There are risks involved with any investment, and
Islamic finance is no exception. Not surprisingly,
some of the more significant risks lie in its relationship with Shariah.
Compliance with Shariah’s code and principles
presents the largest risk because it constitutes the
necessary first step toward acceptance of a product
and service by Muslim consumers and investors.
To prove compliance means that the product and
service must first have the approval of a religious
This is why the single most important factor in
the management of risk in Islamic finance is the
Shariah supervisory board. These boards generally
consist of at least three Shariah scholars who have
specialized qualifications in finance or economics.
They often participate in product research and
development before issuing a fatwa, or ruling, on
its compliance with Shariah law.
Recognizing the importance of this religious
approval, some areas now require a Shariah supervisory board, as well as a fatwa for any company
offering Islamic financial services and products.
Such certification signifies that a product not only
complies with jurisdictional regulations, but has
also been scrutinized by an authority on Islamic
However, issuing a fatwa does not guarantee
market acceptance that a product is Shariah
compliant. In fact, there are several reasons for
the failure of a product or service in the Muslim
community, including differences of legal philosophy among various jurisdictions, a lack of detailed
disclosure in a fatwa, the failure of an investor
Shariah board to comprehend the operations or
structures described in a fatwa, or simply the rejection by consumers who feel that a fatwa has not
adequately addressed their concerns.
The perception of whether a product or service
is Shariah compliant, or whether an institution is
engaged in activities that are deemed unlawful
under Shariah, leads to reputation risk. Again, the
Shariah supervisory board plays a crucial role in
conducting due diligence and helping to ensure
compliance to mitigate this risk.
The development of consistent and universally
accepted accounting and regulatory standards
is also becoming increasingly important for the
industry as Islamic financial activity flows across
borders. The industry is responding by establishing a global financial architecture that includes
the Accounting and Auditing Organization for
Islamic Financial Institutions (AAOIFI), which
was founded in 1990, and the Islamic Financial
Services Board (IFSB), established in 2002. These
organizations have been essential for the stability
of the system, primarily because they have played
a key role in reconciling accounting and regulatory standards across different jurisdictions. They
have also been instrumental in instituting international best practices.
Market, credit, funding and liquidity risks also
pose unique challenges to Islamic financial institutions because of Shariah compliance. The management of market risks is often more difficult for
Islamic banks than their conventional counterparts
because of the limited number of risk management
tools and instruments available to them.
Collateral coverage at Islamic financial institutions is
often higher then at conventional banks since they
have an obligation to back any transaction with a
tangible, underlying asset. Still, certain transactions
carried out by Islamic banks can bear above-average
credit risk, namely musharaka (venture capital
financing) and mudaraba (trust financing).
Funding and liquidity risk is one of the most critical
issues for Islamic financial institutions since only a
small secondary market exists to enable them to
manage liquidity. Their assets are generally not
sellable on a secondary market, and they aren’t
able to invest in fixed-income instruments for treasury management purposes.
The unprecedented volatility persisting throughout
world financial markets today is redefining the
structure and regulation of the financial services
industry and creating a convergence toward the
principles exhibited in Islamic finance. Expressly,
there is heightened awareness for greater diversification of risks in the management of funds.
Against a backdrop of a challenging global environment, Islamic finance is emerging as a competitive form of intermediation in the international
financial system. Ultimately, its expansion may
contribute to a more efficient allocation of capital
globally—as well as to greater financial stability—
as financial linkages among the East Asian, West
Asian and Middle East regions evolve.
For Islamic finance to be fully embraced across the
globe, the industry will need to continue to expand
business parameters and create new product offer-
ings. Specifically, the industry must increase its
investment in research and development to yield
new instruments, education and training, regulatory structures, best practices and higher standards
of risk management to meet the requirements of
the international community. These solutions need
to combine market requirements with Shariah
compliance, as the forces of innovation will expose
the divergence of Shariah views that underlie a
number of Islamic financial transactions.
Moving forward, one of the highest priorities as
a global financial system is to find ways to restore
confidence in the markets. Islamic finance may
indeed provide that opportunity by opening the
door to other alternative forms of investing—
particularly ones that emphasize the sharing of risk
and reward. Despite an impending market recovery,
there will likely be a continued trend toward risk-averse investments and intense scrutiny of investment practices across the board, which will give
Islamic finance a boost for years to come.
Rod Ringrow is a senior managing director of
State Street and is responsible for the company’s
activities in the Middle East and North Africa. He
is based in Doha.
To obtain a copy of this Vision Focus report
on Islamic finance or for more information,
members of the press can contact
firstname.lastname@example.org. All other
requests can be directed to vision@statestreet.
com. Previous reports in State Street’s Vision
series address topics that include the pensions
industry, sovereign wealth funds, the insurance
industry, hedge funds and derivatives.
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