Islamic Finance: The New Regulatory Challenge, 2nd Edition

Chapter 10

Legal Risk Exposure in Islamic Finance

Andrew White and Chen Mee King1

1. INTRODUCTION

In the post-crisis environment of the past few years (since 2007–2008), risk avoidance and the management of risk have both become an increasingly prominent feature of the finance landscape. Financial institutions and regulators are today much more sensitive to the various potential areas of risk and, especially, risk contagion. At broader industry levels, this has led to new accounting standards and requirements for capital adequacy, liquidity, and leverage. Within individual financial institutions, better risk analysis and management mechanisms are being implemented, and even structural changes are occurring as many financial institutions recognise the need for risk management to move from a “back office” function often loosely parked within the credit unit, to a “middle office” function with a unified and more clearly defined enterprise-wide responsibility for not only credit risk but also operational risk, liquidity risk, market risk, legal risk, and myriad other risk exposures.

Islamic financial institutions, especially when structured and conducting business as an analogue to conventional financial institutions, face the same threshold risk/return concerns as conventional financial institutions. But as Islamic financial institutions, they also have additional unique risk concerns arising from ensuring their operations (including risk management mechanisms), investments, and products ...