Risk Management 297
commercial risk. The correlation between the PER and the asset’s return could,
therefore, be an indicator of “displaced commercial risk.” Thirdly, the PaR
model can also be applied to individual business lines within the bank, such
as the case of specifi c portfolios linked to restricted investment deposits to
determine the level of risk. The application of quantitative models such as PaR
can help management with their decision - making regarding the level of PER
and can offer transparency to investors regarding the volatility of profi ts.
Trade fi nancing and lease - based fi nancial instruments on the assets side
of IFIs resemble fi xed-income asset - based securities and thus some of the
standard risk measurement techniques such as duration, gap analysis, buck-
eting, DV01, and Value - at - Risk (VaR) can be computed to monitor the level
of the risks. Baldwin (2002) provides a discussion on duration and VaR
measures for Islamic instruments. The use of such monitoring tools becomes
more important for IFIs given the lack of risk - mitigating derivative products
and the low liquidity of the assets. Also, there could be issues in the use of
parametric VaR for instruments based on mudarabah and musharakah con-
tracts and therefore alternative measures should be designed.
On the credit risk side, the valuation of collateral needs special atten-
tion. Although the use of collateral is recognized as a legitimate risk mitiga-
tion tool, in practice, many supervisory authorities tend to underestimate the
existence of collateral because the valuation and determination of fair market
value is not an easy task, especially in the case of underdeveloped markets.
Therefore, advanced models based on simulations and other analytical tech-
niques should be developed to measure the extent of exposure arising from
credit risk.
Implementation Challenges Implementation of the risk management frame-
work requires close collaboration between the IFIs, regulators and super-
visors. At the institutional level, it is the responsibility of management to
establish internal systems that can identify, measure, monitor, and manage
various risk exposures. Although the general principles of risk management
are common to both conventional and Islamic fi nancial institutions, IFIs
face the following specifi c challenges:
■ (^) Establishing supporting institutions and systems such as a lender of last
resort, a deposit insurance system, a liquidity management system, sec-
ondary markets, and a legal infrastructure favorable to Islamic instru-
ments and for the effi cient resolution of disputes.
■ (^) Achieving uniformity and harmonization in Shari’ah standards across
markets and borders. The current practice of maintaining individual
Shari’ah boards by individual institutions is ineffi cient and should be
replaced by a centralized board within each jurisdiction.
■ (^) Developing risk management systems is costly and out of reach for
many Islamic fi nancial institutions. Efforts should be made to collabo-
rate with other institutions to develop systems that are customized to
the needs of IFIs and which address instrument - specifi c modeling needs.