameworks. Furthermore, the prohibition of the sale of debt other than at par,
prevents the development of the secondary market in these securities, creating liquidity
constraints as these are not easily convertible to cash.
Musharaka and Mudaraba
Under these transactions the Islamic Financial Institution participates in the profit or loss of the
transaction, instead of receiving interest. These transactions even though compliant with Sharia
create above average credit risk, as a known amount of cash flow in form of interest is replaced
by an uncertain amount of profit or loss.
Derivatives Instruments in Islamic Finance
This is one area which has the most controversy in Islamic Finance, as some of the hadith‟s
used to justify derivative contracts like futures, options and forwards are challenged by many
scholars, plus the lack of understanding of the workings of these instruments among Sharia
scholars and the larger public. However, this dissertation would like to take the view that it is
only a matter of time and financial education of Sharia scholars in the working of derivatives to
hedge against market risks faced by IFI‟s like currency risk and commodity risk, that Sharia
compliant products will gain widespread use. The main argument against derivatives are that it
has excessive uncertainity (Gharar) and is gambling (Maysir). A comment in support of
development of Islamic derivative products by a scholar is stated - "we should realize that even
in the modern degenerated form of futures trading, some of the underlying basics concepts as
well as some of the conditions for such trading are exactly the same as were laid down by the
Prophet Mohamed (PBUH) for forward trading. For example, there are clear sayings of the
Prophet Mohamed (PBUH) that he who makes a Salaf (forward trade) should do that for a
32

34. specific quantity, specific weight and for a specified period of time. This is something that
contemporary futures trading pays particular attention to." (Fahim Khan, 1996) 18
A recent development in Iran is to allow trading Islamic Derivative products.
The Securities and Exchange Organization of Iran has put on agenda to add new Islamic
instruments such as Derivative Securities, Istisna & Murabaha in Capital Market as of the next
Iranian calendar year (March 21, 2011).19(Ali Salehabadi, Iran Daily 8th March 2011)
4.6 Summary
It is well understood that Risk Management is Integral for Islamic Financial institutions, which
is supported by both statements in the Holy Quran and traditions of the Prophet Mohamed
(PBUH). It has been seen that Islamic financial transactions are interest (Riba) free, abhors
uncertainty (Gharar), and eschews gambling (Maysir), however these are not risk free. Islamic
Financial Instruments mitigate against certain risks, while creating others for Islamic Financial
Institutions.
The effect of the recent global financial crises on Islamic Financial Institutions has been
minimal, some commentators have tried to portray this as the superiority of the Islamic
economic system which eschews uncertainty, interest and gambling. This is because one of the
key causes was complex derivative products like credit default swap (CDS) and collateralised
debt obligations (CDO) which very few people understood how they operate and the risks
inbuilt in these instruments. While it is agreed that Islamic Financial Institutions would have
avoided these instruments, however some Islamic Financial Institutions For example, a number
of renowned players in the management of Islamic funds, such as The Investment Dar (TID)
and Global Investment House (GIH), both based in Kuwait, have suffered major losses during
the crisis and have become technically insolvent. Plus the debt crises of Dubai and its
consequent real estate market crash revealed excessive speculation. Hence, a majority of Islamic
Financial Institutions while relatively immune because they were not in the centres where the
financial markets were sophisticated. Furthermore, the experience of Kuwait Finance House
during the Souk Al Manakh20, is a signal for Islamic Financial Institutions to be vigilant about
risk management, as being Islamic will not protect them from excessive speculation.
18
Fahim Khan (Islamic Futures and their Markets, Research Paper No.32, Islamic Research and Training Institute,
Islamic Development Bank, Jeddah, Saudi Arabia, 1996, p.12)
19
http://www.sukuk.me/news/articles/28/Irans-Bourse-to-Add-New-Islamic-Financial-Instrum.html (21 March 2011
20
http://en.wikipedia.org/wiki/Souk_Al-Manakh_stock_market_crash (accessed 25 March 2011)
33

