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1. Unique features of an Islamic bank’s risk 1.

Equity Investment Risk Risks inherent in holding of equity instruments or investment purposes Risk profile of potential partners Under PLS contracts, the capital invested by the provider of finance (the bank) does not constitute a fixed return, but explicitly exposed to impairment in the event of losses (capital impairment risk) 2. Inventory Risk: Some Islamic financing contracts involves Islamic banks taking ownership of assets The bank is exposed to inventory risk in the event the customer does not buy the asset (credit risk) Holding of the inventory also exposes the bank to price volatility (market risk) 3. Rate of return Risk Returns to profit-sharing investment account holders are not fixed up-front – theoretically, investors will accept profit or loss on investment Practically, Islamic banks are wary of potential withdrawal of funds due to uncompetitive profit rate Displaced commercial risk Profit Equalisation Reserves and Investment Risk Reserves 2. Types of Risks and Their explanation  Displaced Commercial Risk

The Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) has identified displaced commercial risk as the risk when an Islamic bank is under pressure to pay its investorsdepositors a rate of return higher than what should be payable under the “actual” terms of the investment contract. This can occur when a bank underperforms during a period and is unable to generate adequate profits for distribution to the account holders. To mitigate displaced commercial risk, Islamic banks may decide to waive their portion of profits and thus dissuade depositors from withdrawing their funds. Islamic banks often engage in this self-imposed practice. The practice of forgoing part or all of the shareholders’ profits may adversely affect the bank’s own capital, which can lead to insolvency risk in extreme cases.

 Fiduciary Risk Fiduciary risk is the risk that arises from an institution’s failure to perform in accordance with explicit and implicit standards applicable to its fiduciary responsibilities. Fiduciary risk leads to the risk of facing legal recourse if the bank breaches its fiduciary responsibility toward depositors and shareholders. an investment risk reserve (IRR) is maintained out of the income of investors-depositors after allocating the bank’s share. including legal risk. If an Islamic bank is run inefficiently and keeps producing lower returns. the bank is expected to perform adequate screening and monitoring of projects. in order to dampen the effects of the risk of future investment losses. whereby banks are unable to enforce their contracts.The experience gained from the attempt to mitigate displaced risk has led to the development of two standard practices in the industry.” which results mainly from the competitive pressures an Islamic bank faces both from other Islamic banks and from conventional banks with Islamic windows. If and when the objectives of investors and shareholders diverge from the actions of the bank.  Withdrawal Risk Another type of business risk is “withdrawal risk. and any deliberate or intentional negligence in evaluating and monitoring the project can lead to fiduciary risk. This reserve is funded by setting aside a portion of gross income before deducting the bank’s own share (as agent). The following are some examples of fiduciary risk: In case of partnership-based investment in the form of mudarabah and musharakah on the assets side. The first practice is for the financial institution to maintain a profit equalization reserve (PER). eroding the franchise value of the bank. Governance risk refers to the risk arising from a failure to govern the institution. An Islamic bank could be exposed to the risk that depositors will withdraw their funds if they are receiving a lower rate of return than they would receive from another bank. Islamic banks are expected to act in the best interests of investors-depositors and shareholders. It has been suggested that the basis for computing the amounts to be appropriated should be predefined and fully disclosed. The reserve provides a cushion to ensure smooth future returns and to increase the owners’ equity for bearing future shocks. the bank is exposed to fiduciary risk. negligence in conducting business and meeting contractual obligations. and a weak internal and external institutional environment. depositors eventually will decide to move their money. As fiduciary agents. . Similar to PER. It becomes incumbent on management to perform due diligence before committing the funds of investorsdepositors.  Governance Risk The importance of governance and the risks associated with poor governance have recently attracted the attention of researchers and policy makers.

and risk management practices” . Transparency Risk Transparency is defined as “the public disclosure of reliable and timely information that enables users of that information to make an accurate assessment of a bank’s financial condition and performance. the bank’s risk is higher in nonbinding cases and may lead to litigation in the case of unsettled transactions. in the case of heavy losses on the investments financed by the funds of current account holders. Accordingly. can expose the bank to fiduciary risk as well.who may rush to withdraw their funds. However. others argue that the buyer has the option to decline even after placing an order and paying the commitment fee. which are accepted on a trust (amanah) basis. auditing. For instance. and accounting treatment. First. Finally.  REPUTATIONAL RISK .  Shariah Risk Shariah risk is related to the structure and functioning of Shariah boards at the institutional and systemic level. business activities. lack of transparency creates the risk of incurring losses due to bad decisions based on incomplete or inaccurate information. While different schools of thought consider different practices to be acceptable. Fiduciary risk can lead to dire consequences. It is common practice for Islamic banks to use the funds of current account holders without being obliged to share the profits with them. it may lead to insolvency if the bank is unable to meet the demands of current investment account holders. it can cause reputational risk. Transparency also demands that all banks in the system use a uniform set of standards. Mismanagement in governing the business by incurring unnecessary expenses or allocating excessive expenses to investment account holders is a breach of the implicit contract to act in a transparent fashion. and the second is due to the failure to comply with Shariah rules. risk profile. it can have a negative impact on the market price of shareholders’ equity. which is not the current practice. Lack of transparency arises from two sources: the use of nonstandard conventions for reporting Islamic financial contracts and the lack of uniform standards of reporting among banks. Differences in the interpretation of Shariah rules result in differences in financial reporting. Third. Islamic financial instruments require different conventions of reporting to reflect the bank’s true financial picture. which can result in a financial loss. while some Shariah scholars consider the terms of a murabahahor istisnah contract to be binding on the buyer. it may require the bank to pay a penalty or compensation. Second.Mismanagement of the funds of current account holders. Fourth. it can affect the bank’s cost and access to liquidity. the depositors can lose confidence in the bank and decide to seek legal recourse. This risk could be of two types.creating panic among depositors. the first is due to nonstandard practices in respect of different contracts in different jurisdictions.

Reputational risk. Close collaboration among financial institutions. . reputational risk is the risk that the irresponsible behavior of a single institution could taint the reputation of other banks in the industry. or “headline risk. The Islamic financial services industry is a relatively young industry.and a single failed institution could give a bad name to other banks that are not engaged in irresponsible behavior. profitability. all Islamic banks in a given market are exposed to such risk. Nevertheless. and establishment of industry associations are some of the steps needed to mitigate reputational risk.” is the risk that the irresponsible actions or behavior of management will damage the trust of the bank’s clients. standardization of contracts and practices. and liquidity. Although the fiduciary and Shariah risks also stem from negligence and noncompliance. Negative publicity can have a significant impact on an institution’s market share. self-examination.