Chapter – 10

RISK MANAGEMENT IN ISLAMIC FINANCE

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True/ False Questions

1. Risk is associated with uncertainty, speculation, and obscurity in business

transactions.
Answer: True

2. Generally, risk is limited to the business environment since business transactions are
subject to generating profits and sustaining losses.
Answer: False

3. Despite the fact that excessive risk is prohibited in Islam, Islamic finance links profits
with risks.
Answer: True

4. A number of the Islamic finance products are inherently prone to risks.

Answer: True

5. Unlike their conventional counterparts, Islamic banks are protected from business
risks.
Answer: False

6. The risks faced by the Islamic banking industry are the same as the normal risks of
the banking industry.
Answer: False

7. In addition to the risks faced by conventional banks, Islamic banks also face risks
associated with the compliance with the Sharī'ah in Islamic finance transactions.
Answer: True

8. Only debt-based transactions in Islam finance are associated with risk.

Answer: False

9. The criterion of legality of any return on capital investment is risk.

Answer: True
10. The risk management measures being applied by Islamic Financial Institutions (IFIs)
are either Sharī'ah-based or contemporary conventional measures.
Answer: False

11. Aleatory transactions are transaction completely anticipated by the parties engaging in
contracts such as games of chance or throw of a die.
Answer: True

12. Avoiding risk with zero profit in business activities is not allowed in Islam because
this is equivalent to interest (riba) from loans.
Answer: False
13. Avoiding risk with positive profit is allowed in Islam because such profit is not
equivalent to interest (riba) from loans.
Answer: False
14. Islam holds an impartial attitude towards risk management as risk management is
barely addressed in the Holy Qur’an and Sunnah.
Answer: False
15. Both the Holy Qur’an and Noble Sunnah urge Muslims to effectively manage risks
associated with their worldly activities.
Answer: True
16. The Islamic banks and financial institutions have utilized the conventional risk
management techniques prior to the development of Sharī'ah-oriented framework for
risk management.
Answer: True

17. The fiduciary duty Islamic financial institutions owe their customers requires them
to exercise due diligence in the management of the investment funds.
Answer: True

18. While crafting its guidelines, IFSB considered every technique or mechanism that
originates from the conventional banking industry to be non-Sharī'ah compliant.
Answer: False

19. The new IFSB guiding principles were meant to replace the existing framework of
Basel Committee on Banking Supervision (BCBS) guidelines used in all the banks
and financial institutions across the world.
Answer: False
20. Once Islamic banks and financial institutions decide to lend or extend financing
facilities, then they would have exposure to credit risk.
Answer: True

21. Failure to repay the debt within the time stipulated in the contract and in line with the
terms of the contract constitutes a liquidity risk for the bank.
Answer: False

22. The potential default of a bank’s customer to meet his or her obligations on agreed
terms constitute a credit risk for a bank.
Answer: True

23. Counterparties are retailers/consumers, corporate, or sovereign clients of the bank

who obtain credit facilities based on agreed terms and conditions.
Answer: True

24. The creditworthiness of the counterparties as well as the Sharī'ah compliance of

newly proposed business projects should be properly reviewed and established once
the credit has been approved to respective party.
Answer: False

25. Each Islamic financial instrument must have its unique Sharī’ah-compliant credit risk
mitigating technique.
Answer: True

26. Equity investment in unlisted companies refers to the acquisition of equity (or
ownership) participation in a joint venture company or a start-up.
Answer: True

27. Equity investment in listed companies is considered to be of higher risk than for
venture capital investment. .
Answer: False

28. The relationship between the IIFS and Investment Account Holders (IAH) is a
fiduciary relationship.
Answer: True

29. IFSB guiding principles on equity investment risk require the IIFS to define and
establish the exit strategies in respect of their equity investment activities, subject to
the approval of the institution’s Sharī'ah board.
Answer: True
30. According to IFSB-1, market risk is defined as the risk of losses in on-balance sheet
positions arising from movements in market prices.
Answer: False

31. The fluctuations in foreign exchange rates lead to market risk.

Answer: True

32. Foreign exchange rate risk is the risk arising from the changes experienced in the
currency exchange rates.
Answer: True

33. Liquidity risk involves a kind of systemic failure on the part of the financial
institution where it fails to meet expected and unexpected cash flow needs as they
emerge from time to time.
Answer: True

34. Just like the current account holders, the IAH have a share in the profits of the
business of IIFS as investors.
Answer: False

35. The current account holders do not participate in the sharing of profits realized in
investment activities.
Answer: True

36. The IIFS are under no obligation to maintain adequate liquidity at all times to meet
all their obligations.
Answer: False

37. Although Board of Directors (BOD) plays a vital role in a corporate entity, its role
is very limited especially when it comes to the challenges of liquidity risk.
Answer: False

