Mapping the Risks and Risk Management Practices in Islamic Banking

CHAPTER 2Principles of Islamic Banking and Finance

Until the global credit crunch hit the capital and financial markets in the middle of 2008, Islamic finance had enjoyed uninterrupted growth since the start of the decade to become an industry with about USD 1 trillion in assets (Moody's, 2011a). In terms of the size of the world's finance industry as a whole, this is still very small, less than a 1% share; but with nearly 25% of the world's population being Muslim, it is obvious that the potential for growth is enormous (Eedle, 2009). The global potential market for Islamic finance is conservatively estimated at USD 4 trillion, whereas the actual size of the market is USD 1 trillion, or a market share of 25%, which means that there is still around 75% of the market to capture (Moody's, 2011a).

Despite being presented as a new phenomenon, Islamic finance has been practised since the Middle Ages. It has risen in prominence over the last 30 years. This is largely due to the growing financial resources of oil-producing countries where Islam is the main religion, an increase in wealth and financial sophistication, and an increasing demand for financial services. In recent times, the emerging Islamic banking sector has achieved acceptance in the Western world where there is increasing interest in ethical finance, and funds managed by Islamic institutions continue to grow.

In order to understand the risks that Islamic banks face, this chapter first discusses the nature of Islamic banking. ...