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Home > Financial Risk Management Best Practice > Investment Risk in Islamic Finance

Financial Risk Management Best Practice

Investment Risk in Islamic Finance

by Kamal Abdelkarim Hassan and Hassan Ahmed Yusuf

Executive Summary

  • The unique risks within the Islamic finance investment space are described, along with the challenges faced in developing procedures and processes to address those risks.

  • The categories of shariah risk, and the means available to mitigate this risk, are considered.

  • Investment opportunities are limited due to the restricted nature of the Islamic investment universe.

Introduction

At the inception of Islamic finance, Islamic economists advocated change and developed a policy for Islamic banking practice and process, arguing that the main aspect of conventional banking—riba (interest)—required immediate rectification if Islamic banking was to exist. To achieve this goal, profit and loss sharing methods were introduced, along with other products such as ijarah (lease) and murabahah (cost plus). The rest of the technical banking operational procedure remained almost the same, especially in areas where there was no immediate solution, such as the application of the London Interbank Offered Rate (LIBOR) as a benchmark. This was based on the Islamic maxim al daruuriyaatu tubihu al mahdurat (necessity permits the unlawful). Likewise, the application of risk management within Islamic finance is not completely different from its conventional counterpart. Similarly, both Islamic and conventional financing apply the same methodology and technique in regard to risk management. It is essential to note that there are elements of risk, such as shariah risk, associated with Islamic finance that do not exist in its conventional counterpart due to the nature of Islamic finance and investment. As such, the challenge for the shariah-compliant investment and finance industry is to have procedures and processes in place to deal with risks unique to Islamic finance instruments. Based on the above, we discuss below types of Islamic investment risks unique in Islamic finance, as shown in Table 1.

Table 1. Risks specific to Islamic investment

Shariah risk Risk associated with not implementing Islamic investment and finance products in accordance with shariah principles.
Asset concentration Investing, financing, or drawing earnings and income in a single market or a single asset class.
Default risk Risk that a counterparty fails to meet its financial obligations as they fall due.
Rate of return risk Risk of fluctuations in earnings where expected income targets may not be achieved due to market conditions as Islamic finance and investment concentrates more on equity.
Transparency risk Risk of not disclosing information necessary for users in regard to financial data, risk management, business conditions, and other necessary information.
Equity investment risk Risk associated with holding equity investment during unfavorable situations, where decline in investment caused by market conditions in turn gives volatility of earnings of musharakah and mudarabah investments. (This definition needs more clarity as it appears to include rate of return risk as well.)

Unique Risks in Islamic Finance

There is no the doubt that the recent financial crisis and the rapid development of financial innovation and engineering of Islamic investment instruments necessitate the need for risk management, control, and vigilant supervision. Islamic finance investment is different from its conventional counterpart because it is required to comply with shariah rules and guidance or it could lose its legitimacy, thereby constituting a shariah risk. Shariah risk has a deeper, more profound meaning than its current use in the Islamic finance literature, and its scope is changing relative to the pace of Islamic finance development.1

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Further reading

Books:

  • Archer, Simon, and Rifaat Abdelkarim.Islamic Finance: The Regulatory Challenge. Singapore: Wiley, 2007.
  • Iqbal, Zamir, and Abbas Mirakhor.An Introduction to Islamic Finance Theory and Practice. Singapore: Wiley, 2007.

Article:

  • Moghul, Umar F., and Arshad A. Ahmed. “Contractual forms in Islamic finance law and Islamic Investment Company of the Gulf (Bahamas) Ltd. v. Symphony Gems N.V. & others: A first impression of Islamic finance.” Fordham International Law Journal 27:1 (December 2003): 150–194. Online at: ir.lawnet.fordham.edu/ilj/vol27/iss1/7/

Reports:

  • Bälz, Kilian. “Sharia risk? How Islamic finance has transformed Islamic contract law.” Occasional Publications 9. Islamic Legal Studies Program, Harvard Law School, September 2008. Online at: www.law.harvard.edu/programs/ilsp/publications/balz.pdf
  • Khnifer, Mohammed, Aatef Baig, and Frank Winkler. “The rise and fall of Gulf Finance House.” Design, Implementation and Risk Aspects of Islamic Financial Products and Services module, Reading University, 2010.
  • Saiful Azhar Rosly. “Shariah compliant parameters reconsidered.” Paper presented at the Annual Malaysian Finance Association Conference, Kuching, Malaysia, June 4–5, 2008.

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