Risk Management Application to the Islamic Banking

Abstract

There are indications that Islamic banking is tremendously gaining popularity and expanding fast when compared with the other mainstream banks. Research indicates that even as a majority of the other banks were hardest hit by the ongoing global economic crisis, none of the Islamic banks closed down. There are a number of characteristics that distinguish Islamic banks when compared with their conventional counterparts, one of which is the act of sharing profits and losses with the various parties involved. With strong roots in Islamic principles, Islamic banks frown on the payment of interest. Nevertheless, there are unique products that have gained popularity, such as the Sukuk. On the other hand, there are still numerous risks to which the Islamic banks are faced, ranging from marketing, operations, liquidity, and the rate of interest. These have exhaustively been dealt with by this dissertation. Further, secondary research from scholarly article journals and books shall be utilised, to give a wider insight into the issue of Islamic banking, in effect better informing this research study. Ultimately, this has paved way for recommendations of the study on ways of mitigating these risks.

Background information

Introduction

On a global scale, Islamic banking has witnessed a tremendous growth rate. In such countries as Sudan, Pakistan and Iran, all the banking institutions appear to have fully embraced Shariah laws (Hooker 2008). For other countries such as Saudi Arabia, Egypt, Jordan, Kuwait, Indonesia, the United Arab Emirates (UAE), Malaysia, and Brunei, amongst others, the Islamic banks have streamlined their banking operations in conjunction with the conventional banking institutions (Molyneux 2005).

Islamic-based financial services account for a rising number of different types of institutions, and these include investment and commercial banks, investment companies and mutual insurance. Nonetheless, banks still remain as the heart and soul of financial services in a majority of the Islamic nations (Scholten & Van Wensveen 2000). Special attention must be accorded to effective risk management, with regard to Islamic banks. Even then, there is still a multitude of complex issues which require being understood better.

More specifically, the nature of the explicit risks that the Islamic banks are usually faced with, coupled with the nearly limitless ways that they have at their disposal to avail funds via the utilisation of a number of financing combinations that are permissible by the financing models of Islam, continues eliciting a lot of issues with regard to income recognition, risk management, as well as the adequacy of collateral (Hahm 2004), to name but a few. Accordingly, appropriate adoption and innovative solutions of risk management strategies are necessary to reflect special elements of Islamic financial services and products.

This research study was concerned with the assessment of the existing policies of risk management with regard to Islamic banks. Unlike their conventional counterparts, Islamic banks are usually governed by the guiding principles of the shariah laws, meaning that they are shariah compliant. In this case, there are a number of risks to which the Islamic banks could be exposed, thanks to their being shariah complaint.

This dissertation, therefore, attempted to explore these potential risks, and how they impact the Islamic banks, in addition to how the institutions are trying to cushion themselves against the said risks. Further, the issue of how modern risk management strategies comply with principles of Islamic finance has also been examined, along with the fundamental arguments within the Islamic financial community.

Research Objectives

This research study aims to explore the existing policies of risk management in Islamic financial institutions. Unlike a majority of the conventional financial and banking sector institutions, the risk management for the Islamic banking sector is greatly affected by the defined rules of sharia. In light of this, this dissertation shall endeavour to define the parameters and principals of sharia law, as they impact Islamic banking. Further, the research shall attempt to determine whether such financial instruments as swaps, as offered by the Islamic banks, are in compliance with the sharia laws.

The issuance of Sukuk and the risks associated with them will also be explored. Moreover, the study shall also investigate trends in sharia banking, in addition to the use of modern Islamic investment tools. In addition, the dissertation shall also investigate and record the issues of managers of Islamic banks about how the Islamic financial sector should develop.

The dissertation will also evaluate various case studies of successful and non-successful Islamic financial institutions especially in emerging economies, in addition to risks that are associated with Islamic finances in such Islamic countries. The recent transfer of wealth to Middle East nations will also be investigated, along with the social and legal risk attached to modern-day Islamic finance.

Research Question(s)

The underlying dissertation has the following major questions in mind:

• What kinds of risks are inevitable for financial institutions in the modern-day financial world specifically for Islamic financial institutions?
• How these risks are managed and different implications of risk management for Islamic financial institutions by using a case study.
• What are the fundamental arguments within the Islamic financial community and
• How the uses of modern risk management strategies that comply with a principal of Islamic finance will affect the outcome of projects and feature regulatory requirements.

Literature review

Islamic banking

Islamic banking could be regarded as a form of banking ‘with a conscience’ (Haque & Abbas 1999). Each of the Islamic banks normally consists of a shariah board comprising of financial experts, in addition to scholars, whose responsibility is to assess those activities that the bank carried out are either in compliance with the shariah laws, as well as those that appeared to go against it. Two fundamental principles characterises Islamic banking. To start with, Bodnar and colleagues (1998) contend that the private sector is where investments are normally made, via a form of financing that is free of interest.

In addition, the foundations of financial instruments of Islamic banks hinge upon the sharing of either profit or losses that a bank could make, and also the risks that could emerge. Additionally, shariah laws are the guiding pillars of Islamic banking (Isik & Hassan 2003), which is why there is a prohibition on the banks against the charging of interest. Since Islam contends that interest results in a rise in the capital that is unjustified, bearing in mind that no effort is usually made to earn this form of interest, such an increase, therefore, is usually taken as more of a false value. Consequently, shariah laws prohibit Islamic banks from charging interest.

On the other hand, a lot of arguments surround the issue of interest prohibition, with regard to Islamic banks (Liebenberg & Hoyt 2003). Some of the arguments opine that there is no moral foundation to support interest rates. Secondly, desisting from consumption cannot give a good reason for rewards. Aside from a ban on the payments of interest, money is often strictly viewed as ‘a medium of exchange’ (Neftci & Santos 2003). What this means is that money, on its own, lacks any form of an intrinsic value. For this reason, money ought not to result in the generation of added money.

The relationship existing between a debtor/creditor with regard to Islamic banking tends to be defined differently, as compared with conventional banking. During the early 1970s, Islamic banks started asserting themselves as a force to reckon with in the world of the banking system (Santomero 1997). However, the regulations and rules to which these Islamic banks subscribe have been in place for a long time. According to a 1997 Euromoney publication on Islamic finance, “Although the western media frequently suggest that Islamic banking in its present form is a recent phenomenon, in fact, the basic practices and principles date back to the early part of the seventh century.” (Sundararajan & Errico 2002).

The guiding pillar that governed Islamic banking is the prohibition against interest (Riba) payment. Islamic banking environment is guided by principles whose basis is the regulations and rules of the Islamic faith. Islamic fiancé gained immense popularity during the middle ages, in addition to a wide range of acceptability. Consequently, Islamic finance facilitates furthering business and trade within the Muslim world. Between 1975 and 1976, the Islamic banking system witnessed a major revitalising as a result of the riser in terms of the financial strength of Muslims, buoyed by the increase in the global oil demand (Saunders & Schumacher 2000).

Due to the ensuing sudden economic boost, there was a need for the Muslim countries to come up with a business model that adhered to the regulations and rules of the Islamic religion. The financial and banking sector of the Islamic world was also enhanced by the rise in importance that the upcoming business model sought to give to value systems and ethics (Naceur. & Goaied 2005). There is a clear demarcation between what is legally acceptable in the business world (halal) and that which is unacceptable (haram), thanks to the incorporation of the sharia law into the Muslim banking system.

