Risk Management in Islamic Banking Video Lecture By Tariqullah Khan

This lecture contains three sessions

Session 1

Basic Concept of Risk

Risk can be defined as the variability or volatility of unexpected outcomes. It is usually measured by the standard deviation of historic outcomes. Though all businesses face uncertainty, financial institutions face some special kinds of risks given their nature of activities.

Uncertainty is of two types:

1. General: complete ignorance about future outcomes
2. Specific: some idea about the future outcomes

Risk is measured by the variability or volatility of outcomes – variance and standard deviation.

It is reduced by maintaining certain profile and value maximization.

Classification of risk:

Business & Financial Risk

Risk can be classified as business risk and financial risk.

Business Risk: Business risk relates to uncertainty from the business.

Financial Risk:  financial risk relates to movements in financial markets

Systematic & unsystematic Risk

Systematic Risk: it is associated with overall market.

UN Systematic Risk: it is associated with special asset or firm.

There are many types of financial risk relates to financial institutions. Some relates to both assts and liabilities, some related to just liabilities and some relates portfolio of the bank and this is the main focus of this lecture.

The risk which is face by financial institutions is Market risk, credit risk, liquidity risk and operational risk.

A typical Islamic Bank:

Typical Islamic banking model is – one tier mudarba model.

Model with multiple investment tools on Islamic banking liability side. There are savings, investment accounts and demand deposits Qard Hassan.

While on asset side there are murabha, Salam, istisna and ijarah are fixed income deposits while variable income assets are mudarba and musharka.

Unique risk face by Islamic bank on liability side relates to contractual nature of deposit. , fiduciary risk, withdrawal risk also instrument and operational risk.

 

Session 2

In this session relates specially with risk raised in Islamic financial institutions and modes of financing.

Unique Counterparty Risks of Islamic Modes of Finance

Murabaha Financing

Murabaha is a contemporary contract. It has been designed by combining a number of different contracts. There is a complete consensus among all Fiqh scholars that this new contract has been approved as a form of deferred trading. The condition of its validity is based on the fact that the bank must buy (become owner) and after that transfer the ownership right to the client.

Another potential problem in a sale-contract like Murabaha is late payments by  the counterparty as Islamic banks cannot, in principle, charge anything in excess of the agreed upon price. Nonpayment of dues in the stipulated time by the counterparty implies loss to banks.

Salam Financing

There are at least two important counterparty risks in Salam. A brief discussion of these risks is provided here.

1. The counterparty risks can range from failure to supply on time or even at all, and failure to supply the same quality of good as contractually agreed. Since Salam is an agricultural based contract, the counterparty risks may be due to factors beyond the normal credit quality of the

Client.

2. Salam contracts are neither exchange traded nor these are traded over the counter.

Istisna Financing

While extending Istisna   finance the bank exposes its capital to a number of specific counterparty risks. These include for example:

1. The counterparty risks under Istisna faced by the bank from the supplier’s side are similar to the risks mentioned under Salam. There could be a contract failure regarding quality and time of delivery.

2. The default risk on the buyer’s side is of the general nature, namely, failure in paying fully on time.

3. If the Istisna‘ contract is considered optional and not binding as the fulfillment of conditions under certain Fiqhi  jurisdictions may need, there is a counterparty risk as the supplier maintains the option to rescind from the contract.

Musharakah - Mudarabah (M-M) Financing

The credit risk is expected to be high under the M-M modes due to the fact that there is no collateral requirement.

One possible way to reduce the risks in profit sharing modes of financing is for Islamic banks to function as universal banks.

Session 3

Financial Murabha:

Mitigation risk- financial murabha. How the risk involved in this instrument and how bake tackle this.

Challenge for Islamic bank to use this traditional instrument for financing.

In the lecture the process flow is tell us by detail. After completion of murabha a debt is create

Bai-mujal comes in.

The debt cannot be soled at discount it becomes Riba.

Risk in Financial Murabha & It's Solutions:

Pre Sale Risk:

1. Loss and damages before delivery. This can b handles by minimizing the holding period.
2. Refusal of buyer to take delivery. This can be handles by (1) bank returned the goods and there should take time from vendor in case of reutn of goods. (2) Bank sells the good and Clint has to bear the actual losses occurred.
3. Market risk. This can be handling by initiate sale after the purchase of asset by bank.

Post Sale Risk:

1. 1. Defacts in goods. This can be handle by transferring the liability to vender it self . Take warranty against goods.

2. Credit risk. This can be handle by asking guarantees, collateral etc. bank can charge penalty against late payment but this will go to charity fund not to the income account of the bank.
3. Bench mark. Bank can made short term contracts so bench mark will not effect it.

Conclusion:

If we want to manage risks in Islamic bank it is very essential to understand the contracts themselves. Only that way we get good tools to manage the risks in Islamic banks. It is also very essential to understand those risks come in Islamic banking.