284 AN INTRODUCTION TO ISLAMIC FINANCE
Some of the distinct features of equity investment risk are:■ (^) The nature of equity investment requires enhanced monitoring meas-
ures to reduce informational asymmetries. These include proper fi nan-
cial disclosures, closer involvement with the project, transparency in
reporting and supervision during all phases of the project from apprais-
als to completion. Therefore, Islamic banks need to play an active role
in the process of monitoring, in order to mitigate this risk.
■ (^) Both mudarabah and musharakah are profi t/loss - sharing contracts and
are subject to loss of capital despite proper monitoring. The degree of
risk in equity investments is higher than in other investments and, there-
fore, Islamic banks should take extreme care in evaluating and selecting
the projects in order to minimize any potential losses.
■ (^) Equity investments (other than stock market investments) do not have
secondary markets and therefore an early exit is costly. The illiquidity
of such investments can cause fi nancial losses to the bank.
■ (^) Equity investment may not generate a steady income, and capital gain
might be the only source of return. This unscheduled nature of cash
fl ows can pose diffi culties for the Islamic banks in forecasting and man-
aging the cash fl ows.
Business Risks
Business risks are associated with a bank’s business environment, including
macroeconomic and policy concerns, legal and regulatory factors and the
IFSB PRINCIPLES OF EQUITY INVESTMENT RISK
Principle 3.1: [Islamic Financial Institutions] shall have in place appro-
priate strategies, risk management and reporting processes in respect
of the risk characteristics of equity investments, including mudarabah
and musharakah investments.
Principle 3.2: [Islamic Financial Institutions] shall ensure that their
valuation methodologies are appropriate and consistent, and shall
assess the potential impacts of their methods on profi t calculations
and allocations. The methods shall be mutually agreed between the
institution and the mudarib and/or musharakah partners.
Principle 3.3: [Islamic Financial Institutions] shall defi ne and estab-
lish the exit strategies in respect of their equity investment activities,
including extension and redemption conditions for mudarabah and
musharakah investments, subject to the approval of the institution’s
Shari’ah Board.