Introduction

Islamic banking does not permit money to make money by itself, meaning that it is forbidden to charge interest. Therefore, a financier must provide some form of effort or take some form of business risk to generate a legitimate profit.

This puts risk at the heart of a Shari’ah-compliant banking transaction. A bank can mitigate its risks but it can not eliminate them completely if it is to be compliant.

But this form of banking has grown rapidly from its tentative beginnings just three decades ago. It is weathering the recent turmoil and some commentators have suggested it as a way for western banks to regain the trust of the public and their clients.

Key findings

• Equity finance – The treatment of the equity based finance of some of the Islamic financing instruments are unfavourably dealt with under Basel II.
• Rate of return/displaced commercial risk - The rate of return received by Islamic banks on their investments is less certain than those of conventional banks so the returns to their clients are less certain. In extreme cases the bank may make up returns from its own profits (or even its capital) so they are equivalent to those of conventional interest based banks.
• Inventory - In some Islamic financing instruments the bank needs to actually own the asset before it can be sold to the client. This can expose the bank to the risks of ownership and if the transaction fails it can also leave it with an asset that needs maintenance and the need to find another buyer.

Conclusion

Risk is an important and inherent part of Shari’ah compliant banking. Financial institutions are encouraged to take steps to mitigate and manage those risks but they are not permitted to remove all risks, or allocate their trading risks to another party such as an insurance company, as this would negate their compliance.

The ethical nature of the banking relationships promoted by Islamic banking has also attracted attention in the current global financial crisis. This attitude may in the long term act as a catalyst for change in the conventional banking system to help reduce systemic risk of over indulgence.

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Tagged with: 2009, Islamic, risk, Risk Research Report