Risk Management 281
in addition to the typical principal/agent problems, the Islamic bank
is exposed to an enhanced credit risk on the amounts advanced to the
mudarib. The nature of the contract is such that it does not give the bank
appropriate rights to monitor the mudarib or to participate in the man-
agement of the project, which makes assessment and management of the
credit risk diffi cult. The bank is not in a position to know and decide how
the activities of the mudarib can be monitored accurately, especially if
claims of losses are made. This risk is especially present in markets where
information asymmetry is high and there is low transparency in fi nancial
disclosure by the mudarib.Managing credit risk is further complicated by some additional exter-
nalities. In the case of default by the counterparty, Islamic banks are pro-
hibited from charging any accrued interest or imposing any penalty, except
in the case of deliberate procrastination. This can be misused by clients
who may delay the payment, since they know that the bank will not impose
extra charges. During the delay, the bank’s capital is not productive and its
investors/depositors are not earning any income. Another example is where
the bank’s share in the capital invested through a mudarabah or musha-
rakah contract is transformed into a debt obligation in the case of proven
negligence or misconduct of the mudarib or the musharakah’s managing
partner. As a result, the rules to recover a debt are applied, which are differ-
ent from the rules of mudarabah and musharakah investment.
Risk mitigation techniques used by Islamic banks for credit risk do not
differ much from those used by conventional banks. Risk measurement can
be achieved by maintaining good - quality data on past performances of the
counterparty and by determining the probability of default. In many devel-
oping countries where there are no formal institutions to maintain credit
data, banks often rely on the client’s track record with the bank. In the
absence of rating agencies and public disclosures, information about a cli-
ent’s creditworthiness has to be gathered through informal sources and local
community networks.
Using collateral and pledges as security against credit risk is a common
practice among all Islamic banks. The bank might ask the client to post
additional collateral before entering into a murabahah transaction. In some
cases, the subject matter of the contract is accepted as collateral. Posting col-
lateral as security is not without diffi culties, especially in developing coun-
tries. Typical problems include the illiquidity of the collateral or the inability
of the bank to sell the collateral, and diffi culties in determining the fair mar-
ket value on a periodic basis. The most important of these, however, are the
legal hindrances and obstacles in taking possession of the collateral. Due to
weak legal institutions and slow processing, it becomes diffi cult for the bank
to claim the collateral. In addition to collateral, personal and institutional
guarantees are also accepted to minimize credit risk.