Topic: Shariah Compliant Risk Management
Houda Cherrak and Bouchra Touzani
Doctor: David Hampton
March 27, 2008
Introduction to Islamic banking system
Islam not only prohibits dealing in interest but also in liquor, pork, gambling, pornography and anything else, which the Shariah (Islamic Law) deems unlawful. Islamic banking is an instrument for the development of an Islamic economic order. Islamic banking, with 15 to 20% growth a year, has emerged as one of the vital pillars of the global economic system. Islamic financial institutions (IFI) are operating in over 75 countries, managing between $500 billion and $1 trillion assets.
The Islamic financial system employs the concept of participation in the enterprise, utilizing the funds at risk on a profit-and- loss-sharing basis. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions. It is possible, that investment in Islamic financial institutions can provide potential profit in proportion to the risk assumed to satisfy the differing demands of participants in the contemporary environment and within the guidelines of the Shariah. The concept of profit-and-loss sharing, as a basis of financial transactions, is a progressive one as it distinguishes good performance from the bad and the mediocre. This concept therefore encourages better resource management. Islamic financial industry has come a long way during its short history. The future of these institutions, however, will depend on how they cope with the rapidly changing financial world. With the advent of globalization and informational technology, scopes of different financial institutions have expanded beyond national boundaries. As a result, the financial sector in particular has become more dynamic, competitive, and complex. Moreover, there is a rapidly growing trend to mergers & acquisitions and financial consolidation, which blurs the unique risks related to various segments of the financial industry. Furthermore, there has been an unprecedented development in computing, mathematical finance and innovation of risk management techniques. All these developments are expected to enlarge the challenges that Islamic financial institutions face particularly, as more well established conventional institutions have started to provide Islamic financial products. Islamic financial institutions need to equip themselves with the up-to-date management skills and operational systems to deal with this environment. One major factor that will determine the survival and growth of the industry is how well these institutions manage the risks generated in providing Islamic financial services. Developing risk management compliant Islamic financial institutions issues becomes more significant but complex subject. Risk management processes and techniques enable financial institutions to control undesirable risks and to take benefit of the business opportunities created by the desirable ones. These processes are of important concern for regulators and supervisors as these determine the overall efficiency and stability of the financial systems. Islamic financial services need to strengthen risk management practices in the process of defining their own capital requirements in accordance with their loss tolerant. In fact, IFI could invest in the collection of loss information and adoption of loss data management systems. IFI products would benefit from implementing risk management methodologies and adapting their staffing skills accordingly. The present paper discusses and analyzes risk management of Islamic Intermediaries. First, it presents an overview of Islamic banking sector. Second, it develops different Islamic financial instruments. The third part shows that the Islamic financial...