There are numerous rules that the shariah law upholds, and which have to be followed, such as a restriction on the financing of gambling or casino investments, or the charging of interest rates. In this case, the Islamic banks have sought to follow these norms, intending to aid in the maturation of the economy in the Islamic world. For the last 10 years, Islamic banking has undergone a process of maturation from what was then regarded as a niche market, to what can today be regarded as a financial industry with a global reach.

At the same time as borrowers and bankers bid for new funds so that they can pump these into the Gulf region, to reap revenues from high oil prices, the ensuing growth of the banking industry may be anticipated to continue in the years to come. By 1999, only a handful of investment funds with the Islamic bank were in the market (Shaari & Fadhilah 2001). These have however now increased to close to 240 on a global scale (Hooker 2008).

Owing to the high rate of blossoming that has characterized Islamic banking, there is a dire need for the institutions to provide different products and services for both low as well as middle-income depositors. In addition, the Islamic banking system must provide professional training to its managers, to ensure that they are quite well versed in practical and theoretical concepts.

Islamic banking principles

The beliefs of the Islamic faith ensure that Muslims do not engage in dealings that entail interest (Riba) or usuary. For this reason, Muslims have for a long time shunned mainstream banks (Berger Mester 1997). This is despite the fact that just like anybody else, the Muslims require banking services in order to help them venture into business, buy a car, houses involve themselves in trading activities, facilitate capital investment, and also obtain a safe place to maintain their savings.

In addition, Muslims are not against the idea of obtaining legitimate profit (van Greuning & Iqbal 2008), because their religion (Islam) often encourages its followers to ensure that they utilize money in business ventures that are quite legitimate, as opposed to having their funds lying idle. On the other hand, in a world that is moving at a fast pace, the question is, are Muslims in a position to create a room, with respect to banking principles, for the very principles that their religion strongly upholds?

Amid all the advancements in the banking sector, there have emerged investments houses, global Islamic banks network, along other financial institutions. These have assumed their shape on the basis of Islamic fiancé principles, just like they have been stipulated by the Quran, and in keeping with the traditions of Prophet Muhammad. On the basis of the prohibition by the Quran that interest should not be charged on fiancés, Islamic banking institutes have endeavored to abandon the hypothetical concept, resulting in a mushrooming of financial institutions.

Within the financial services market in the Middle East, Islamic banking is perceived to be the leading sector in terms of growth. Prohibition on interest still remains the leading and best-known feature, with regard to Islamic banking (Scholten Van Wensveen 2000). According to the Quran, any amount of money that is lent should not attract interest or Riba. There is a need, however, to comprehend some of the Islamic principles which uphold Islamic finances. Sharia is made up of Quranic commands, in line with the stipulations of the Holy Quran, and according to the deeds and words of Prophet Muhammad. It then follows that Riba is not allowable by Shariah.

In addition, it is now generally held in agreement, at least amongst the various Muslim economists, that the restriction of Riba should not just apply to usuary only, it should also find application in their payment of interest. The Quran stipulates clearly that the payment of Riba is prohibited, sometimes taken to mean excessive interest. “O You who believe! Fear Allah and give up that remains of your demand for usury, if you are indeed believers.” (Jairus 2007).

Scholars and academicians in Islam have since come to embrace the meaning of Riba as any guaranteed or fixed payment over interests to either a deposit or cash that has been advanced. Some passages within the Quran explicitly caution its faithful against payment of interests.

The rules, as they apply to Islamic finance, may be summed up in five categories:

• prohibition against predetermined payment on top of the genuine principal

The Islam faith makes room for qard-el-hassan, which is a form of a loan usually regarded as a good loan, in which the lender of such a loan fails to incorporate an additional amount of money or interest, over and above that amount of money that they have lent out.

Conventional Islamic jurists sought to strictly interpret this principal in such a strict manner that “this prohibition applies to any advantage or benefits that the lender might secure out of the qard (loan) such as riding the borrower’s mule, eating at his table, or even taking advantage of the shade of his wall.” (Venardos 2005). The derivations of the principle may be traced back to that quotation that stresses that the indirect or associated benefits ought to be avoided.

• Losses of profits issues

A financial lender ought to share in the losses as well as the profits that emanate from the venture in which that money which they have lent out. The Islam faith usually encourages its believers to ensure that they not only invest their money but also become partners in such an investment, for purposes of risks and sharing in such a venture, as opposed to being perceived as mere creditors. Islamic finance, as per the Islamic law definition (Lopez, Irving & Constable 2001), is strongly supported by the belief that a capital financier, as well as the user of such form of capital, ought to absorb the risk that would characterize any business venture that they might engage in, in an equal manner.

From the point of view of banking terms, what this means is that the bank, a depositor, as well as the borrowers, all need to share both the rewards and the risks that emanate from financing business ventures. This appears to contradict the commercial banking systems that are more interest-based. In this case, the borrower of finances is subjected to all the pressure, in that he/she is required to pay back the entire amount of loan they have assumed, in addition to the stipulated interest, despite the consequences that may befall the business in which they have aspired to venture in (Lopez et al 2005).

From such a perspective, the principle that appears to emerge is that investments are usually encouraged by Islam for purposes of ensuring that the entire community benefits. On the other hand, this principle does not make room for the existence of a loophole for those individuals that are not interested in the assumption of risks, or engaging in an investment, but are instead satisfied with the activity of depositing or hoarding money within a bank, to obtain a rise of such held funds, with no risks fixed to it (except in the event of a bank becoming quite insolvent).

For that reason, under Islam, either individuals suffer loss, or invest with risk via inflation devaluation, through a way of ensuring that their money remains quite idle.

It is important to note here that Islam usually encourages the idea behind higher returns and higher risk, in addition to advancing for the course of such risks and returns by ensuring that no additional investment avenues are available to the investors. The main objective, in this case, is to make use of the high-risk investments, to act as an economic stimulus, and also to encourage those with the spirit of entrepreneurship to venture more into business.

• Making money out of money is not acceptable, according to Islam.

According to the tenets of Islam, money could be viewed as just another exchange medium and as such, no value ought to be attached to it. For this reason, money should not be used as a basis for acquiring additional money, though, for example, fixed interest payments, bank deposits or the act of lending it out to another individual (Saeed 1996). The initiative and risks are undertaken by a human effort towards investing in a venture that is perceived as productive by far exceed the amount of money that could be used for purposes of financing these initiatives.

According to Muslim jurists, money could be regarded as potential capital, as opposed to capital per se. the implication here then is that money only gets to be regarded as capital following the investment of the same in a business venture. For this reason, any form of money that could be awarded to a business entity in the form of a loan, becomes a form of debt to such a business, as opposed to capital (Saeed 1996). Therefore, this form of money would not attract any form of interest or returns.

The Islamic faith encourages Muslims to make purchases, but at the same time also discourages them to desist from ensuring that their money remains idle. This means that the act of hoarding money, like keeping it in a bank to gain interest over time, is an activity that is regarded by Muslims as unacceptable.

Within the Islamic faith, money is a symbol of purchasing power, oftentimes taken as the only ideal avenue for the utilization of money. Such a purchasing power that money symbolizes, may not, therefore, be utilized for purposes of making additional money (purchasing power), in the absence of the intermediate step that involves the use of such money for buying of services and goods.

• Prohibition of Gharar (risk, uncertainty or speculation)

This prohibition provides that any form of transaction that is entered by parties, and which involves the use of money, ought to be free of risk, uncertainly, or speculation (Djojosugito 2008). In addition, the various contracting parties are required to be in possession of the perfect knowledge regarding those counter values that the parties wish to exchange following the executions of their transactions. In addition, parties may also not predetermine an income or profit, with a guarantee.