35. Chapter 5: Analysis of Risk Management disclosures in Financial Statements
5.1 Introduction
This chapter will look at disclosed information on Risk Management in the published financial
statements of three Islamic Financial institutions namely:-
 Meezan Bank (Pakistan)
 Khaleej Takaful (UAE)
 Al Baraka Banking group (Kingdom of Bahrain)
Disclosures on risk management made in the financial statements will be analysed in reference
to figure 2.2 Key Drivers of Risk in Chapter 2.
5.2 Meezan Bank (Pakistan) - based on the Annual Report 2009
Meezan bank is a Pakistan based bank offering retail, corporate and investment banking
services i.e. savings products, Investment products, credit cards, trade finance, capital raising
(Sukuk) for corporate clients and the Government of Pakistan. The products are similar to those
offered by conventional banks.
Risk Management Framework (Annual Report 2009 - Operations review & Note 40)
“Risk management is an integral part of the business activities of the Bank. The Bank manages
the risks through a framework of risk management policies and procedures, organizational
structure and risk measurement and monitoring mechanism that are closely aligned with the
overall operations of the Bank. Risk management activities broadly take place at different
hierarchy levels. The Board of Directors provides overall risk management supervision while
the management of the Bank actively ensures that the risks are adequately identified, measured
and managed. An independent and dedicated Risk Management department guided by a prudent
and a robust framework of risk management policies and guidelines is in place.
The Board has constituted the following committees for effective management of risks
comprising of the Board members: 1. Risk Management Committee
2. Audit Committee
The Risk Management Committee is responsible for reviewing and guiding risk policies and
procedures and control over risk management. The Audit Committee - comprised of three non-
executive directors - monitors compliance with the best practices of the Code of Corporate
Governance and determines appropriate measures to safeguard the Bank's assets.
The Board has delegated the authority to monitor and manage different risks to the specialized
committees at management level. These committees are comprised of senior management team
members with relevant experience and expertise, who meet regularly to deliberate on the
34

36. matters pertaining to various risk exposures under their respective supervision. Such committees
include: 1. Credit Committee
2. Asset Liability Management Committee (ALCO)
The Credit Committee is responsible for approving, monitoring and ensuring that financial
transactions are within the acceptable risk rating criteria. Well defined policies, procedures and
manuals are in place and authorities have been appropriately delegated to ensure credit quality,
proper risk-reward trade off, industry diversification, adequate credit documentation and
periodic credit reviews.
ALCO is responsible for reviewing and recommending all market risk and liquidity risk policies
and ensuring that sound risk measurement systems are established and comply with internal and
regulatory requirements. The Bank applies Stress Testing and Value at Risk (VaR) techniques
as market risk management tools. Contingency Funding Plan for managing liquidity crisis is in
place. Liquidity management is done through cash flow matching, investment in commodity
murabaha, Sukuks and placements in foreign exchange. Treasury Middle Office monitors and
ensures that banks exposures are in line with the prescribed limits. The Bank ensures that the
key operational risks are measured and managed in a timely and effective manner through
enhanced operational risk awareness, segregation of duties, dual checks and improving early
warning signals. The Bank has developed effective manuals and procedures necessary for the
mitigation of operational risk. The Bank has an Internal Audit department that reports directly to
the Audit Committee of the Board. Internal Audit independently reviews various functional
areas of the Bank to identify control weaknesses and implementation of internal and regulatory
standards. The Compliance department ensures that all directives and guidelines issued by the
State Bank of Pakistan are being complied with in order to manage compliance and operational
risks. The Internal Controls and Operational Risk Management Committee ensures adequate
internal controls and systems are in place thereby ensuring operating efficiency.
The Board has constituted a full functional audit committee. The audit committee works to
ensure that the best practices of the Code of Corporate Governance are being complied by the
Bank and that the policies and procedures are being complied with. The Bank‟s risk
management, compliance, internal audit and legal departments support the risk management
function. The role of the risk management department is to quantify the risk and ensure the
quality and integrity of the Bank‟s risk-related data. The compliance department ensures that all
the directives and guidelines issued by SBP are being complied with in order to mitigate the
compliance and operational risks. Internal audit department reviews the compliance of internal
control procedures with internal and regulatory standards.
35

