Risk Management 279
document on risk management, identifying the different risks and listing
15 guiding principles of risk management for institutions offering Islamic
fi nancial services.
Figure 13.1 presents an overview of the risk profi le for operating an
IFI. Risks are grouped into four broad categories: fi nancial, business, trea-
sury, and governance risks. While these categories are also applicable to
conventional fi nance, there are risks specifi c to Islamic banks and fi nancial
institutions arising from the different nature of the intermediation, products
and constitution of the balance sheet. The major risks are discussed below.
FINANCIAL RISKS
Financial risks are the exposures that result in a direct fi nancial loss to the
assets or the liabilities of a bank. In the evolution of the risk management
discipline, fi nancial risks were the fi rst to appear in the discussion and policy
making. Both conventional and Islamic fi nancial institutions are exposed to
credit and market risks, but Islamic fi nancial institutions are also exposed
to equity investment risk.
Credit Risk
Credit risk is the potential risk that a counterparty will fail to make pay-
ments on its obligations in accordance with the agreed terms. It also includes
the risk arising in the settlement and clearing of the transactions. Credit risk
is present to varying degrees in almost all of the instruments and there are
many techniques to mitigate such risk. Traditional banking business based on
lending operations is considered a credit - risk business since the bank’s abil-
ity to minimize credit risk is the source of its profi tability. In the case of IFIs,
where lending is replaced with investments and partnerships, the importance
of credit-risk management becomes more critical. The unique characteristics
of the fi nancial instruments practiced by Islamic banks have special credit
risks such as the following:
■ (^) In the case of murabahah transactions, Islamic banks are exposed to credit
risks when the bank delivers the asset to the client but does not receive
payment from the client in time. In the case of a non - binding murabahah,
where the client has a right to refuse the delivery of the product purchased
by the bank, the bank is further exposed to price and market risks.
■ (^) In bay’ al - salam or istisna’ contracts, the bank is exposed to the risk
of failure to supply on time or to supply at all, or failure to supply the
quality of goods as contractually specifi ed. Such failure could result in
a delay or default in payment, or in delivery of the product, and can
expose Islamic banks to fi nancial losses of income as well as capital.
■ (^) In the case of mudarabah investments, where the Islamic bank enters into
the contract as rabb-ul - mal (principal) with an external mudarib (agent),