Risk management is underdeveloped in the Islamic banking due to limited resources, high cost management information system and lack of technological machinations to assess and monitor risk.
There are still only few risk hedging instruments and techniques in Islamic finance despite its rapid growth. Moreover, Islamic banks is perceived to have higher operational risk associated with greater number of contracts, newer supporting system, evolving skill sets and lack behind best practice adopted by conventional banks. Applications of financial engineering techniques require Islamic banks to focus on risk-return characteristic of the products. Another challenge for Islamic banks is the standardisation of the process in introducing new products in the market.
Cross border comparison of Islamic banking performances is difficult because the regulatory frameworks of Islamic banking jurisdictions are not standardised and remain highly divergent, ranging from frameworks that promote dual banking such as in Malaysia to frameworks that only recognised Islamic banking system such as in Iran.
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The issue of capital framework and liquidity standards is central in adopting the Basel III. The banking institutions are required to raise minimum capital requirements and hold a capital buffer. However, Islamic banks are exposed to operational risk arising from compliance to Basel III requirements. Some of the principles of risk management as proposed in Basel III can be applicable to the Islamic financial industry with necessary modification and adaptations.
Even so, Basel III could not answer all the risk management issues for Islamic financial institutions. Hence, there has been a need for alternative and supportive standards on risk management. Nevertheless, serious and sustained efforts are needed to find the applicability which is specific to countries and markets.
Islamic banks should enhance the risk mitigation strategies by ensuring best practices through sound risk management. The risk management practices should focus on strengthening their risk culture by increasing awareness of various risks exposure. Top management should ensure the suitability, adequacy and effectiveness of the risk management framework and risk management processes are embedded into their daily operations. Basel III has to a certain extent, enhanced risk coverage that can be assimilated by Islamic financial institutions. Even so, these accords are not considered much relevant to Islamic banks.
Islamic banks need to be ahead in exploring other dimensions of risks in the Islamic financial contracts such as emerging risk. Extensive investment by Islamic banking requires to have a place in a comprehensive internal risk management infrastructure.
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The risk management infrastructure in Islamic banking must therefore be in place to identify, measure, monitor and control all specific risks in Islamic financial transactions. Islamic banking need to be equipped with the required capacity and infrastructure to capture the respective risk weights and assign appropriate amount of regulatory capital at each of the different stages of Islamic financial transactions. There is need for thorough and appropriate credit evaluation techniques focusing on regular assessment of the creditworthiness and repayment abilities of the customers which lower the credit risk exposure.
The mitigation of liquidity risk in Islamic banking operations
It is essential to carefully examine the risk assessment, asset valuation, due diligence and monitoring before entering into equity-based financing. A proper governance framework should be established to consider appropriate level of disclosure that will create an adequate level of transparency and effective prudential supervision.
An effective regulation and supervision will ensure the soundness and the stability of the system. Effective risk management framework is pertinent as the magnitude of exposure to risk is indeed great in banking industry. A well-developed risk management framework is essential for Islamic banks to protect against unforeseen losses, achieve earnings stability, maximise profitability and withstand financial shocks.
Sharpening risk management capabilities in Islamic banks will contribute significantly to their competitiveness and sustainability.
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Operational Risk Management. New York: Plagrave MacMillan. New York: Palgrave MacMillan. A eds. Islamic Finance: Regulatory Challenges. Sunday, September 22, Share on Facebook Tweet on Twitter. The Concept of Risk Management The concept of risk management is acceptable to contemporary Islamic scholars based on the Quranic verse Al-Baqarah: , which requires Muslims to record debt or provide witnesses and supported by Hadith Sunan al-Tirmidhi: on the requirement to tie the camel before leaving its fate to Allah swt tawakal.
Key Risks in Islamic Banks There are several different types of risk Islamic banks face that can be divided into financial and non-financial risks.
Credit risk Credit risk is known as the potential risk attributed to delayed, deferred and default in payments by counterparties. Risk Mitigation Strategies Islamic banks should enhance the risk mitigation strategies by ensuring best practices through sound risk management.
A detailed look at the fast-growing field of Islamic finance and banking The guiding principle of Islamic finance has existed throughout Islamic history, yet modern Islamic banking has been around for a relatively short period of time.
Islamic Banking: How to Manage Risk and Improve Profitability
Discusses the history and development of Islamic finance Offers straightforward strategies for implementing Islamic finance into your business activities Sheds light on the effect of the global economic crisis on Islamic banks versus conventional banks Filled with in-depth insights and expert advice, this detailed analysis of Islamic finance will help you gain a firm understanding of how effective this proven approach can be. Select Parent Grandparent Teacher Kid at heart.
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