For central banks and financial regulators encountering Islamic banks for the first time, the challenge is often less one of socio-political legitimacy, but rather one of simply understanding that institution’s risks and putting in place an adequate supervisory framework to manage that risk.
We should make clear at the outset that not all Islamic banks are structured in the same manner and not all operate in equivalent legal and regulatory frameworks, hence a “one size fits all” supervisory approach is rarely appropriate. By way of simple example, some jurisdictions make the rules of AAOIFI (the global accounting and auditing body of the Islamic finance industry) mandatory for Islamic banks and others do not. Even those jurisdictions where AAOIFI rules are mandatory often have derogations from the rules and it is therefore quite difficult to generalise across the globe as to precise measures needed to address each risk.
Within Islamic banks, we typically find some risks which are customary across all banks (interest-bearing and Islamic) and some which are said to be unique to Islamic banks. Of course, we should not forget that interest-bearing banks also have their own unique risks (e.g. overdependency on derivative products) and these became glaringly obvious during the 2007/8 financial crisis (from which Islamic banks emerged largely unscathed).
Of the risks customary to all banks, we can list out liquidity risk, credit risks, market risks, operational risk, concentration risks and legal risks. The first of these (liquidity risk) was, at one time, somewhat problematic for Islamic banks because Islamic banks are unable to borrow short-term funding in interest-bearing markets). Nowadays however a range of measures (e.g. liquidity management companies, organised commodity murabaha trades and active sukukbased treasury operations) make it easy to mitigate the risk liquidity mismatches.
More interesting are those areas of risk that differentiate Islamic bank:
Margin risk reflects the fact that Islamic banks are, for the most part, buying and selling assets (under a contract called murabaha) where they apply a “mark-up” on the price they originally purchased for before reselling. This mark-up invariably bears a relationship to the cost of funds in interest-bearing markets (in fact, benchmarking against LIBOR or some other index is permissible) and because this mark-up cannot be adjusted post-trade it requires the banker to make accurate assessment of the likely cost of funds during the tenure. This risk can be mitigated (albeit never entirely eliminated) by the use of shorter term (and reoccurring) maturity periods.
Equity risk is simply recognition that Islamic banks do sometimes take equity positions (e.g. by way of mudaraba or musharakha) and equity, as opposed to debt, is the preferred method of funding in Islamic finance. Here education plays an important role – ensuring that the consumer understands he is engaging in investment activity rather than traditional banking of the “deposit and lend” type. It has to be said however that, on the asset side of their balance sheets, Islamic banks tend to have relatively few equity investments (and hence often little equity risk). Legislators can of course always introduce new laws to readjust the relationship between debt and equity, but this would be a major policy decision.
Displaced Commercial risk is a much used phrase in Islamic banking circles, but in practice is far overstated in importance. It refers to a situation where depositors (actually investment account holders) are likely to be aggrieved with their return on investment during a given period and shareholders feel obliged to “top up” that return in order to prevent the risk of depositors withdrawing their money. Much can be said about this. Firstly, not all deposits are investment based – some are simply safeguarding (“wadia”) or loan and loan back (“qard hasan”) arrangements. Where investment principles are applied, fluctuating returns can be mitigated by “profit 10 equalisation” mechanisms – which effectively even out returns by building-up a buffer during the most profitable years and distributing it during the lean years. Finally, we again stress the importance of good financial education – regulators need to ensure that Islamic banks make clear to consumers the nature of the contracts they are entering into.
Lastly, there is said to be Sharia’s risk – where an Islamic bank fails to comply fully with religious requirements and thus undermines confidence in its integrity and distinctiveness, possibly resulting in customer’s withdrawing their money. This risk is mitigated by each Islamic bank having a Sharia’s Supervisory Board which attempts to guide the bank’s adherence to religious rules. Most Islamic banks now also have a full-time Sharia’s Adviser or compliance department and some regulators in the Muslim world are now mandating Sharia’s Auditors. Clearly most Muslims view this subject as critically important, but we wonder to what extent it is of concern to non-Muslim customers of Islamic banks (of which there are many). Certain regulators, such as the UK’s Financial Conduct Authority refuse (probably quite rightly) to get involved in questions of religious adherence. And yet, it should be a subject important to all because Sharia’s adherence is (at least theoretically) a way of ensuring Islamic banks only do things which are ethical – things which have meaningful value, that share risks, that treat all parties fairly and, above all, avoid the curse of riba (usury) which has blighted so many people.
Overall, risk management in Islamic banks is different compared to interest-bearing banks, but in this writer’s opinion it is no more difficult. It is an established principle of Islamic finance that the financier should accept some of the risks of every transaction. We suggest to regulators and supervisors that the critical question is not just whether there is risk at an institution, but whether there is an appropriate allocation of risk as between institution and consumer. We believe that the events of 2007/8 have shown Islamic banks to be more favourable in their protection of the consumer than the interest-bearing banks.