The basis behind this assertion of the ‘uncertain gains’ principle that, through a stringent restriction, fails to even recognize the undertaking off, for example, a customer to a bank, to repay the principle to money that they have borrowed, and an additional amount to allow for inflation. The basis for such a strong stand of this prohibition is so that the weak may not be subjected to exploitation. Consequently, futures as well adoptions are usually regarded as un-Islamic and for this reason, deemed as foreign exchange and foreign transactions since rates are usually on the basis of the differences in interests.

Nevertheless, we have several Islamic scholars who have opted to object to the indexation of the aspect of being indented to a financial institution, following inflation, and instead, seek to provide an explanation behind this particular prohibition based on the qard-el-hassan framework. These Muslim scholars argue that by advancing loans to the beneficiaries, creditors are out to win Allah’s blessings and that they anticipate receiving Allah’s rewards only.

We have several transactions that are usually seen as the exception here, as far as the gharra principal is concerned. Such transactions include bai’ bithaman ajil (‘sales with advanced payment’), hire contract (Ijara), and Istisna (contract to manufacture). On the other hand, we have quite a number of legal requirements that stipulate that the conclusion of these kinds of contracts requires to be organised in such a manner as to reduce the risks associated (Sait & Lim 2006).

• Investments ought to augment those products and practices which have not been discouraged or forbidden by the Islam faith. As such, trade in such products as alcohol could not under any circumstances receiving the financial backing of an Islamic bank. Others include making a loan towards a real estate, whose intention is to construct a casino. Also, Islamic banks would not lend their money to fellow banks to gain interest.

Trends in Sharia-compliant banking

Islamic or Sharia-compliant finance seeks to enhance moderations, equity, as well as social justice in as far as banking systems are concerned (Timur 2005). This system is concerned with minimization of risk, prudent lending, profits sharing, and the forbidding of short-selling activity of the stocks, in addition to speculation. There is also an active discouragement of debt, meaning that and types of dealings that involve a firm whose balance sheet is made up of over a third in debt, is also a forbidden concept.

Other forbidden business ventures include making investments in enterprises that have been deemed as being unethical by the various scholars of Islam. These would include weapons factories and casinos. Interest prohibition is one of the rarest features that characterizes the Islamic banking system. In this case, Islamic banks are forbidden from attached any amount of interest on a loan that they lend to beneficiaries. Given the inability for banks to attached a certain amount of interest on loans that they lend out, it follows that those deals that are sharia-compliant are so structured as to enable the banks to say, lease a given property like a house, to the homeowner.

In turn, the homeowner shall continue paying rent for the house that they occupy, until such time as when they shall assume full ownership of the property. A number of critics’ postulate that the issue of rent is somewhat suspicious, in the sense that it bears a correlation with the payment of interest. Such critics further assert that the homeowners shall in the long run pay more in terms of paying for conventional products and mortgages, just as would have been the case with some of the other niche products, and more so, with what is known are ethical investments or ‘piety premium’. On the other hand, Islamic financiers have sought to disagree with the perspective held by the opponents of Sharia-compliant banking, emphasizing the elements of profit-sharing and joint-ownership of the sharia model.

According to Sultan Choudhury, who is the commercial director with Britain’s Islamic Bank, “The relationship between us and the customer is based on sharing risk and sharing the rewards from the financing and investments we make on their behalf,” (Mehdi 2008). Britain’s Islamic Bank is the only sharia-compliant, a stand-alone retail bank in the country. Sultan Choudhury further opines, “The returns are based on the amount of profit realised from each transaction.” (Mehdi 2008). Islamic finance seeks to bring about social democracy and fairness into the banking systems, through incorporating these tenets with the freedoms that are found within the market economy.

Even then, it is important to note that there is a massive growth of Islamic finance, in comparison with other global banking subsets. In this case, the annual growth rate of Islamic banking has been projected to average between 15 and 20 percent. A report that was released by the international monetary fund (IMF) contends that the reach, coupled with the number of the financial institutions that are sharia-compliant on a global scale, has increased drastically from a single institution in a single country, way back in 1975, to now stand at over 300 institutions, with operations in over 75 countries (Mehdi 2008).

In 2007, sharia-compliant assets all over the globe were seen to observe a near one-third growth rate, to stand at over $ 639 billion. This is as per the industry analysis that was reported in the Banker magazine. Going by the current trend in sharia-compliant banking, it is estimated that by 2010, Islamic finance shall exceed the $ 1 trillion mark. In Britain for instance, the FSA (Financial Services Authority) has already issued out operating licenses to a total; of five ‘stand-alone Islamic banks’, and this includes also Britain’s Islamic Bank. The latter has in recent years recorded a significant rise in terms of the customers of non-Muslim descent who have been applying to be issued with accounts by the bank, ever since the global financial crisis has begun.

According to bank officials, the increase in these numbers is due to the fact that Islamic finance provides a “safer option” for investors and savers alike, their faith notwithstanding. Steven Amos, the marketing director of Britain’s Islamic Bank contends, “Our core business will always be Muslims, but the numbers of non-Muslims are really picking up. We’ve had increased interest and it’s one of the numbers of reasons why we’re insulated from the credit crunch.” (Mehdi 2008).

Thus far, over 20 major financial institutions on the globe have embarked on an exercise of establishing units that give sharia-compliant financial services. For example, HSBC started giving its customers Islamic services and products way back in 2003. , In 2005, Lloyds TSB followed suit. The outstanding characteristic of products, assets, and financial institutions that are based on Islam is that even as they may not have managed to yield remarkable high returns pr anyone gives the financial year, nevertheless, they have managed to post consistent reruns for the last decade or so.

In addition, their returns have also remained somewhat consistent, even as the credit crunch wave bites harder. In 2008, global markets were seen to witness a drop of over one third their usual peaks. On the other hand, the DJIFI (Dow Jones Islamic Financials Index) only shed 7 percent for a similar period. In September of 2008, the DJIFI increased by 4.75 percent. One wonders then, whether the Islamic banking systems may have saved us from what was going to be a much-worse global financial crisis. Dan Taylor, the banking head at BDO Stoy Hayward, an accountancy giant, says, “Had the Islamic financing principle of fairness and the concept of investing in partnership been slightly more prevalent in conventional banking of late, events may have turned out a little differently,” (Mehdi 2008).

Taylor further opines that “The Islamic principle of requiring securities to be backed by assets means that the use of, say, collateralised debt obligations, or CDOs, would not have been allowed by sharia-compliant institutions.” (Ebrahim & Khan 2002). These sentiments have received the backing of a Durham University-based scholar, Professor Rodney Wilson, who lectures in Islamic finance. The scholar asserts that no single financial institution that is sharia-compliant has collapsed ever since the global financial crisis has begun.

The reason behind this, Professor Wilson contends, is because “Islamic banks follow a classical model of funding from their own deposits rather than borrowing from wholesale markets.” (Edwardes 2004). In this case, excessive leverage is not seen as an alternative for a bank that is sharia-compliant, in comparison with our conventional banking institutions that were seen to lend out close to £700billion in Britain, in 2007 (Mehdi 2008). This is a figure that is way above what these banks managed to collect, in the form of deposits.

Risks associated with Islamic banking

The issue of managing risk within the banking industry is not a new phenomenon (Schroeck, 2002). Having to handle risks has for a long time now occupied a central place with regard to financial intermediation, along with principles that underlie it (Scholtens and van Wensveen, 2000). It is not in doubt that commercial banks are in a business that is mired by a lot of risks (Santomero, 1997). According to Nocco and Stulz (2006), a holistic, integrated approach in as far as risk management is concerned may very well act to ensure an enhanced value for the shareholders of a busies entity.

