Contracts and Deals in Islamic Finance: A User s Guide to Cash Flows, Balance Sheets, and Capital Structures

Chapter 23Risk Management for Islamic Banks

Risk is an inherent force on all marketplaces. Each industry offers its own unique risks and its own unique ways of managing these risks. The art of risk management consists of identifying risks, measuring risks, and mitigating risks. This is a classroom definition of risk management. Risk simply refers to the probability of events occurring that adversely impact future expected outcomes. Risk addresses the probability of such events occurring and the impact they have on any given system. Manufacturing companies face the risks that by the time products come to the marketplace they are obsolete, unwanted, or are selling at prices lower than the cost of production. Banks confront a host of different risks that are unique to the business model of banks.

Financial intermediaries mobilize deposits from households, companies, and governments and lend these deposits back to other households, companies, and governments. At one stage banks are borrowers of funds and at another stage they are lenders of funds. The risks that impact a bank's ability to mobilize funds at a certain cost are different from the risks they face in being able to recover moneys lent out to third parties. Islamic banks face many of the same risks that are faced by conventional banks. These risks are categorized into credit risk, market risk, and liquidity risk. Islamic banks also face shariah risk, which is unique to Islamic Financial Institutions (IFIs); however, that ...