Islamic Finance – Types of Risks

As far as teaching field concerned I always try to pick knowledge from different articles and then combine them to make unique notes which will become useful for my students who are studying in my institute of Islamic banking and finance . I will mention in my article which topic is useful for which courses or levels now let’s begin the article.

First let us know that how many types of risks are there in Islamic finance and what are their names then we will go for detailed definitions. According to several institute of Islamic banking and finance and experts (PhD in Islamic finance) there are six types of risks named:

•  Credit Risk
•  Market Risk
•  Liquidity Risk
•  Operational Risk
• Legal Risk
• Capital Structure Risk

(First let me tell you as far as aptitude tests are concerned the above list of types is important for aptitudes of Islamic finance qualification, diploma in Islamic finance and mba Islamic finance.)

Now let’s start with detailed definitions

Credit risk

Under Islamic finance, credit risk refers to the probability that a third party or counterparty fails to meet its obligations in accordance with the terms agreed, e.g. a customer fails to meet monthly repayments. As a result, loss of revenue and principal due to default on the part of customers may arise from financing, dealing and investment activities. The risk management techniques used by conventional banks can be used to mitigate this risk (for example, by using good-quality data on the past performance of the counterparty to gauge this risk and by determining the probability of default). Collateral and pledges can be used as security against credit risk, as well as personal and institutional guarantees.

Market risk

Market risk for an IIFS arises in the form of unfavorable price movements, such as regarding equity and commodity prices (price risk), benchmark rates (interest rate risk), foreign exchange rates (FX risk), yields (rate of return risk) and volatility in the value of tradable or leasable assets. For example, under an ijarah operating lease contract, an IIFS might be exposed to market risk due to a reduction in the residual value of the leased asset at the expiry of the lease term or, in the case of early termination, due to default. Another example would be the price risk involved when the price of a commodity fluctuates during the period between the date of delivery and the date on which it is sold at the prevailing market price. In order to mitigate this risk, an IIFS must have in place an appropriate framework for managing the market risk (and related reporting) of all assets held, including those that do not have a ready market and/or are exposed to high price volatility.

Liquidity risk

Similar to conventional institutions, IIFSs also face the challenge of managing their asset and liability mismatches. Typically, liquidity risk can occur under two scenarios. In the first, due to a lack of liquidity, the IIFS is constrained in its ability to meet liabilities and financial obligations by illiquid assets. In the second, the IIFS is unable to borrow or raise funds at a reasonable cost when required. Therefore, it is paramount to ensure that sufficient Shari’ah-compatible money market instruments and interbank facilities are available to support IIFSs in their liquidity risk management. (These three definitions are very useful in exams or papers of Islamic finance qualification and diploma in Islamic finance)

Operational risk

Operational risk is the risk of loss resulting from external risks or from the inadequacy or failure of internal processes related to people or systems. Operational risks also include the risk of failure of technology, systems and analytical models. It is argued that operational risks for IIFSs can be significant due to specific contractual features (e.g. the cancellation risks related to non-binding murabahah contracts) and the issue of the enforceability of Islamic contracts in a wider legal context. Therefore, having an end-to-end Shari’ah-compliant process is crucial with regard to mitigating operational risk. This would include having systems that recognize the specificities of Islamic contracts, talent that understands and executes Islamic contracts in the correct manner, and internal processes that mitigate the risks associated with any potential non-compliance.

Legal risk

Legal risk (which can also be categorized as part of operational risk) refers to the potential loss that may be incurred by an IIFS as a result of insufficient, improperly applied, or simply unfavorable legal proceedings in the country in which it operates. The lack of a legal framework to support the products and services that IIFSs offer may stunt the growth of the Islamic finance industry and reduce stakeholders’ confidence in the viability of Islamic financial solutions. Specific measures that can be undertaken to mitigate this risk would include amending existing laws or guidelines in favor of the industry, appointing Shari’ah experts to provide advice on IIFS’s operations, preparing legal documentation that is enforceable and which conforms with existing laws and the Shari’ah, and ensuring that the talent behind Islamic finance operations is well-versed in Islamic contracts.

Capital structure risk

Both an IIFS and its conventional counterpart face capital structure risk, which refers to how a firm finances its overall operations and growth by using different sources of funds. Both types of institutions use a combination of debt (short and long-term) and equity (common equity and preferred equity) for funding. Nevertheless, the instruments issued by IIFSs, as mentioned in IFSB Exposure Draft 15 that will make up an IIFS’s additional capital, would be required to meet the necessary requirements in order to ensure Shari’ah compliance. The risks associated with such instruments would therefore be assessed differently than those of conventional instruments.

(At the end let me confess that I grabbed last three definitions from my friends thesis of PhD in Islamic finance and overall article is taken from Islamic finance certification syllabus and mba Islamic finance syllabus)