There is a need for any financial institution to undertake effective measures on risk management, as a way of enhancing its performance. Al-Tamimi and Al-Mazrooei (2007) have noted that financial institutions serve the purposes of reducing revenues, in addition to ensuring that their shareholders attain the highest possible value. This is made possible thanks to the numerous financial services on offer by financial institutions, and more so with regard to the issue of risk administration. The issue of risk management is very critical; as far as Islamic banking is concerned.

The success, along with the rate of survival of financial institutions largely hinges upon their risk management efficiency. For this reason, the management of risk becomes a leading and critical element, as banks seek to give their shareholders better returns (Akkizidis & Khandelwal, 2008). In addition, risk management shall also be determined by the level to which such organizations are capable of handling a multitude of risk that their usually encounter, as they seek to execute different operations (Khan & Ahmed 2001). Further, prudential standards as concerns risk management and capital adequacy, and which have been stipulated by IFSB (Islamic Financial Services Board) underscores the level of importance that is tied to the issue of the management of risks by Islamic banks.

The efficient and effective risk management by shariah-compliant financial institutions has assumed a certain level of importance, in a bid to handle globalization challenges (Sundararajan & Errico, 2002). There are negative as well as positive elements that characterise the issue of risk management (IRM, AIRMIC & ALARM, 2002). From the point of view of banking, practices of risk management that are geared towards the avoidance of potential negative consequences bear correlations with compliance reasons.

The implication here is that banks opt to embrace risk management as a way of avoiding possible financial distress, in addition to ensuring that they have adequate capital. In contrast, in order that practices of risk management attain positive results, in situations whereby risk is taken to mean an opportunity, practicing of risk management in this case, is not just for compliance reasons; it also assists the banks to enhance the value attached to their shareholders (Pagach & Warr 2007), by way of ensuring that their financial improvements are achieved.

Gallati (2003) has given the expected value objectives of a shareholder, with regard to the sophistication of risk management. These include cushioning against losses that are not foreseeable, stabilising earnings, and increasing earning potential. Further, KPMG (2004) explains that a strategy for risk management that echoes a balanced approach towards the performance of a business, in addition to management compliance, could very well enable organizations to obtain enhanced business confidence, in addition to top attainment of sustainable value. Consequently, one would anticipate the existence of a link between the performance of a business and risk management.

The features that are a characteristic of Islamic banks, coupled with the financing modes that such banks have been aligned to, are inclusive of special risk which calls for recognition, to enable the management of such risk. Mohd and colleagues (2006) contend that a number of important considerations have been raised by the PLS form of financing. In particular, at the same time as PLS modes seek to alter direct risk that faces the Islamic banks to the depositors in such institutions; they also have the potential to increase the cumulative level of risk from the side of assets held by such a bank.

From a practical perspective, PLS modes appear to create an increased vulnerability of Islamic banks to risk that would under normal circumstances be assumed by equity investors, as opposed to debt holders (Grais & Kulathunga 2007). This is the case due to several reasons. To start with, the manner in which the PLS modes are administered is rather complex, in comparison with conventional financing. The implication that one gets from these modes is that take into account a number of activities that the conventional banks do not under normal circumstances perform. Such includes the assessment of ratios for loss or profit-sharing, with regard to investment projects at various economic sectors, in addition to ongoing auditing of those projects that the banks’ finances, for purposes of ensuring that these projects are governed in a proper manner.

Further, we have several activities that are available, and which the Islamic banks could engage in as well, aside from the several ways available for funds provisions via the application of non-PLS and PLS modes. At a time when Islamic banks provide funds via PLS facilities, and more so with respect to the Mudarabah contract, what this means is that no default that is recognisable, with respect to a beneficiary or entrepreneur exist, up to that point at which the PLS contract comes to an end. Should PLS contracts be defaulted, what this means is that the project that Islamic banks had invested in could not deliver its expectations. Consequently, a loss or low profits gets to be shared between the various parties involved (Harker & Zenios 2000), as par the ratios that have been stipulated by the PLS (profit-and-loss sharing) contract.

Islamic banks lack the means, from a legal perspective, to exert control over fro example, an entrepreneur whose business entity has received financing courtesy of mudarabah contracts. As such, the individual benefits from complete freedom that enables them to manage their enterprise based on their judgment. In this case, banks can only share the loss or profit from an entrepreneur within the confines of the contract ratio. With respect to direct investment and musharakah contracts, banks are in a better position to assess businesses since in these kinds of contracts it is possible for partners to exert their influence on such an enterprise (Iqbal & Llewellyn 2002), in addition to utilising their voting rights. Within the context of Islamic finance, it becomes a quite hardtop make PLS modes with either collateral or other forms of guarantees, with a view to reducing the types of risks that the Islamic banks could be subjected to.

According to Chapra and Khan (2000), operational risks, with regard to Islamic banks could come from a variety of sources. These include those unique activities which could be performed by Islamic banks, the fact that some of the Islamic products and services offered by shariah-compliant banks are non-standard, and a Shariah legislation system that is lacking in terms of reliability and efficiency when it comes to the issue of implementing financial contracts. The special risk could also emanate from the non-PLS financing mode, and it is important that these are recognised.

In particular, the act of making a purchase whose delivery is deferred (otherwise known as Salam contract), ensures that the Islamic banks are quite exposed to commodity price and credit risk (Stulz 1996). The reason behind this is that banks enter an agreement to purchase a given commodity on a specific date in the future, against the present-day payment, in addition to gaining the possession of such a commodity up to the point at which the commodity gets to be converted back to cash.

A related risk is that of leasing (Ijarah), owing to the fact that this form of a contract fails to provide Islamic banking institutions with the capability of ensuring that they transfer rewards and substantial risk in the form of leased assets to a lessee, which has to be executed on a bank’s balance sheet during the leasing time. From the side of liability, some of the specific risks that could be identified, with respect to Islamic banks’ operations, emanate from the special nature that is a characteristic of investment deposit. The implication here is that the rates of return and capital value are not tied to any form of guarantee. Such a feature, along with asymmetric information emanating from this feature, coupled with asymmetric information resulting in unobstructed non-PLS and PLS contracts, in which banks get to control the deposits of individuals based on their own judgment.

Capital adequacy vs. risk management practices of Islamic banks

As opposed to the conventional banks, the Islamic financial institutions seek to share the risks that they may be faced with, with both their borrowers and investors. The existing basic difference between, on the one hand, Islamic banking and on the other hand, conventional banking, at least from the point of view of risk, lies in the risk-sharing nature of these institutions.

The model of profit sharing that is a characteristic of the Islamic banks, distinguishes the kind of risk to which these institutions are prone. As a result, this paves way for the distribution of losses and profits equitably, between partners or banks, and the depositors. The investment made by depositors stands to gain a return by way of sharing to ensuring profits. This way, depositors seek to share, literary in the institution’s business risks. In the same way, any form of financing that borrows from Islamic principles alters the nature of risk that Islamic institutions are faced with.

Even as conventional banks often assure their depositors a fixed rate of interest on the deposits that they make, irrespective of whether such an institution is able to make a loss or profits, Islamic banks, on the other hand, provides none of these guarantees. Should the bank realizes a certain amount of profit for anyone given financial year, then the depositors with such a bank stand to gain from agreed rates of profit distribution. On the other hand, should an Islamic financial institution record a loss in a given financial year, it then follows that the depositors with such a bank have to absorb the losses, along with their lending bank.

