Islamic Finance: The New Regulatory Challenge, 2nd Edition

Chapter 3

Risk Characteristics of Islamic Products: Implications for Risk Measurement and Supervision

Venkataraman Sundararajan

1. INTRODUCTION

This chapter discusses risk characteristics of various Islamic finance products and key issues in the measurement and control of risks in Islamic financial services institutions. In particular, the chapter highlights the role of risk sharing in Islamic finance and the implications of profit-sharing investment accounts (PSIA, or “investment accounts”) for risk measurement, risk management, capital adequacy, and supervision. Empirical evidence suggests that the sharing of risks with PSIA is fairly limited in practice, although, in principle, well-designed risk (and return) sharing arrangements with PSIA can serve as a powerful risk mitigant in Islamic finance. Supervisory authorities can provide strong incentives for effective and transparent risk sharing and for the associated product innovations. The chapter also covers the scope of supervisory intervention and a value-at-risk (VaR) methodology for measuring these risks.

A key principle underlying the design of Islamic financial products and services is the notion that mutual risk sharing (for example, between banks and entrepreneurs, or between banks and depositors) is a viable alternative to interest-based financing, which is prohibited in Islamic finance. Islamic financial products and Islamic banks face a unique mix of risks and risk-sharing arrangements that arise from the contractual ...