CHAPTER 1
Introduction: Research Background and Motivation

Risk knows no religion

-Michael Ainley, Head of Wholesale Banking, FSA (2007)

Was Michael Ainley right when he assumed that risk management is similar across different cultures and religions, in this case Islamic and conventional banks? Are Islamic banks just like any other bank that provides financial services, and hence have similar risk management requirements?

The subject of risk management in Islamic banking has many facets. On the surface, the frequently repeated story that Islamic banks are more resilient than conventional ones is attractive in a world torn by a financial tsunami. Unfortunately, at least in the current form in which Islamic banking is practised, this is not entirely true. The assumption at one point early in the crisis was that the Islamic market would be entirely unaffected and would sail through the crunch; and people thought that the financial crisis would be the lift-off platform for Islamic banks. On the contrary, the crisis exposed a number of areas in Islamic banking that needed to be dealt with.

This study examines different aspects of risk management issues in Islamic banking. At the heart of this book is the question of whether Islamic banks are more or less risky than their conventional peers. A review of the existing literature does not provide a clear-cut answer to this question. The majority of the relevant literature gives conflicting views using theoretical arguments rather than a formal empirical analysis. The question is clearly an empirical one, the answer to which requires feedback from the market place. The study thus attempts to fill this gap in the empirical literature on risk management in Islamic banking through a survey-based questionnaire and in-depth interviews.

The difficulties afflicting conventional financial markets since mid-2007 have led to more attention being paid to Islamic alternatives. While the modern Islamic finance industry is still young, it has been growing rapidly for several years, largely on the back of an oil-fuelled economic boom in the Middle East. Much demand came from non-Islamic investors who were simply attracted by good investment opportunities. With awareness of the industry rising, Islamic banks have expanded their operations, especially in the core markets of the Middle East and South Asia, but also in newer markets with substantial Muslim populations, including Sub-Saharan Africa and parts of Europe.

At the same time, risk management is receiving increased attention everywhere due to the financial crisis, and risk management products and methods for Islamic banking and finance (IBF) are certainly a hot issue. The market turmoil of the past few years has triggered a wide-ranging reassessment of the global financial system and a need to understand the causes that led to a financial crisis of a severity not seen since the Great Depression. One of the main areas of attention has been the failure of many financial institutions to manage their risks adequately. In most cases, the industry debate has focused on pure risk management failures, particularly the shortcomings of risk models in measuring risks accurately, without addressing the broader issue of how risk is managed at the highest macroeconomic levels and how the whole financial system is based on greed and lack of morality. Since then the credit crunch has afforded advocates of Islamic finance an opportunity to emphasise Shari'ah principles relating to debt and risk, finding a receptive audience beyond the Muslim world. For Islamic financiers, highly complex structured products such as subprime and toxic assets were seen as unacceptable because they were so far removed from their underlying assets.

There appears to be great potential for further growth in Islamic banking, which is still at a relatively early stage. However, there are also a number of challenges associated with developing a new industry with a different approach to risk management. It is notable that although Islamic banks were unscathed by the subprime crisis, many have since suffered from the negative effects of the broader recession, including a collapse in property prices in Dubai, where many Gulf Islamic banks had substantial exposure. The first sukuk defaults occurred in 2009 from two Gulf-based corporate institutions: Kuwait's Investment Dar and Saudi Arabia's Saad Group; others followed shortly after.

This research provides an up-to-date overview of current market practices, issues and trends in risk management for Islamic banks. It focuses on practical applications and discusses a wide range of unique risks faced by Islamic banks from the perspective of different ranges of practitioners. The book asserts that the weaknesses of many financial firms in managing their risks have to be looked at in a comprehensive fashion. The root drivers of the prevailing financial system have to be challenged and replaced by a more transparent and ethical alternative.

This research combines conceptual frameworks with 'hands-on' practical perceptions of risk management in Islamic banking in a pioneering piece of research that Shari'ah scholars, policy-makers, practitioners, academics and researchers will find of relevance and a motivation to conduct further research in this vital but under-researched area. Although a few Shari'ah opinions are included in the book, religious and Shari'ah discussions are beyond the scope of this research.

SYSTEMIC IMPORTANCE OF ISLAMIC BANKING AND FINANCE

Islamic finance is the fastest-growing sector in the financial industry at present. Launched to reconcile the financial with the theological needs of a global community of 1.5 billion Muslims, Islamic finance today offers a broad and sophisticated range of products and services. Double-digit growth rates for Shari'ah-compliant assets over the past decade have naturally driven Islamic financiers to look beyond historical boundaries to explore new territories, both within and outside the Muslim world.

The increasing international interest in Islamic finance is a reflection of the success that this industry has achieved during its short history. Moreover, Shari'ah principles that place emphasis on providing economic added-value to stakeholders, and aim to create equivalence in benefits and costs, free from harmful speculation, are gaining more attention and better understanding globally. Several Western supervisory bodies are incorporating amendments to their supervisory and regulatory legislation to allow for Islamic institutions and Shari'ah-compliant products, which will reinforce the role of Islamic finance globally. Nowadays, in European, American and most Western markets, financial institutions are offering more products and services to cater for Islamic finance. Moreover, a great number of financial institutions in Gulf Cooperation Council (GCC) countries and in Asia are managing funds of over USD 300 billion and are encouraged by their markets to provide Islamic financial services (Moody's, 2011a).

Islamic banking, being the main sub-sector within the Islamic finance industry, has been pioneering this exponential growth. According to Moody's (2011a), the total assets held by Islamic banks globally amounted to more than USD 1 trillion by the end of 2010. While Islamic banks have been hit by the economic downturn, they have been considerably less affected than most conventional banks. This is mainly because, unlike conventional banks, the Islamic banks have not been exposed to losses from investment in toxic assets, nor have they been highly dependent on wholesale funds. Furthermore, Islamic instruments are highly useful alternative investments for the diversification of portfolios, as they have low correlation to other market segments, allow the selective underweighting of particular sectors, and seem to be relatively independent of even market turbulences like the subprime crisis. As a consequence, the increasing standardisation of derivatives and sukuk, as well as the growing liquidity and organisation of the Islamic capital market, offers many opportunities to innovative investors.

With such a background, it is obvious that Islamic banks have come a long way. The future of these institutions, however, will depend on how they cope with the rapidly changing financial world. With globalisation and the information technology revolution, the scope of different financial institutions has expanded beyond national jurisdictions, particularly for investment and wholesale banks. As a result, the financial sector in particular has become more dynamic, competitive and complex. There has been unprecedented development in computing, mathematical finance and innovation of risk management techniques. Moreover, the financial crisis is likely to challenge the global risk management foundations. All these developments are expected to magnify the challenges that Islamic financial institutions (IFIs) face, particularly as more well-established conventional institutions have begun to provide Islamic financial products. IFIs need to equip themselves with the up-to-date management skills and operational systems to cope with this environment. One major factor that will determine the survival and growth of the industry is how well these institutions manage the risks generated in providing Islamic financial services.

The last three decades have witnessed a shift of focus in the development of Islamic banking. The original objective of the 1960s and 1970s of developing an interest-free...