Perhaps one of the most outstanding risks as regards the Islamic banking system has to do with the risk that is associated with failing to comply with the tenets of Shariah. Islamic banks seem to be very much attached to differing levels of significance as regards elements of capacity, capital, character, collateral, as well as the condition, as opposed to the conventional banks (Hull 2000). Conventional banks are in a position to give top priority to collateral. On the other hand, priority goes to a customer’s character, for the Islamic banks. To the conventional banking system, capacity and capital are elements of interest (Heffernan 2003), while the Islamic banks tend to emphasise more on capacity, as opposed to capital.

In contrast, we have a certain level of similarity between Islamic banks and conventional banks, with respect to a priority that these financial institutions usually attach to such issues as a project’s soundness and security that a customer could present to a bank, for purposes of receiving financing. The controls of capital rank as the leading element of risk management (Cai & Wheale 2007). Consequently, banks supervisors usually consider capital to be a fundamental aspect with regard to their regulatory framework (Freeland & Friedman, 2007).

Rowe and colleagues (2004) have sought to define two leading perceptions that make up the decisive role assumed by capital in as far as the issue of banks’ portfolios management is concerned. To start with, in order that a bank may evaluate and manage the risk that it could be faced with, such a financial institution must explore the suitable amount of capital needed to absorb those losses that could emanate from the market unexpectedly. This is in addition to an assessment of operational risk and credit exposures.

In addition, profits ensuing from a number of business activities require being assessed, against the capital that is suitable to account for associated risks. As a result of the enormous and rapid transformations that the banking system is undergoing (for example, the issue of globalisation, embracing of electronic communication, competitive business environment, as well as new regulatory regimes) new realities have emerged within the banking industry in the world. There is a need therefore for the Islamic banks as well to respond swiftly to such new realities, in addition to assessing the inherent risks with regard to the Islamic banking system (For instance, poor reporting of finances, deficient instruments for liquidity management, substandard systems of management and the need to abide by sharia laws).

Use of modern Islamic investment tools

Less than a decade ago, Islamic banking was seen as an industry still in its infancy stage; one that was endeavoring to prove its competitiveness and viability. Then, the sector was perceived to be experiencing an organic growth that was, for the most part, concentrate in those countries that were characterised by a significant population of Muslims. Lately, however, there has been a dramatic growth in Islamic finance, with the result that now Islamic banking systems are available in over 75 countries, dominated by the non-Muslim and Muslim population alike.

There has also been an increase in number with regard to the international centers of finance, such as London, Hong Kong, and Singapore that have been seen to start providing banking products and services that are in line with the Islamic banking system. Globally, Islamic banking institutions have witnessed a two-fold increase, to now stand at over 300. This figure also includes conventional banks which have also started to provide Islamic banking products and services.

The cumulative financial assets that are being managed by Islamic financial institutions are projected to be in the range of $ 1 trillion. This represents a fivefold increase within a period of only five years.

Today, Islamic finances rank amongst the financial segments that are witnessing a rapid rate of growth, as far as international systems of finance are concerned, resulting in an annual rate of growth that has been estimated to range from 15 percent and 20 percent. Lately, the services and products being offered by the Islamic banking systems have been seen to grow both in terms of range and diversity. The market for Islamic bonds (better known as Sukuk) has thus far recorded a phenomenal rate of growth, seeing that it has increased twofold, and it is estimated to be worth $ 28 billion today, relative to the same period last year.

Financial analysts project that the market for Sukuk shall continue to witness a significant expansion, owing to the massive requirements for finances with regard to infrastructural investment, in addition to other forms of investments within the private sectored by those nations that have registered a keen interest in as far as Islamic funding is concerned. Furthermore, Islamic financial products have continued to experience significant innovations over the years, and more so in as far as Sukuk products are concerned.

In 2002, the Malaysian government initiated the issuance exercise of the first-ever global sovereign Sukuk in the world. Accordingly, other nations have followed in the footsteps of the Malaysian government. As a result of this development, domestic and international corporations alike have deemed it necessary to also issue international corporate Sukuk. An innovation of the Islamic finance that is worthy of note here is the 2006 landmark issuance of an exchangeable Sukuk by the sovereign wealth management firm, Khazanah National, in Malaysia. The way these arrangement works is that the Sukuk so issued is capable of being exchanged in place of other forms of shares that Khazanah National holds.

Still, in 2006, a corporation based in the Middle East also issued a convertible Sukuk that allows the holder to convert the Sukuk to their individual shares at a time when an initial public offering (IPO) for shares held, is announced (Nor Aiza Mohd Jamil & Abdul Rahim 2007). As a result of the development of innovative and diverse structures in as far as the Islamic investment funds are concerned, Islamic wealth and asset management have witnessed a significant rate of growth. This has also been the case with regard to Islamic hedge funds. At the moment, over 250 mutual funds exist, overseeing assets estimated at $ 300 billion, all of which are sharia-compliant.

Additional developments involve the standard indices such as the DJIMI that comprises a market capitalization of more than $ 10 trillion in not less than 40 nations; Islamic mechanisms of funding that have been listed on a global exchange; and the FTSEGIIS. This has enhanced the performances of the Islamic financial market adversely thus attracting a large number of investors.

Swaps

Islamic banking has also developed a derivative market by way of introducing profit-rate and Islamic currency swaps (Gleason 2000). Similar to a currency swap usually offered by conventional banks, Islamic currency swaps are capable of performing a multitude of functions, such as acting as a risk management tool, lowering costs due to a rise in resources, categorization of appropriate investment opportunities, as well as better management of asset-liability. A profit rate swap as offered by Islamic banks is more of an agreement between one party that is floating a given rate, and another party with a fixed rate. In this case, the two parties reach an agreement that they will exchange the rates of profit.

Such a profit rate swap is often executed via successive fundamental; contracts that allow for the trading of specific assets, as stipulated by the Shariah contracts. The payment obligation that each of the parties involved is subjected to, is usually computed through the application of a number of pricing formulas. Under the profit rate swap of the Islamic banks, one of the rules is that the notional principle ought to be never exchanged. This is because it is usually netted off through the utilization of the Muqasah principle.

The aim of a profit rate swap offered by Islamic banks is to strike a balance between the rates of return due to investment with the funding rates. Another aim is to attain reduced funding costs, streamline the debt profile that already exists without the need to alter an organisation’s balance sheet or raise new finance, and manage the movement of interest rate exposure.

Further, profit swaps are geared towards protecting financial institutions against potential fluctuations in terms of rates of borrowing, as well as providing a mechanism for control of risk. Similar to other Islamic contracts, Islamic swaps contracts are also required to be free of such elements as maysir(gambling), riba (usury), jahl (ignorance), and Gharar (unnecessary risk). Moreover, there is a difference between, on the one hand, the Islamic Swaps and on the other hand, swaps offered by conventional banks, as the Islamic swaps bear a correlation with a number of asset-backed transactions that are in line with Shariah law.

Introduction and use of Sukuk (Islamic bonds)

According to the definition provided by AAOIFI (Accounting and Auditing Organisation for Islamic Financial Institutions), Sukuk is “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 intangible assets, usufructs and services, or equity of a given project or equity of a special investment activity” (AAOIFI 2002). From a general point of view, Sukuk is a “shariah-compliant Bond” (Bitcon 2008).

Put simply, Sukuk symbolizes the ‘ownership of an asset’ (Bitcon 2008). The claim in material form for a Sukuk is more of an ownership claim, as opposed to a cash flow one. This is an important observation, as it also seeks to differentiate between, on the one hand, conventional bonds and on the other hand, Sukuk. Whereas conventional bonds advance above interests bearing securities, on the other hand, Sukuk is by and large more investment certificates made up of ownership claims towards a given poll of assets.

