How is risk managed in Islamic Finance?

Why talk about Islamic finance? Islamic finance is a small but growing element in the world’s financial systems, and has grown fast since the start of this century, but it remains a very small part of the world’s financial business. Assets within the category of Islamic finance are estimated to be not much greater than 1% of the world’s total financial assets.

The two main types of Islamic finance are Islamic banking and the issuance of Islamic securities, called sukuk, by governments and firms that seek finance. Those markets comprise financial transactions or contracts designed to comply with the principles that can be traced all the way back to the teachings of the Prophet Mohammed 1,400 years ago. Their legal basis is located in shariah law that encapsulates those principles. The most recognised feature of Islamic finance is that those providing finance cannot receive interest. An individual, firm, or government raising finance cannot be charged interest.

That principle, the prohibition of interest, takes us to the heart of how risk is managed in Islamic finance, and it derives from the notion that if business is financed by debt, with an obligation to pay interest, the risk of the business is not being shared fairly. For example, a business using finance provided by lenders in conventional finance is obliged to pay interest on the debt even if the business makes losses. Islamic finance prohibits interest and requires that finance is provided on the principle of profit and loss sharing instead.

Well, think of an Islamic bank based on pure profit and loss sharing. If a business that has finance from the bank makes a loss, the bank would share the loss, instead of receiving interest that the business has to pay even in bad times. Meanwhile, people with deposits in the bank would find that the value of their deposits goes down if the bank makes losses, and that contrasts with conventional banking, where bank deposits have a fixed value. In other words, a pure Islamic bank’s reward for financing business goes up and down with the profitability of the enterprise, and its depositors’ wealth goes up and down in line with the bank’s profits. Economies do have ups and downs.

Business profits are always uncertain. With Islamic banks’ profit and loss sharing, all parties share the profits and losses. They share the risks. Now think of savers providing finance directly to a business. In conventional finance, an important means for doing this is to lend by buying a firm’s new bond. The bond contract promises to pay a rate of interest. In Islamic finance, though, the firm would issue a sukuk, not a bond, and you can finance the firm by buying a sukuk. Instead of receiving interest, the return you would get would fluctuate with the profitability of the enterprise. If it makes a loss, the value of your sukuk would fall.

Thus, sukuk finance is seen, in principle, as an instrument for sharing risk. But in practice, sukuk finance sometimes does not have pure risk sharing.

Islamic banks and sukuk today are based on contracts that formally match what is required by shariah law, but many scholars argue that the way they operate in practice is not based on Islamic profit and loss sharing. In substance, they are not different from conventional finance.

Pure Islamic banks would share risks, share profits and losses with their customers. But to minimise undesirable risks, they still need to manage risks. To do this, they can use some of the same methods as conventional banks. For example, to minimise credit risk, the risk of default, they can investigate and monitor the businesses they finance, although it’s not always easy. But some key instruments that conventional banks use for managing the risk on their balance sheet are not available. Financial derivatives, such as financial options, are not used in Islamic finance. Why not?

One reason is that a market in financial derivatives requires an accepted way to value the derivatives, and existing valuation methods involve discounting at an interest rate, which contravenes the prohibition of interest. A more significant difficulty is that a fundamental principle, set out by the Prophet Mohammed, is that finance must be directly tied to real economic activity. A financial instrument whose value is determined by another financial instrument, such as a financial derivative, contravenes that principle of materiality.

Islamic finance can and will grow. Its risk sharing and risk management practises might evolve. But the need to conform with shariah law principles will restrict its ability to grow and to develop a richly varied and deep financial system. For analysts and scholars, there is a lot more to learn and discover within this space.