Mapping the Risks and Risk Management Practices in Islamic Banking

CHAPTER 3Risk Management in Islamic Banks: A Theoretical Perspective

The fact that people are full of greed, fear, or folly is predictable. The sequence is not predictable.

—Warren Buffett

It has been argued by proponents of Islamic finance that most Islamic banking products are less risky than conventional banking products because they are based on real assets. These advocates strongly argue that Islamic banks are recession-proof and are more resilient to economic shocks than their conventional peers. On the other hand, opponents of Islamic finance believe that most of the conventional risks are also present in Islamic banking in addition to further risks that are quite specific to the Islamic structure. They strongly argue that Islamic banking is more risky and less developed than the Western Wall Street banking model. Who is right? Where does the truth reside?

These are challenging questions, the answer to which requires careful examination of the associated risks within Islamic finance in general as well as other areas of Islamic operations and the macro environment that could have an impact on the risk culture, risk tolerance and risk management of Islamic banks. A review of the existing literature does not provide a clear answer to these grey areas in Islamic banking, as the existing body of knowledge is still limited.

Risk management is at the heart of banks' financial intermediation process, and has assumed the utmost importance amid the recession, which has witnessed ...