37. RISK MANAGEMENT (Note 40)
The wide variety of the Bank‟s business activities require the Bank to identify, measure,
aggregate and manage risks effectively which are constantly evolving as the business activities
change in response to credit, market, product and other developments. The Bank manages the
risk through a framework of risk management, policies and principles, organisational structures
and risk measurement and monitoring processes that are closely aligned with the business
activities of the Bank.
40.1 Credit risk
The Bank manages credit risk by effective credit appraisal mechanism, approving and reviewing
authorities, limit structures, internal credit risk rating system, collateral management and post
disbursement monitoring so as to ensure prudent financing
activities and sound financing portfolio under the umbrella of a comprehensive Credit Policy
approved by the Board of Directors. The Bank also ensures to diversify its portfolio into
different business segments, products and sectors. Bank take into account the risk mitigating
effect of the eligible collaterals for the calculation of capital requirement for credit risk. Use
of credit risk mitigation (CRM) resulted in the total credit risk weighted amount of Rs.
58,863.71 million whereas in the absence of benefit of CRM this amount would have been Rs.
61,883.49 million. Thus, use of CRM resulted in improved capital adequacy ratio of the Bank
from 12.25% (without CRM) to 12.77% (with CRM).
40.1.2 Credit Risk - General Disclosures Basel II Specific
The Bank is operating under standardised approach of Basel II for credit risk. As such risk
weights for the credit risk related assets (on-balance sheet and off-balance sheet-market and non
market related exposures) are assigned on the basis of standardised approach.
The Bank is committed to further strengthen its risk management framework that shall enable
the Bank to move ahead for adopting Foundation IRB approach of Basel II; meanwhile none of
our assets class is subject to the foundation IRB or advanced IRB approaches.
40.2 Equity position risk in the banking book-Basel II Specific
The Bank makes investment in variety of products/instruments mainly for the following
objectives;
- Investment for supporting business activities of the bank and generating revenue in short term
or relatively short term tenure.
- Strategic Investments which are made with the intention to hold it for a longer term and are
marked as such at the time of investment.
36

38. Classification of equity investments
Bank classifies its equity investment portfolio in accordance with the directives of SBP as
follows: - Investments - Held for trading
- Investments - Available for sale
- Investments in associates
- Investments in subsidiaries
Some of the above mentioned investments are listed and traded in public through stock
exchanges, while other investments are unlisted.
Policies, valuation and accounting of equity investments
The accounting policies for equity investments are designed and their valuation is carried out
under the provisions and directives of State Bank of Pakistan, Securities and Exchange
Commission of Pakistan and the requirements of approved International Accounting Standards
as applicable in Pakistan. The investments in listed equity securities are stated at the revalued
amount using market rates prevailing on the balance sheet date, while the investment in
unquoted securities are stated at lower of cost or break-up value. The unrealized surplus /
(deficit) arising on revaluation of the held for trading investment portfolio is taken to the profit
and loss account. The surplus / (deficit) arising on revaluation of quoted securities classified as
available for sale is kept in a separate account shown in the balance sheet below equity. The
surplus / (deficit) arising on these securities is taken to the profit and loss account when actually
realised upon disposal. The carrying value of equity investments are assessed at each balance
sheet date for impairment. If the circumstances exist which indicate that the carrying value of
these investments may not be recoverable, the carrying value is written down to its estimated
recoverable amount. The resulting impairment loss is charged to profit and loss account.
Market risk
The Bank is exposed to market risk which is the risk that the value of on and off balance sheet
exposures of the Bank will be adversely affected by movements in market rates or prices such as
benchmark rates, profit rates, foreign exchange rates, equity prices and market conditions
resulting in a loss to earnings and capital. The profit rates and equity price risk consists of two
components each. The general risk describes value changes due to general market movements,
while the specific risk has issuer related causes. The capital charge for market risk has been
calculated by using Standardized Approach. The Bank applies Stress Testing and Value at Risk
(VaR) techniques as risk management tool; Stress testing enables the Bank to estimate changes
in the value of the portfolio, if exposed to various risk factor. VaR quantifies the maximum loss
that might arise due to change in risk factors, if exposure remains unchanged for a given period
of time.
37

