Modern Islamic Banking

CHAPTER 11Risks in Islamic Banks

The ethical framework governing Islamic finance prohibits gambling, uncertainty and interest. Although at first glance this sounds like a risk manager's dream, it does not at all mean that an Islamic bank runs little to no risk. Like other banks and financial institutions, Islamic banks face risks inherent in the financial industry, and in most countries they have to abide by the same rules as other financial institutions for the calculation of regulatory capital. However, Islamic banks also have their own set of unique risk management challenges.

Conventional banks are subject to a wide range of risks, which are described in Table 11.1. The need to quantify these risks has resulted in the development of what is currently the most widely used risk measure for banks, value at risk (VaR). VaR attempts to measure the downside risk of either a portfolio or, in aggregation, a firm by one single number, taking into account financial leverage and diversification effects. The result of the VaR equation is represented in the maximum amount a bank is likely to stand to lose on a given day or over a number of days (e.g. a week), generally with a confidence interval of 95% or 99%. It incorporates traditional risks and risks related to adverse market movements of financial derivatives and structured products. In addition, VaR may also be used as a basis for calculating the amount of economic capital required to support a business, which is an essential component ...