An Introduction to Islamic Finance: Theory and Practice

275

CHAPTER

13

Risk Management

A

s the banking business has changed signifi cantly in the last two decades,
the nature of the risks faced by fi nancial institutions has also changed.
Where three decades ago these were primarily credit and market risks only,
today’s fi nancial institution is exposed to a whole array of new risks and this
list is expanding. Several factors are responsible for this changed scenario:

■ Increased market volatility: Financial institutions fi rst realized the impor-

tance of risk management after the breakdown of the Bretton Woods sys-

tem of fi xed exchange rates, which led to signifi cant volatility in the foreign

exchange and interest-rate markets. Since then, volatility in the markets

and the subsequent demand for risk management products has become a

permanent feature of the markets.

■ Financial innovations: Financial innovations and rapid developments

in the derivatives market have increased the complexity of managing

fi nancial institutions. Innovative products have appeared on both sides

of the balance sheet and each new product brings its own unique risk/

return profi le, which ultimately affects the risk profi le of the institution.

The risk/return characteristics of some of the new instruments are com-

plex and are subject to highly volatile markets, exposing banks to new

or higher degrees of risk.

■ Shift in banking business: There has been a permanent shift away

from traditional lending business towards fee - earning activities. The

expanded role of money and capital markets has changed the nature

of intermediation by moving it away from formal institutions to direct

access to the market. The emergence of institutional investors such as

mutual funds has taken a signifi cant share of the market from tradi-

tional banking business.

■ Increased competition: Competition has increased, making it diffi cult

for small banks to compete as a result of the increasing costs of doing

business and the high costs associated with managing risks. A wave of

consolidation of fi nancial institutions was witnessed in industrial coun-

tries in the late 1990s, making the need for risk management even more

critical.

An Introduction to Islamic Finance: Theory and Practice, Second Edition

by Zamir Iqbal and Abbas Mirakhor

Copyright © 2011 John Wiley & Sons (Asia) Pte. Ltd.