Islamic Finance: The New Regulatory Challenge, 2nd Edition

Chapter 6

Inherent Risk: Credit and Market Risks

John Lee Hin Hock

1. INTRODUCTION

Islamic finance has grown significantly since its rise to prominence in the last decade, with a growing number of countries adopting Islamic finance as the emblem of their financial services sector. The prominence received a further boost with the global financial crisis, when doubts were cast on the role of the conventional financial system in financial intermediation insofar as it was evident that the conventional financial system increasingly was decoupled from the “real” economy.

Nonetheless, while the interest in Islamic finance has grown, the management of the risks inherent in the operation of Islamic financial institutions (IFIs), particularly relating to specificities of Shari’ah-compliant products and services, is still relatively new and developing. Although some progress has been made through the establishment of Islamic finance risk and governance frameworks, advances in the area of risk management for Islamic finance have not kept pace relative to the growth of the industry.

The chapter explores the risk specificities of Shari’ah-compliant products and services, particularly the credit and market risks of these products and services.

2. DISTINCTIVE RISKS

IFIs are faced with risks that are distinct from those of their conventional counterparts. The tenets of Islamic finance are based on the conformity to Shari’ah law, which is the juristic code of Islam based on the Qur’an and the