39. 40.3.1 Foreign exchange risk
The foreign exchange risk is the risk that the value of a financial instrument will fluctuate due to
the changes in foreign exchange rates. The Bank does not take any currency exposure except to
the extent of statutory net open position prescribed by SBP. Foreign exchange open and
mismatch position are controlled through internal limits and are marked to market on a daily
basis to contain forward exposures.
40.3.2 Equity position risk
Equity position risk is the risk arising from taking long positions, in the trading book, in the
equities and all instruments that exhibit market behaviour similar to equities. Counter parties
limits, as also fixed by SBP, are considered to limit risk concentration. The Bank invests in
those equities which are Shariah compliant as advised by the Shariah adviser.
40.3.3 Yield / Interest Rate Risk in the Banking Book (IRRBB) - Basel II Specific
IRRBB includes all material yield risk positions of the Bank taking into account all relevant
repricing and maturity data. It includes current balances and contractual yield rates. Bank
understands that its financings shall be repriced as per their respective contracts. Regarding
behaviour of non-maturity deposits, the Bank assumes that 75% of those deposits shall fall in
upto one year time frame and remaining 25% of those deposits shall fall in the range of one to
three years time buckets. The Bank estimates changes in the economic value of equity due to
changes in the yield rates on on-balance sheet positions by conducting duration gap analysis. It
also assesses yield rate risk on earnings of the Bank by applying upward and downward shocks.
These IRRBB measurements are done on monthly basis.
40.4 Liquidity risk
Liquidity risk is the risk that the Bank either does not have sufficient financial resources
available to meet its obligations and commitments as they fall due or can fulfil them only at
excessive cost that may affect the Bank‟s income and equity. The Bank seeks to ensure that it
has access to funds at reasonable cost even under adverse conditions, by managing its liquidity
risk across all class of assets and liabilities in accordance with regulatory guidelines and to take
advantage of any lending and investment opportunities as they arise.
38

40. 40.5 Operational risk
The Bank uses Basic Indicator Approach (BIA) for assessing the capital charge for operational
risk. Under BIA the capital charge is calculated by multiplying average positive annual gross
income of the Bank over past three years with 15% as per guidelines issued by SBP under Basel
II. To reduce losses arising from operational risk, the Bank has strengthened its risk
management framework by developing polices, guidelines and manuals. It also includes set up
of fraud and forgery management unit, defining responsibilities of individuals, enhancing
security measures, improving efficiency and effectiveness of operations, outsourcing and
improving quality of human resources through trainings.
Critical Analysis
 There is a risk committee at board level and there is a Head of Risk Management as part of
the senior management team. However in Meezan, he does not sit in the board of directors.
It is suggested that “the key to making the enterprise or integrated approach actually happen
is through the appointment of one key individual who takes charge of the whole process and
is given the power at board level to follow through all ideas. Often the person is the Chief
Risk Officer(CRO)” (Merna & Thani 2010)21
 The Meezan bank‟s statement on risk management in the operations review and notes to the
financial statements does not disclose its classification risks undertaken by kind of
transaction and type of risk posed, mitigating factors and its response. Although it claims to
have a robust risk management framework, the disclosures are skewed towards financial
risks (probably due to focus by external auditors on quantifiable information) and scant
reference to strategic risks and hazard risks. It would have been interesting to classify risks
in accordance with type of transactions like Sukuk, Islamic Credit card business, Mudaraba,
Ijara, Musharaka etc transactions, how these are mitigated and risks which are retained as
part of the business undertaken.
21
Corporate Risk Management 2nd Edition Merna and Thani
39