During the middle ages, Muslims extensively utilized Sukuk as a paper that symbolized financial commitments whose origin was traded (Mirakhor 1995), in addition to other commercial activities. On the other hand, the current-day Sukuk structure varies from Sukuk that were in use originally, and is somewhat similar to the securitization concept, as practised by the conventional banking institutions. The securitisation concept entails a procedure in which there is a transfer of ownership as regards underlying assets

Hjh and colleagues (2005) opine that two distinctive features characterises a bond and a Sukuk. Whereas a bond is seen as more of a contractual commitment to debt, in which an issuer is committed through a contract to ensure that on the dates that have been specified, they pay bondholders, principal, and interest, the holders of Sukuk on the other hand, lay claim to complete ownership of the assets that are underlying a contract. As a result, the holders of Sukuk are at liberty to lay claim to any revenues that the Sukuk assets may generate, in addition to the permission to get a share of the proceeds that Sukuk assets may have realised.

Another feature that makes a distinction between a bond and a Sukuk is that in cases in which the certificate of a Sukuk symbolises debt to its holder, nevertheless, such a certificate may not be tradable within a secondary market. In its place, such a certificate is maintained till such time as when it is either sold or matures. There are a number of features and benefits that characterises Sukuks. To start with, Sukuks are products of the capital market that are tradable and shariah-compliant. Therefore, it means that they can yield ‘medium to long-term fixed or variable rates of return’ (Hjh et al 2005).

In addition, Sukuks are rated and assessed by rating agencies of international reputation. In this case, investors often use these international rating agencies as a form of guidelines for purposes of assessing the return/risk parameters surrounding the issue of Sukuk. It is also important to note that regular as well as period incomes usually stream at the period during which an investor has invested in Sukuks. Such streams of income are characterised by an efficient and easy settlement, with a high chance that the Sukuk shall with time, appreciate, in terms of capital. Moreover, Sukuks can also be regarded as liquid instruments that may be traded with ease in a secondary capital market.

There are many uses to which Sukuk funds can be subjected. Nevertheless, the readily utilized of these includes, project-specific Sukuk, ‘balance sheet-specific, and assets-specific Sukuk.

There is a wide variety of techniques around which Sukuk could be structured. With a conventional bond, this symbolises the promise that one shall honor the loan that they have obtained, by paying it back. On the other hand, a Sukuk is symbolic of ‘partial ownership in a debt, project, asset, investment, or business.

A majority of the Sukuk structures that are commonly used are more of an imitation of cash flows that characterises conventional bonds. In addition, Sukuks are not only listed on exchanges, but they are also tradable via such conventional organisations as Clearstream or Euroclear. Sukuks are surrounded by a great level of controversy as a result of their “perceived purpose of evading the restrictions on Riba” (Siddiqi 2004). A majority of the conservative scholars do not believe that Sukuks are in themselves effective. Such scholars have even gone further to cite that an Islamic bond, or Sukuk, usually calls for ‘real-value of money’ payment. In this case, this is seen as the underlying assessment of interest.

Investors in Sukuk benefit from a fixed return over the type of investments that they have assumed. This also bears a correlation with interest, in terms of appearance, given that the return of an investor does not have to rely on the kinds of risks that are associated with this kind of venture. On the other hand, those banks that often issue Sukuk may be said to be making investments in assets, as opposed to currency. The latest innovations with regards to Islamic finance have acted to later the dynamics that have hitherto characterized the Islamic finance industry. This has especially been the case as far as the issue of securities and bonds are concerned, in which Islamic securities, better known as Sukuk are increasingly gaining popularity.

Consequently, governments have resorted to the use of Sukuk as a way of helping raise the necessary finances, through what are known as sovereign issues. In addition, companies have also resorted to the issues of Sukuk to aid in the realisation of funds by way of providing corporate Sukuk. The issuance of Sukuk started as a modest activity in 2000 when three Sukuk valued at $ 336 million was issued. However, this figure had risen to the US $ 27 million by 2006, and the total number of Sukuk has also increased dramatically to 77.

By the close of 2007, it was anticipated that this figure would increase to a high of US $ 35 billion. Thanks to Sukuk, we now have in place a very vital mechanism to facilitate the raising of finance, within capital markets at an international level, via the use of Islamically acceptable structures. Sovereign bodies, multinational corporations, financial institutions, and state corporations all utilize international Sukuk in place of syndicated financing. Seeing that Sukuk have a significant place in the international capital market, there is a need, therefore, to fully define them, their structure, and also the manner in which they differ when compared with conventional bonds and processes of secularization.

Research methods

Introduction

In this section, the study attempts to shed light on the methods of research that were adopted, for purposes of facilitating the collection of data, to help in answering the research questions. Research methodology has been defined as “the application of science-based procedures to acquire solutions to a number of research questions (Creswell 2003). A research methodology supplies the necessary tools to aid in the carrying out of research, whose objective is to obtain the needed information, as is the case of this specific research.

A research methodology entails the whole conceptualization process, an observation of the problems that need to be studied, research questions formulation, the collection of data, data analysis, and the eventual generation of the research findings. Nevertheless, there are a number of authors who have come up with alternative methods of research (Creswell 1998; Yin 1999). The available literature regarding methods of research assists in the process of choosing the suitable and appropriate methods necessary to conduct a specific kind of research.

Moreover, Creswell (2003) suggests that the method often selected for use in a given research study is determined by the objectives and problems that a research presents. Furthermore, selecting a desirable method of research is determined by the context of the potential research. In addition, the availability of adequate literature for such a study shall also determine the research method that is adopted for a given research study, so that the relevant topics can be adequately assessed. In case this does not happen, then there is a need for the conduction of further studies in order to fill in the remaining gap.

Research design

According to Creswell (2008), a research design is a framework for collecting and utilizing sets of data that aim to produce logical and appropriate findings with great accuracy and that hopes to adequately and reasonably rest a research hypothesis, especially in a case whereby a quantitative study is being undertaken. A research design could either be qualitative, or quantitative.

Creswell (2008), states that there are five main differences between the two approaches. The first is the different ontological assumptions. Quantitative research assumes that there is only one external and objective reality whereas qualitative may suggest that multiple subjective realities can coexist. The second difference is on the epistemological assumptions.

Quantitative researchers tend to distance themselves from the studied phenomena whereas qualitative research interacts with them. The third is the different axiological assumptions. Quantitative researchers “overtly act in an ‘unbiased’ and ‘value-free’ way”. Qualitative researchers on the other hand “overtly act in a more ‘value-added and ‘biased’ manner” (Lee 1999:6). Fourth, we have different rhetorical assumptions. Quantitative research uses impersonal, formal, and rule-based text, contrary to the personalized, informal, and context-based language of qualitative research.

The fifth difference, according to Creswell (2008), lies in methodological assumptions. The quantitative strategy applies a deductive approach whereas the qualitative makes use of induction (Lee 1999). Moreover, Quantitative research is mostly concerned with the quantification of the findings. Qualitative research on the other hand is defined as a research strategy that emphasizes words rather than quantification in the collection and interpretation of the data. The quantitative strategy applies a deductive approach whereas the qualitative strategy makes use of induction (Lee 1999). The former aims to test a theory and the latter builds it.

Qualitative research usually provides a more detailed and profound analysis of the specific situation. The openness between the parts is much higher than with the quantitative method, which can facilitate the generation and creation of new theories. The participation of both parts is evident and they can discuss problems and explain uncertainties or ambiguities. This level of depth and detail is not achievable in quantitative research if the individual only answers closed questions.