38.The IIFS are discouraged from using balance sheet techniques to minimize exposure to
risks.
Answer: False
39.Rate of return risk management entails that necessary steps must be taken to mitigate
any mismatch between the assets and balances from the funds of the investors.
Answer: True
40. Operational risk can be defined as a risk that arises from the execution of the business
functions of an Islamic bank.
Answer: True

41. It is unlikely that operational risk leads to withdrawal of funds by the fund providers
and ultimate closure of accounts costing Islamic banks substantial losses in tangible
and intangible terms.
Answer: False

42. Operational risk includes risk arising from non-compliance with the Sharī'ah
requirements.
Answer: True

43. The risk management techniques or systems for Islamic banks and financial
institutions are meant to mitigate, transfer, avoid, or absorb the risk in particular
business undertaking.
Answer: True

44. Any measure undertaken to reduce the effect of any form of risk will be regarded as
risk management or risk mitigation techniques.
Answer: True
45. Gap analysis is a tool that helps companies to compare actual performance with
potential performance.
Answer: True

46. Risk-adjusted return on capital (RAROC), and gap analysis are standard Sharī'ah-
compliant techniques used for risk identification and management for Islamic banks
and financial institutions.
Answer: True
47. Gap analysis is also called need-gap analysis, needs analysis, and needs assessment.
Answer: True

48. Risk-adjusted return on capital (RAROC) is meant to give decision-makers the ability
to compare the returns from different projects with varying risk levels.
Answer: True

49. Risks that cannot be eliminated nor transferred in the business of an Islamic bank
must be ignored by the financial institution.
Answer: False
50. In Islamic finance, “entitlement to return is related to the liability of risk”.
Answer: True
51. Any futures, forwards, swaps, or options contracts involving market speculations are
not Sharī'ah compliant.
Answer: True
52. Market speculators are allowed to deliberately expose themselves to risk in order to
gain profit from currency fluctuations.
Answer: False

53. Hedging is applicable in all cases regardless of the purpose being to maximize profit
or to protect against loss of value as a result of various factors such as currency
fluctuation in the transaction involving an underlying real asset.
Answer: False

Multiple Choices Questions

1. The most common risks faced by the banking industry include:

a) credit risk
b) equity investment risk
c) market risk
d) all of the above

2. The followings are some of the most common risks associated with the banking
industry EXCEPT:
a) liquidity risk
b) job security risk
c) rate of return risk
d) operational risk

3. meaning entitlement to the return of an asset is associated with the risk resulting
from its possession.
a) al-ghunm bi al-ghurm
b) al-kharaj bi al-daman
c) sadd al-dhari’ah
d) aleatory transactions
 4. The Islamic Financial Services Board (IFSB) issued the Guiding Principles of
Risk Management for Institutions which:
a) offers both conventional and Islamic financial services (other than Insurance
Institutions)
b) offers only Insurance Services
c) offers only Islamic Financial Services (other than Insurance Institutions)
d) offers only retakaful services

5. The new IFSB guiding principles were meant to:

a) replace the existing framework of Basel Committee on Banking Supervision (BCBS)

guidelines used in all the banks and financial institutions across the world.

b) complement the existing framework of Basel Committee on Banking Supervision

(BCBS) guidelines used in all the banks and financial institutions across the world.

c) specifically cater for the needs and unique nature of institutions offering Islamic
financial services

d) b and c

6. The non-financial risks that Islamic banks are exposed to include:

a) operational risk
b) legal or Sharī'ah risk
c) reputation risk
d) all of the above

7. __________________is a type of banking risk that relates to the repayment of a debt

at the appointed time in accordance with the terms of such debt loan
a) credit risk
b) market risk
c) displace commercial risk,
d) operational risk

8. Which of the following risks is considered to be the most important type of risks
faced by banks and financial institutions in their relationship with the owners of
wealth due to the frequent defaults on payments?
a) liquidity risk
b) regulatory risk
c) credit risk
d) displace commercial risk
 9. According to IFSB-1, the proposed framework of credit risk for IIFS should
include an effective and practical system to:
a) monitor the condition of ongoing individual credits
b) manage problem credit situations according to an established remedial process
c) ensure that adequate provisions are allocated.
d) all of the above

10. The risk involved in the most popular Islamic finance instruments Mudarabah
and Musharakah is known as equity investment risk since
a) mudarabah and Musharakah are equity-based products
b) mudarabah and Musharakah are based-on joint venture through the partnership
of capital provider and the entrepreneur
c) both parties of the contract undertake to share the business risk, such as losses
d) all of the above

11._____________________are the bank’s customers who opt for the investment

account of the Islamic bank, which yields legitimate returns of predetermined share
of profits
a) Investment Account Holders (IAH)
b) entrepreneurs
c) financial experts
d) special Account Holders (SAH)

12.The IFSB guiding principles on equity investment risk management stipulate that
IIFS shall
a) ensure that their profit sharing methods are appropriate and consistent,
b) have in place appropriate strategies for risk management and adequate
reporting processes.
c) define the fiduciary relationship between the contracting parties.
d) all of the above
e) none of the above

