276 AN INTRODUCTION TO ISLAMIC FINANCE
■ (^) Regulatory environment: In the wake of a series of fi nancial crises, from
the Third World debt crisis of the 1980s to the East Asian crisis of the
1990s, there has been greater awareness of the need for coordinated
regulation and supervision of fi nancial institutions, with a special focus
on risk measurement and management and prudential capital require-
ments. There is a greater emphasis on coordinated efforts at the global
level to harmonize standards, promote transparency in the system and
to combat money - laundering and the fi nancing of terrorism.
These developments have increased the need for risk measurement,
management and controls. A comprehensive framework of risk manage-
ment is applicable to conventional and Islamic banks alike. Research and
experience in the past two decades have resulted in a much deeper under-
standing of the issues relating to risk management and, consequently, well -
established principles of risk management have emerged. The process of risk
management is a two - step process. The fi rst step is to identify the source
of the risk; that is, to identify the leading variables causing the risk. The
second step is to devise methods to quantify the risk using mathematical
models, in order to understand the risk profi le of the instrument. Once a
general framework of risk identifi cation and management is developed, the
techniques can be applied to different situations, products, instruments and
institutions.
The absence of a developed risk management framework in Islamic
fi nance has a signifi cant impact on the current and future growth of the
market because:
■ (^) A Shari’ah - compliant fi rm will lose its business competitiveness because
of its inability to handle variability in its costs, revenues, and profi tabil-
ity through active hedging of fi nancial risk.
■ (^) A fi rm without active risk management will be perceived as a high - risk
fi rm and thus will be subject to higher funding costs and to a higher
expected rate of return.
■ (^) There will be fewer optimal investment and diversifi cation opportunities.
■ (^) The fi rm will be subject to a high risk of fi nancial distress, especially
during a system - wide crisis.
All of these factors will lead to increased riskiness for the investors and
their wealth.
Having a robust risk management framework can also help Islamic
banks reduce their exposure to risks, and enhance their ability to compete in
the market. A reduction in each institution’s exposure will reduce the overall
systemic risk. Therefore, it is necessary that IFIs have a comprehensive risk
management and reporting process to identify, measure, monitor, manage,
report and control different categories of risks. This process should also pay
special attention to compliance with Shari’ah rules and principles.