One of the several disadvantages of qualitative methods is that is a very long process. It is impossible to make it quick and some individuals participating in the interview do not feel comfortable and can give answers under duress, or may not participate in the interview because as a result of concerns about their identity being revealed. Also, it is extremely complicated to aggregate and formulate systematic comparisons.

It is not easy to define qualitative research; given that the term lacks its own distinctive paradigm or theory. Additionally, qualitative research lacks a discrete set of practices of methods that could entirely be attributed to it. According to Patton (2002), qualitative methods offer detailed events description, interactions, and situations between things and people providing detail and depth. Other researchers (for example, Covaledki & Dirsmith, 1990) have viewed qualitative methods as a strategy that could be utilized in the analysis of the social truths of say, a phenomenon. Despite there being variations as far as the definitions of qualitative research go, nevertheless, these definitions all seem to have a common feature; they are aimed at providing a richer perceptive of social realities and processes.

The philosophical background of qualitative methods lays emphasis on the benefits of better understanding the social interactions from an organizational context, as well as the human behaviour meaning. This shall often entail the development of an emphatic understanding grounded on a subjective experience, and also an understanding of the links between behaviours and personal perceptions as the author attempt to do in this research.

For purposes of data collection for this research study, uses shall be made of qualitative research. Williamson (2009) asserts that due to the appropriate and sensitive application of qualitative research, it has yielded new directions and insights. Further, this research study that was adopted was also inductive in nature, and this was in line with the nature of qualitative research that has often been seen to employ the inductive strategy, as a way of ensuring the completeness and specificity of a research design.

Flick (2002) offers that those research studies that tend to stick to inductive strategies are best conducted using a qualitative strategy. Furthermore, qualitative research assists a researcher to embrace contextual conditions while at the same time also acting as a tool for detecting novel issues, and aiding in the development of theories that are grounded on empirical evidence. Besides, qualitative methodologies tend to have high validity levels, while at the same time also preserving data flow chronologically. In any case, qualitative data is rarely vulnerable to retrospective alterations (Creswell 2003).

Moreover, the task of qualitative research is usually to understand and describe groups as well as individual’s experiences, situations, and also meanings, prior to the testing and/or development of more explanations and general theories (Frankel & Devers 2000a). The reason why this research study opted to employ qualitative research is due to the fact that qualitative research designs tend to be by and large, flexible and emergent, resulting in a study that is not only engaging and interactive to both the researcher and the subjects, but also one that is quite dynamic.

According to Bogdan and Taylor (1998), the dynamism of qualitative research ensures that the relationship between, on the one hand, the research subject and on the other hand, the researcher, in addition to the research setting to which they are subjected, remains open to change and development, in effect adding on to the richness of the potential research findings of a research study. It is however important to note that a researcher is not in a position to control and manage all the various aspects of a research design. In this case, the flexibility and state of dynamism of a qualitative study make such control and management easier for a researcher.

Data collection tool

Evidence exists to support the claim that good qualitative studies usually provide answers to important and stated research questions (Frankel & Devers, 2000). At times, the activity of developing a research question for a study that is sound could be somewhat straightforward. Usually, this happens at a time when the conceptual and theoretical frameworks of a study have been well developed in advance, and at a time when much is also already known, regarding the topic in question (Thorne 1997).

The accessible research literature serves to provide areas of research in which additional research may be necessary. At other times, it may be more difficult to come up with the question(s) to research. A qualitative research study seeks to pursue research in specific areas since the available substantive and theoretical literature has failed to sufficiently capture the much-needed data (Frankel & Devers 2000b).

In order to facilitate the collection of data for this particular research study, use was made of secondary research, by a review of related research articles, scholarly journals, and academic publications. This was deemed necessary, in order to explore the position of academicians and researchers alike, regarding the issue of Islamic banking institutions, relative to the other banking institutions in the modern-day financial world. Secondly, the secondary type of research helped this study to better understand how the risks that face Islamic banking institutions are managed by the Islamic banks and the different implications of risk management for Islamic financial institutions. In this case, the secondary data examined provided a number of case studies in which Islamic banks across the globe had managed to manage potential risks with success.

The study also wished to enquire on the fundamental arguments within the Islamic financial community and how the uses of modern risk management strategies that comply with a principal of Islamic finance will affect the outcome of projects and feature regulatory requirements for these banks. Again, the secondary data that was examined helped shed light on this issue.

Data analysis techniques

This research employed the use of a secondary source of data. The secondary sources of data were used for purposes of informing the literature review of the study, in which case journals, books publications relevant to the research topic were explored.

Study limitations

There are a number of limitations that this research study was faced with. To start with, the time allocated for the research was inadequate, meaning that the research was not as comprehensive as this researcher would have wished. Another limitation that faced this particular research study was access to good secondary sources of materials regarding Islamic banking. In this case, the secondary sources that were obtained were scarce, while others that this researcher found online required a subscription fee first, and this further added a financial strain to the limited funds allocated for this particular study.

Discussion and Analysis

Risks to Islamic banks

According to the research findings of this study, it emerged that there are unique risks that characterises the Islamic banking system. Some of these risks include credit risk, liquidity risk, legal risk, market risk, commodity risk, and operational risk, amongst others. Liquidity risk covers those risks emanating from resources availability and applications, mismatching of sources and tenors, inability to meet the requirements for prudential liquidity, funds application, and inability to access the market (Berger & Humphrey 2000), amongst others.

The conventional banks are in a position to place any excess finds at their disposal into the money market, in effect cushioning against potential liquidity risk. With regard to the Islamic banks, however, Shariah constraints prohibit them from doing this. In addition, some of the managers at the Islamic banks that were interviewed by this researcher concurred that with the Islamic banks, it is not easy to transfer any surplus liquidity to the conventional banks, seeing that Islamic banks are not in a position to accept any form of interest.

Nevertheless, it is still possible for Islamic banks to exchange this kind of surplus fund amongst themselves through what is popularly known as the Musharahak/Mudarabah basis (Abdul & Abdul 2003). In this case, it means that with more Islamic banks within a given jurisdiction, there shall be a consequent rise in the level of cooperation and exchange of funds (Smith 2001), in effect translating into a reduction in terms of the liquidity risk. Affective management of liquidity requires that the cash positions of a bank be quite visible (Greuning & Iqbal 2008).

In addition, there is a need for proper projection mechanisms.

It is however important to note that in terms of the management of liquidity for the Islamic banks, regulatory concerns are not the only challenge that may be anticipated. At the moment, it could prove quite a challenge to oversee excess liquidity. Even then, progress is being made to facilitate better management of liquidity challenges. For example, IIFM (International Islamic Financial Market), an organization based in Bahrain, has been created by a number of banks within the Gulf region (for example, the Monetary Agency in Bahrain, the Islamic Development Bank from Saudi Arabia, Bank Nagara Malaysia, and the Brunei Darussalam). The establishment of IIFM is with a view to coming up with a management structure for liquidity, as it impacts on Islamic banks.

Credit risk

Another major risk that appears to seriously impact the viability of the Islamic banks is credit risk. To this end, Sarker (1999) has revealed that there is a rise in growth in terms of the bad debt associated with Islamic banking. Moreover, Khan and Ahmed (2001) have indicated that bankers contend that the risks that are associated with Islamic banking are least understood. From the perceptive of Islamic banking, credit risk takes the form of payment/settlement risks in following the payment of money by one of the various parties to a business transaction (or instance, Istina or Salam contract). It could as well be assets delivery (Murabahaha contract) prior to such a party receiving their cash or assets. What this means is that an Islam bank is readily exposed to credit risks, and a potential loss (Khan and Ahmed, 2001).