13. __________________ is also known as systematic risk

a) credit risk
b) liquidity
c) market risk
d) operational risk
14. In some cases, market risk in a lease contract may arise from the:
a) default of payment on the part of the lessee due to price variation
b) default on the asset delivery by the bank/lessor
c) termination of the lease by the lessee earlier than the contractual term either
through default in payment or due to some other factors
d) All of the above

15.__________________ is a commodity sale involving an advance payment where

the delivery of the commodity is deferred.
a) Ijarah contract
b) murabahah contract
c) salam contract
d) restricted investment contract

16. Changes in exchange rates affect:

a) the value of investment by the IIFS
b) IIFS that engage in export and import business activities
c) IIFS that engage in international investments
d) all of the above

17.Liquidity risk can be caused by:

a) unanticipated change in cost capital
b) abnormal behavior of financial markets
c) risk activation by secondary sources
d) all of the above

18.The major funds directly managed by the IIFS include:

a) current account holders
b) unrestricted Investment Account Holders (IAH)
c) both of the above
d) none of the above

19.Apart from general withdrawal needs, the withdrawals made by IAH may be the result
of
a) lower than expected or acceptable rates of return
b) concerns about the financial condition of the IIFS
c) non-compliance by the IIFS with Sharī`ah rules and principles
d) all of the above
e) none of the above
 20. In their pursuit to retain their fund providers in order to avoid insolvency and an
ultimate liquidation, IIFS might:
a) guarantee fund providers a healthy return on their investments.
b) waive some of their rights by giving up their share of profits in the mudarabah
arrangement with the IAH
c) involve fund providers in the assets management
d) all of the above

21. _______________________is the amount appropriated by IIFS out of income of

IAH, after allocating the Muḍārib share, in order to soften the effects of the risk
of future investment losses on IAH
a) displaced commercial risk (DCR)
b) a Profit Equalization Reserve (PER)
c) an Investment Risk Reserve (IRR)
d) profit Rate Swap (PRS).

22. Operational risks can arise from:

a) strict compliance with the Sharī'ah requirements
b) failures in the internal controls of a financial institution involving processes,
people and systems
c) abnormal behavior of financial markets.
d) the fluctuations in foreign exchange

23. Failure of financial institution to uphold the fiduciary relationship with its
customers may result in:
a) loss of investments
b) an overall balance sheet exposures
c) inability of IIFS to meet their obligations
d) none of the above

24.________________is the potential that counterparty fails to meet its obligations in

accordance with agreed terms.
a) liquidity risk
b) rate of return risk
c) market risk
d) credit risk

25. Risk mitigation generally includes the followings EXCEPT:

a) risk avoidance / elimination
b) risk bearing
c) risk absorption / management
d) risk Transfer
 26._________________ is a tool that helps companies to compare actual performance
with potential performance.
a) SWOT analysis
b) quantitative analysis
c) gap analysis
d) risk analysis

27. Risk avoidance or elimination techniques in Islamic banks include:

a) measures that promote risk sharing start from the contractual stage; most
contractual terms in Islamic commercial transactions were legislated to share risks
b) all business-related documents must be standardized in line with the
requirements of the Sharī'ah and endorsed by the Sharī'ah Board of an
Islamic bank.
c) all processes, procedures and services rendered by the financial institution should
also be subject to the approval of the Board of Directors of an Islamic bank.
d) all of the above

28. In order to effectively absorb or manage various types of risk, the financial
institution should adopt the following techniques:
a) collateral (security against credit risk)
b) guarantees (supplements collateral to avoid absorb credit risk)
c) loan loss reserves
d) all of the above

29.Risk transfer involves:

a) the use of derivatives for hedging
b) changing borrowing terms and selling or buying of financial claims
c) excluding all elements of uncertainties (gharar) and interest (riba) from the
contract
d) a and b

30. The Sharī'ah-compliant risk transfer mitigation techniques developed by experts in

the Islamic finance industry include:
a) swaps such as debt-asset swap, swap of liabilities, deposit swap.
b) options include parallel contracts, such as bay al-arbun
c) futures include salam and commodity
d) all of the above
31. Derivatives are:
a) financial instruments or securities whose value depend upon or derived from
one or more underlying assets, or from the value of a rate or index of asset value.
b) proactive business positions intended to reduce the impact of potential loss that
may be incurred by a companion investment.
c) contingency plans in order to effectively mitigate instances of liquidity risk.
d) none of the above

32. The Islamic perspective on hedging is that:

a) hedging can be modified to suit the requirements of the Sharī'ah
b) hedging is applicable in all cases regardless of the purpose being to maximize
profit or to reduce risk and protect investments
c) any futures, forwards, swaps or options contracts are Sharī'ah compliant
d) all of the above