Managing special risks of Islamic banks

Like any business, financial institutions or banks are exposed to various risks. Managing these risks in the banking sector has been a matter of utmost importance in recent times due to worldwide recession and subsequent fall of many renowned banks across the globe, the global and local competition, increasing deregulation, the innovation of new products and services and the introduction of various delivery channels with the help of advanced technology.
In the financial arena, these risks are mainly Credit risk, Operational Risk, Market Risk, Operational Risk and Liquidity Risk. Islamic banks operate in the same business environment in which conventional banks operate; therefore, all risks faced by conventional banks are also relevant to Islamic banks.
However, Islamic banks are exposed to additional risks which are unique to Islamic banks. Bangladesh Bank (BB) has issued various guidelines related to core risk issues such as: Credit Risk Management, Asset Liability Risk Management, Internal Control and Compliance Risk Management, Foreign Exchange Risk Management, Anti-Money Laundering Risk Management and Information Technology Risk Management. But there are no guidelines available on the risk management of Islamic banks especially by taking in to consideration the unique risks of Islamic banks.  This write-up is an attempt to look at some aspect of risk Islamic banks is exposed to while operating their business.
THE ORIGIN OF SPECIAL RISKS IN ISLAMIC BANKS: Unlike conventional banks, Islamic banks operate without interest and act as a sort of investment banks, if we put simply.  Banks invest this money through an array of financial tools and techniques that do not violate the norms of Islamic jurisprudence (Shariah) and share the profit or loss with the depositors.
As an alternative financial intermediary with profit and loss sharing contract (in Mudarabah and Musharakah contract) as its cornerstone, Islamic banks use various profit and loss share (PLS)-based contracts and non-PLS-based contracts (Murabaha, Ijara, Salam, Istinsa, Qurad etc.) while operating their business. These contracts, sometimes, may, slightly, resemble to what conventional banks practice i.e. debt financing (in Murabahah contract). But the fact is the nature of debt in an Islamic bank is qualitatively different from that of conventional bank since debt contract in an Islamic bank requires to be backed up by underlying assets. Besides, unlike conventional financing, a debt contract in Islamic financing scheme is not a Riba-based contract.  These essential features of Islamic banks and the modes of financing that they follow involve special risks that the management of Islamic banks should consider.
SPECIAL RISKS SURROUNDING ISLAMIC BANKS: In Islamic banks, depositors who deposit for sharing profit or loss with banks are known Investment Account Holders (IAHs). The IAHs typically expect their funds to be managed and invested in such a way which will ensure returns on their funds that are comparable to the returns paid by competitors (both other Islamic banks and conventional institutions). They also expect the Islamic bank to comply with Shariah rules and principles at all times. Consequently, the banking operations of all Islamic banks pose two   common risks which are as follows:
Shariah-compliance risk: This risk arises when Islamic banks fail to comply with the shariah rules and principles determined by the Shariah Board of the banks or relevant body in the jurisdiction in which Islamic banks operate. According to Islamic Financial Services Board (IFSB), shariah compliance should be given higher priority than anything else since violation of shariah principles will result in transaction being cancelled or income generated from them shall be considered illegitimate.
Performance risk: It is vital for Islamic banks to have sound financial performance and good reputation for managing the funds.  If they fail to perform their fiduciary responsibilities and show poor performance in aligning the objectives of the investors and shareholders with the actions they are supposed to carry out, they may start losing their customers which may affect banks' liquidity and ability to retain or attract more customers.
OTHER RISKS: While the above risks are general to all Islamic banks, other risks are mainly   associated with various PLS-based and non-PLS-based principles Islamic banks use.
The two Profit and loss sharing principles Islamic banks use are: Mudarabah and Musharakah. Under Musharakah, the Islamic banks may form partnership with a customer by providing a shariah-complaint investment facility on a profit and loss sharing basis.  It is an agreement, under which the Islamic banks provide funds, which are mixed with the business enterprise and others. The customer normally is the managing partner in the venture and bank may participate in the management. In Musharakh, banks profit on the investment is equal to a certain percentage of partners' profit.  Once the principal amount of the investment is repaid, the profit-sharing arrangement is concluded.  
Mudarabah is agreement between bank and an entrepreneur where bank provides capital and the entrepreneur provides expertise and labour. Any profits made will be shared between bank and entrepreneur according to an agreed ratio while in case of loss, capital provider bears all the loss.  It is to be mentioned here that Islamic banks use Mudrabah on both asset and liability side where Musharakh is normally used on asset side. In both cases, banks are exposed to certain risks which are as follows:
* As for Islamic banks, the use of PLS-based principles for the purpose of financing  do not refer to credit risk in the  conventional sense, but share the characteristic of credit risk due to the capital impairment. When a bank invests on Mudarbah basis, it assumes the role of Rab-al-mal and the entrepreneur hold the role of Mudarib. Bank does not directly run the business and depends on entrepreneur for managing the business financed through Mudarbah contracts. However, in case of Musharakh, banks have better opportunity to involve in the business, because in Musharakh contracts, partners may involve in managing the business.  
* In Musharakah and Mudarbah, there is a chance of default which normally occurs when the investment project fails to deliver the expected results. In this case, the low profit or loss is shared between parties according to pre-agreed ratios.  In PLS-based contracts, there is no recognised default on the part of entrepreneur until the PLS contract expires. Furthermore, PLS contract cannot logically be made with collateral or other guarantees to reduce the risks.