Khan and Ahmed (2001) sought to carry out a research study that entailed financial institutions that are Shariah-compliant in a total of 28 countries. The research findings of this study indicated that Musharakah accounted for the highest amount of credit risk (at a score of 3.69, out of a possible score of 5). This was closely followed by Mudarabah, at a score of 3.25. The managers for Islamic banks that were interviewed by this researcher further concurred with these findings.

In addition, the findings by Khan and Ahmed (2001) underscores the fact that bankers usually view PLS (profit-and-loss sharing) modes as being characterised by elevated credit risk.

According to Sundararajan and Errico (2002), even as PLS modes have the potential to directly alter the credit risk as they impact on their investment depositors, they are also in a position to enhance the cumulative level of risk, with regard to an Islamic bank’s asset side. This is because the assets, as they apply to this particular model, are often uncollaterised. In principle, what this implies is that Islamic banks need a higher ratio of the assets that they deem as being riskier, relative to the overall assets at their disposal, relative to the conventional banks. Some of the analysts of the risks associated with Islamic banks contend that striking such a balance has been a real challenge for them.

Market risks

Market risks come about as a result of adverse movements with regard to the price of commodities in the market, bonds, stocks, derivatives, as well as currencies (Akkizidis & Khandelwal 2008). With regard to the legal risks of the Islamic banks, capital adequacy regulations exist to place an edge on the prospect of adverse outcomes that would go beyond the capacity of a business to bear potential losses.

The reason why the focus appears to be solely on capital is that capital alone affords a cushion or buffer for taking up potential losses intrinsic to the conduct of a bank. Traditionally, bank regulators the world over have demanded that the Islamic financial institutions should follow similar norms to those that the conventional banking system adheres to. Towards this end, there are a number of academicians and researchers into Islamic banking institutions who have voiced a concern to the effect that the ban regulator should also recognize the place of the Islamic banks and the connection with the Shariah law.

It is important to note that there is a multitude of distinctive features that characerises Islamic banking when compared with their conventional counterparts. Therefore, it can only be expected that the magnitude and nature of the risk that could confront these institutions shall also tend to differ significantly, from those of conventional banking. As a result, Akkizidis and Khandelwal (2008) have noted that with the application of similar norms for the Islamic as well as the conventional financial institutions, it may be expected that an inequitable scenario could very well be experienced.

Moreover, Akkizidis and Khandelwal (2008) further opined that such an action would be to the disadvantage of the Islamic banking institutions. Separately, Abdul Majid and Abdul Rais (2003) argue that such a move would go against the banking sector regulator’s objective; the maintenance of a “level playing ground”. In terms of operational risks, Islamic banks aim to substitute real investment and trading in projects, in place of interest-based transactions.

Different from the conventional banks, their Islamic counterparts are forbidden from including debt transactions that are based on interest. Accordingly, those Islamic banking institutions that are principally characterised by trade operations that are based on murabaha, the exposure to market risk could be somewhat different (Abdul Majid & Abdul Rais 2003). Furthermore, those Islamic banks that enjoy international operations have to contend with risk exposure to the foreign-based currency.

Rate of return on risk

This study has further revealed that the Islamic banking institutions are usually faced with a risk on their rate of return, from the perspective of the exposure to their overall balance sheet. In this case, it is important to consider that when benchmark rates increase, this, in turn, could lead to a corresponding increase in the expectations of PLS deposit holders that they could anticipate rates of returns that are also higher. There is a difference between, on the one hand, the return rate on risk and on the other hand, an interest rate risk. The main concern for the Islamic banks is the end result of the activities that they have invested in, once the period for the investment holding has ended. Therefore, it becomes quite difficult to exactly pre-determine these kinds of results.

One of the results of the risk of a rate of return is the issue of a displaced commercial risk. In this case, Islamic banks could be faced with pressure from the market to make a payment for a return that surpasses the earned rate in terms of those assets that deposit holders of PLS have financed, at a time when the assets return rate is performing below expectations, relative to the rates of the competition. Consequently, Islamic banking institutions could opt to relinquish their entire (or part of) share of the anticipated profits, to retain the providers of their funds, in effect talking them out of withdrawing the funds that they have invested in the financial institution. As can be seen, this is already a risk that the Islamic banks assume, whose results may not be succinctly predicted.

Conclusion

The management of risk forms the foundation for the financial intermediation process by banks. For this reason, it has been accorded priority by financial institutions, and more so now that volatility and complexity within the financial markets are being seen as distinctive elements with regard to the establishment of competitive benefits, as well as act as a source for the entanglement of risks. A number of authors (for example,) have underscored the value of sufficient capital in a financial institution but perhaps, more importantly, is the establishment of a framework for enhancing the general management of risks within the banks.

In comparison with their conventional counterparts, Islamic banks are usually faced with a number of challenges that entail sufficient identification, definition, selection, assessment, mitigating, and pricing risks, with regard to asset classes and business lines. Some of the risk that the Islamic banks are normally faced with includes the liquidity risk, credit risk, market risks, new operational risks, and risk on the rate of return for capital invested. As an expanding division of the larger global financial systems, Islamic finance is progressively turning into a mainstream industry. Even though we have definite features that are unique to the Islamic financial institutions, when compared with their conventional counterparts, nevertheless the two have commonly related building blocks.

It is also important to note that Islamic banks are guided by the tenets of Shariah law. Accordingly, the issue of interest over capital does not feature.

This also means that Islamic banks are not in a position to finance such projects as the establishment of a casino, or gambling business. One of the Islamic products gaining prominence is the Sukuk, with a number of Islamic finance analysts contending that this particular product ought to be equity-based, along with the risk-sharing securities. The latter is a characteristic of Islamic financial banks, in which all the parties involved tend to share rewards and risks as well. Another element of the Islamic banks that distinguishes them from their conventional peers is inventory management, such as what are known as Musharaka contracts, which are increasingly becoming a mechanism for financing by Shariah-compliant banks, especially in Dubai.

In case of a default, the asset that is being financed in this case becomes the collateral. The risk here is that the value of such a financed asset could be volatile. This is an indication that the level of collateralization for the Islamic financial institutions, with regard to their credit portfolio, are by nature extremely high, with the result that this usually lowers their regulatory and economic exposures, in case of a default. There is a need therefore for the Islamic financial institutions to utilises the sector diversification portfolio, for purposes of managing their risks.

Recommendations

In order to reduce the risks that the Islamic banks are often faced with, this research study wishes to provide the following recommendations for adoption:

Islamic banking institutions need to assume liquidity risks that correspond to their capability for an adequate recourse in terms of funds that are Shariah-compliant, as a way of minimizing such a risk. In terms of operational risks, Islamic banking institutions are usually faced with risks emanating from such failed internal controls as people, processes, as well as systems. In this case, there is a need to ensure that the controls for Islamic banks give logical assurances regarding the dependability of such operations, in addition to the reliability that is associated with reporting their operations.

Regarding the risk of the rate of return, the Islamic banking institutions need to implement a process for reporting and risk management that is comprehensive, to examine possible consequences of market forces which could impact their assets’ rate of returns, relative to the rate of returns that the deposit holders of PLS (profit-and-loss sharing) anticipate. To counter the market risks, it is important that the Islamic financial institutions implement a suitable framework for the management of market risks, in addition to reporting, with regard to the entire assets held by such a bank, in addition to the issue of being exposed to the volatility of high market prices, and how to cushion against this.

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