Risk Islamic Bank
Risk Management in Islamic Banking
Literature Review:
There are a couple of research papers and books on risk management in banking but only few in the field of Islamic banking. Clearly, Islamic banks are more risky than their conventional peers and it is clearly stated in many of the publications. A paper in Jan 2004 by V. Sundararajan titled Risk in Islamic Banking & the general Framework to Deal with these Risks discussed the risks faced by Islamic banks and how they can be controlled or avoided since the use of risk hedging techniques is not permissible in Islamic banking. The Islamic Shariah (law) does not allow Gharar (high uncertainty) that are associated in hedging techniques like options and futures. Therefore, traditional banks have an advantage of the use of these products and Islamic banks can not since they carry high degree of uncertainty. In additions, the research paper mentioned how risk is regulated and managed in Islamic banks by maintaining disclosure of information which is the basis of profit and loss sharing (PLS) in an Islamic bank.
A book Risk Management: An Analysis of Issues in Islamic Financial Industry by Tariqullah Khan and Habib Ahmed identified the risk attached to Islamic banks such as business and financial risk and their systematic (non-diversifiable) and un-systemic (diversifiable) risk. Also, they said that financial institutions face three types of risks, risk that can be eliminated, risk that can be transferred, and risk that can be managed. Moreover, they mentioned that Islamic banks can mange their risk by hiring external sources to evaluate the risk environment in bank and give a credit rating or by establishing an internal risk management department that mitigate the exposure to risk. The book goes in to more detail about different risk in a typical Islamic bank and the different ways of dealing with it.
Another book by Joel Bessis Risk management in Banking emphasized the measurement of risk in banking in accordance to its volatility and sensitivity. Further, he adapted two main risk measurements Value at Risk (VaR) and Capital at Risk (CAR). Both indicators quantify potential losses, for instance, VaR is compared to the tolerance level that gives the level of losses as a percentage, and the lower the tolerance level, the higher the VaR. The CAR on the other hand is also another loss measure but in a general view where it measures the entire bank portfolio. This will be an excellent reference for risk measurement.
An article titled A Compression between Traditional and Islamic Banking in the Field of Risk Management by Andrew Cunningham pointed out three difficulties that Islamic banks face. First, compliance with the Shariah then worrying about financial issues for an Islamic bank but for a conventional bank they pay attention only to the volatility of earnings. Besides, every Islamic bank should have its own Shariah board which consists of three scholars that make sure that bank operations are in accordance with Shariah. Second, the other difficulty that Islamic banks face is the engineering of Islamic financial products such as Mudaraba and Musharaka contracts. As have been mentioned before the Islamic bank is based on profit loss sharing so the borrower in any of the instruments is not obligated to repay if loss occurs. So, the interrelation in banks operation may affect deposits or the investment accounts. Another type of instrument is when a bank buys an asset and sells it again with profit to give cash to the borrower but in this type the bank acts as a mediator which increases the exposure to risk. The author summarizes this point by showing that Islamic banks are less risky since it's tagged to assets but in a traditional bank it is entirely credit risk. Finally, difficulties in deciding the allowable Shariah hedging technique to mitigate the whole bank risk, to some extent hedging is allowable in Shariah but is not permissible when high uncertainty exists.
The final peace of literature is Thirty Years of Islamic Banking by Phillip Molyneux and Munawar Iqbal (2005) which was a comprehensive reference in the field of Islamic banking. The book gave a good description of the Islamic banks operations compared to conventional banks. Most importantly they showed the profitability of Islamic banks compared to their conventional peers which proved that Islamic banks are far profitable. Finally, the book listed challenges facing Islamic banks and its route to development for instance corporate governance, and challenges from innovating new products.
All these literatures will be the base for the working paper on Risk Management in Islamic Banking. The dissertation will cover other references that will be included in the bibliography. This dissertation intended's to be for the completion of the Master of Science in Accounting and Finance.
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