* PLS-based principles pose Equity Investment risk to banks and make Islamic banks vulnerable to risks normally attributable to equity investors rather than holders of debt. The risk arises from difficulty or wrong investment appraisal due to   lack of reliable information as to as to the quality of the partner, underlying business activities and ongoing operational matters. In PLS-based investment, the risk profiles of potential partners are crucial considerations for evaluating the risk of an investment to undertake. Banks may face delays and variations in cash flows patterns and possible difficulties in executing a successful exit strategy.
* The specific risks inherent to the operations of Islamic banks arise from the special nature of investment deposits where the capital value and rate of return is not guaranteed.  This may create problem for Islamic banks while offering return to the IAH's of the bank due to PLS based contarcts. Due to competition Islamic banks are under market pressure to pay a return more than the rate they have received from the investment of the funds provided by IAHs. On the liability side if returns are not competitive, banks may loss customers.
* PLS-based contacts poses liquidity risk to Islamic banks as well. For example, in restricted Mudarbah investment account and current account, a sound repayment capacity is required because the depositors have the right to withdraw their funds at any time.  In the same way, in Musharakha, banks must be able to provide committed funds as well as any expenses of the partnership or profit to the partners.
* Islamic jurisprudence offers its own framework for the implementation of commercial and financial contracts and banking and company laws appropriate for the enforcement of Islamic banking and financial contracts do not exist in many countries.  Therefore, for Islamic banks the impact of legal risks are substantial and may create legal problems for Islamic banks. For example, when a bank enters into musharaka contracts, it needs to acquire some shares from separate legal entity. A mixture of shares in one entity may lead to legal risk if the regulations don't allow doing such action.  Besides, the existing law may invalidate the legality of some PLS-based instruments. For example, In Indonesia, the law views some of the Mudarbah bonds issued as debt which in effect is guaranteed by the patrimony of Mudarib which directly conflicts with Shariah ( Izhar,2010)
The above risks have made PLS-based contract very unpopular, especially on the asset side of the banks and banks normally prefer non-PLS based modes. Like most of the Islamic banks in the world, Islamic banks in Bangladesh also use mainly non-PLS-based financing for investment activities. According to Bangladesh Bank, as on September 2014, the highest investments was made through Bai-Murabaha mode (44.01 per cent), followed by Bai-Muajjal (24.94 per cent), HPSM (15.73 per cent), Ijara & Ijara-bil-Bai (7.48 per cent), others (4.48 per cent), Quard with Security (1.95 per cent), Musharaka (1.20 per cent), Mudaraba (0.05 per cent) and Bai-Istisna (0.17 per cent). However, non-PLS-based principles are not risk-free at all and contain many risk elements some of which are in common with the above risks while some are unique to the specific contracts.
Let us consider the case of Murahaba which is the most popular financing mode among Islamic banks. Under this mode, Islamic banks buy an asset and sell it to the clients by expressing the purchase price and adding some profit or mark-up. The clients may pay the price to bank in one go or according to an agreed term.  A Murabaha transaction is completed through various stages and each stage takes time and involves a fresh contractual agreement which increases the risk of disagreements and complications. Further, it is also very important for banks to maintain the sequence of the contract in Murabahah transaction. Inability or failure to conform to the sequences and Shariah requirement will result in the transaction to be deemed illegitimate.  Other risks that may arise in case of Murabaha are:
* the  inability  to meet  the  specified  commodity stipulated in the contract and  subsequent  failure  to deliver the specified product agreed in  the contract on due date;
* Buyers' breach of contract in terms of keeping their promise to buy the commodity.
Bai-Muajjal also bears the same risk like Murahaba. Hire purchase under Shirkatul Melk (HPSM) is a Special type of contract consisting of three contracts: Shirkat, Ijarah and Sale and completed through three stages: purchase under joint ownership, hire and sale and/or transfer of ownership to the other partner, hirer. In hire purchase under Shirkatul Melk agreement, the exact ownership of both the hire (bank) and hirer (client) must be recognised in order to avoid the risk of any complications and disagreement. The share of the purchased asset owned by the bank is put at the disposal/possession of the client keeping the ownership with bank for a fixed period under a hire agreement in which the amount of rent per unit of time and the benefit for which rent to be paid along with all other agreed upon stipulations are also to be clearly stated. Islamic bank may be exposed to legal risk in respect of the enforcement of its contractual right to repossess the asset in case of default or misconduct by the hirer. This may be the case particularly when the asset is a house or apartment that is the lessee's home, and the lessee enjoys protection as a tenant. Furthermore, Ijarah (leasing) contract does not provide Islamic banks with the ability to transfer  substantial risks and rewards to the lessee as leased assets must be carried on the balance sheet of banks for the term of the lease. In case of  Salam (purchase with deferred delivery) contracts, banks agree to buy the commodity on a future date against current payment and also hold the commodity until it can be converted to a cash which expose banks to both credit and commodity price risk.
In conclusion, the unique features of Islamic financial contracts and the nature of business make Islamic banks exposed to some unique risks which are substantially different from conventional ones. The relative complexity of contracts, the fiduciary obligations, shariah-compliance risk and legal constraints imply that the dimension of risk exposure in Islamic banks is more sophisticated than in conventional banks. The absence of clear strategy to tackle these risks may hinder the usage and applicability of various Islamic contracts which ultimately may affect the industry and its growth.
The author works in a private bank in Bangladesh and has a post-graduate degree in Islamic banking, finance and management from the United Kingdom.
 akbar.chowdhury@yahoo.com