41. 5.3 Al Khaleej Takaful Insurance and Reinsurance Q.S.C.(Qatar)
Al Khaleej is a fully fledged Takaful company offering the full range of insurance products
similar to conventional insurance companies which are Sharia compliant in the State of Qatar.
Risk Management Framework (extracts from Annual Report 2009 Note 25)
The risks faced by the Group and the way these risks are mitigated by management are
summarised below.
Insurance risk
The principal risk the Group faces under insurance contracts is that the actual claims and benefit
payments or the timing thereof, differ from expectations. This is influenced by the frequency of
claims, severity of claims, actual benefits paid and subsequent development of long-term
claims. Therefore, the objective of the Group is to ensure that sufficient reserves are available to
cover these liabilities. The above risk exposure is mitigated by diversification across a large
portfolio of insurance contracts. The variability of risks is also improved by careful selection
and implementation of underwriting strategy guidelines, as well as the use of reinsurance
arrangements.
Reinsurance risk
In common with other insurance companies, in order to minimize financial exposure arising
from large claims, the Group, in the normal course of business, enters into agreements with
other parties for reinsurance purposes. Such reinsurance arrangements provide for greater
diversification of business, allow management to control exposure to potential losses arising
from large risks, and provide additional capacity for growth. A significant portion of the
reinsurance is effected under treaty, facultative and excess-of-loss reinsurance contracts.
To minimize its exposure to significant losses from reinsurer insolvencies, the Group evaluates
the financial condition of its reinsurers and monitors concentrations of credit risk arising from
similar geographic regions, activities or economic characteristics of the reinsurers. Reinsurance
ceded contracts do not relieve the Group from its obligations to policyholders and as a result the
Group remains liable for the portion of outstanding claims reinsured to the extent that the
reinsurer fails to meet the obligations under the reinsurance agreements. The two largest
reinsurer account for 32% of the maximum credit exposure at 31 December 2009 (2008: 45%).
40

42. Concentration of risks
The Group‟s insurance risk relates to policies written in the State of Qatar only. The segmental
concentration of insurance risk is set out in Note 26.
Sensitivity of changes in assumption The Group does not have any single insurance contract or
a small number of related contracts that cover low frequency, high-severity risks such as
earthquakes, or insurance contracts covering risks for single incidents that expose the Group to
multiple insurance risks. The Group has adequately reinsured for insurance risks that may
involve significant litigation. A 5% change in the average claims ratio will have no material
impact on the consolidated statement of income (2008: same).
Financial risk
The Group‟s principal instruments are available-for-sale investments, receivables arising from
insurance and reinsurance contracts and cash and cash equivalents. The Group does not enter
into derivative transactions. The main risks arising from the Group‟s financial instruments are
interest rate risk, foreign currency risk, market price risk and liquidity risk. The board reviews
and agrees policies for managing each of these risks and they are summarised below:
Regulatory framework risk
Regulators are primarily interested in protecting the rights of the policyholders and monitoring
these rights closely to ensure that the Group is satisfactorily managing affairs for their benefit.
At the same time, the regulators are also interested in ensuring that the Group maintains an
appropriate solvency position to meet unforeseen liabilities arising from economic disasters.
The operations of the Group are also subject to regulatory requirements within the jurisdictions
where it operates. Such regulations not only prescribe approval and monitoring of activities, but
also impose certain restrictive provisions (e.g. capital adequacy) to minimize the risk of default
and insolvency on the part of the insurance companies to meet unforeseen liabilities as these arise.
Foreign currency risk
Foreign currency risk is the risk that the value of a financial instrument will fluctuate due to
changes in foreign exchange rates. Management believes that there is minimal risk of significant
losses due to exchange rate fluctuations and consequently the Group does not hedge its foreign
currency exposure.
Other than balances in United States Dollars, to which the Qatari Riyal is pegged, there is no
significant foreign currency financial asset due in foreign currencies included under reinsurance
balances receivable.
41