The increasingly important role Islamic finance plays in the global financial industry and its unabated expansion raises questions about the sector’s growing impact on financial stability. What we learned from the financial crisis ten years ago was that large conventional financial institutions were unable to cope with the financial meltdown because they had built up excessive and leveraged risk concentrations. They were also not adequately equipped to assess, price-in or mitigate those risks, neither had they adequate management mechanisms in place to manage the inherent risks they were exposed, too.
As a result, the crisis prompted improvement and enhancement of accounting and liquidity standards such as Basel II and Basel III to equip banks with better risk buffers, and more intense scrutiny by rating agencies and credit insurance providers of the banks’ credit worthiness and complexity of their financial products.
To believe that Islamic finance institutions are immune to those risks simply because their business is asset-backed by design would be inconsiderate, as well as irresponsible from an investor’s viewpoint. The main reason why most Islamic banks navigated relatively unharmed through the last financial crisis was that they tended to be small and had limited cross-border dependencies and international networks, thus did not have a real systemic relevance for the global financial system, apart from a few exemptions. But still, a couple of Islamic banks got into trouble during the crisis, particularly those with a high exposure to the real estate sector.
As long as the structure of Islamic finance remains relatively fragmented and liquidity and risk managements instruments aren’t sophisticated enough to shield Islamic banks from possible issues arising from their current rapid expansion and growing risk concentration, challenges can’t be ignored.
As a matter of fact, Islamic banks do not only face the same risk like conventional banks on a macro-economic level such as currency, credit, liquidity, market and operational risks, but they also face unique risks that conventional financial firms generally don’t, such as equity investment risk, rate of return risk, displaced commercial risk and Shariah-noncompliance risk in tandem with a lack of instruments that conventional banks readily use to manage their risk but are prohibited for Islamic banks or simply not in place.
For example, Shariah-compliant money markets and government securities are underdeveloped in most countries were Islamic finance plays a dominant role, and access to central banks’ lending facilities are also often limited. There is also no developed derivatives market for futures contracts or options which could be used to mitigate price risks of underlying assets.
Options have been declared haram by many scholars anyway.
One particular risk for Islamic banks is the equity investment risk which arises from the asset-backed nature of Islamic finance contracts which are most commonly murabaha (cost-financing), mudaraba (partnership) and musharaka (joint-venture partnership). Since an Islamic bank cannot create debt without physical assets such as machinery, equipment, inventory, property or permitted services to back it, a risk arises from a possible decrease in the fair value of the equity position held. This can lead to problems such as a reduction or loss of potential returns on the investments or even the loss of the entire capital.
Another essential risk is the mark-up risk or rate-of-return risk. Unlike in conventional finance, where returns are usually fixed over the entire duration of a credit relationship, in Islamic finance (in a murabaha contract, for example), the agreed fixed mark-up is tied to a benchmark, often the Libor or, less commonly, the Islamic Interbank Benchmark Rate, and added to it, which makes the returns uncertain for both the bank and the borrower who shares both profits and losses with the institution.
In case the benchmark rates increases, as it happens now with the Libor, a borrower comes under pressure to provide increasing returns over time until a point might be reached of having to repay more returns than the asset earnings as such merit, which is a financially unhealthy situation. In an Islamic leasing contract, or ijara, the equipment itself is exposed to commodity price risk and the rental payments are exposed to mark-up risks, doubling the risk exposure in such a structure.
Another key risk comes with the growing market size and competitiveness of Islamic finance: The displaced commercial risk. While the risk-sharing principle remains a pillar of Shariah-compliance, investors still want returns on their monies rather than losses and have ever more options to shift their assets to other Islamic banks that provide better yields than another. As a result, an Islamic lender will seek to retain its investors by increasing returns even though underlying assets don’t provide enough profit, which naturally cuts into a bank’s reserves. To avoid a bumpy ride, mechanisms such as a profit equalisation fund or investment risk reserves should have been built up by the bank in better days as a precaution.
Due to the higher complexity of Islamic finance contracts, risks are also more complex, can evolve and change at different stages of a financing transaction. This makes it necessary that Islamic banks install risk management systems that reach beyond standard techniques such as risk reporting and internal and external audits. Advanced risk management for Islamic banks, based on a standardisation of all business-related activities and processes, include contractual and legal risk mitigation, constant risk-weighting of all assets, reducing operational risk by closely monitoring a client’s business, developing Shariah-compliant variants for currency hedging, credit derivatives, debt-assets swaps and commodity futures, increasing and improving the quality of collaterals, guarantees and loan-loss reserves, as well as providing risk-adjusted return on capital depending on the asset class.
As a rule of thumb, murabaha is considered less risky than profit-sharing modes of financing like mudaraba and musharaka, while lease agreements and forward financing structures such as ijara, istisna and salam fall in a higher risk category and diminishing musharaka is seen as the asset class with the highest risk category due to its elaborate redeeming sale-and-lease-back concept in a joint ownership structure.
As long as the structure of Islamic finance remains relatively fragmented and liquidity and risk managements instruments aren’t sophisticated enough to shield Islamic banks from possible issues arising from their current expansion and growing risk concentration, challenges can’t be ignored
