Risk Management 291
the IFI and the investors/depositors would be based on a risk - sharing and
profi t/loss - sharing basis, the IFI still has to design investment products for
varying risk appetites and maturity ladders.
In that case, the ALM exposure becomes merely an operational matter
of aligning products on the liabilities side to the portfolios on the assets
side, and the challenge would be to ensure that the funds are not comingled
across investor classes and maturity ladders. This requires ensuring trans-
parency in the management of different portfolios.
In this respect, the IFI’s role in the fi nancial system would be similar to
that of a conventional asset manager and the balance sheet would resemble
a fund - of - funds, which would not be exposed to any ALM risk but would
be subject to operational risks.
Hedging Risk Hedging risk is the risk of failure to mitigate and manage
different types of risks. This increases the bank’s overall risk exposure. In
addition to non - availability of derivative products to hedge risks, illiquid,
non - existent and shallow secondary markets are other sources of the increas-
ing hedging risk of the Islamic banks.
Governance Risks
The importance of governance and the risks associated with poor gover-
nance have recently attracted the attention of researchers and policymakers.
Governance risk refers to the risk arising from a failure in governing the
institution, negligence in conducting business and meeting contractual obli-
gations, and from a weak internal and external institutional environment,
including legal risk, whereby banks are unable to enforce their contracts.
Operational Risk
A related type of governance risk is operational risk, defi ned as the risk of
loss resulting from the inadequacy or failure of internal processes, as related
to people and systems, or from external risks. Operational risk also includes
the risk of failure of technology, systems and analytical models. It is argued
that operational risks are likely to be signifi cant in the case of Islamic banks
because of their specifi c contractual features and the general legal environ-
ment. Specifi c aspects that could increase operational risks in Islamic banks
include:
■ (^) Cancellation risks in the non - binding murabahah and istisna’ contracts
■ (^) The failure of internal control systems to detect and manage potential
problems in the operational processes and back - offi ce functions, and
technical risks of various sorts
■ (^) Diffi culties in enforcing Islamic contracts in a broader legal environment
■ (^) The need to maintain and manage commodity inventories, often in illiquid
markets