Risk Management 285
overall infrastructure of the fi nancial sector. Business risk also includes the
risk of becoming insolvent as a result of having insuffi cient capital to con-
tinue operations. While IFIs are exposed to the regular business environ-
ment, solvency, and infrastructure risks, they are particularly exposed to
one specifi c business risk — the rate - of - return risk.
Rate - of - return Risk
The rate - of - return risk stems from the uncertainty in the returns earned by
Islamic banks on their assets. This uncertainty can cause a divergence from
the expectations investors have on the liabilities side. The larger the diver-
gence, the bigger the risk. Another way of looking at this risk is that it is the
risk generally associated with overall balance-sheet exposures where mis-
matches arise between assets and balances of the depositors. For example,
an Islamic bank is expected to make fi ve percent on its assets, which will be
passed on to the investors/depositors. Meanwhile, if current market rates
rise to six percent, which is higher than what the bank may make on its
investment, the investment account holders/depositors may also expect to
earn the same on their deposits.
The rate - of - return risk differs from interest rate risk in two ways.
Firstly, since conventional commercial banks operate on interest - based
fi xed-income securities on the assets side, there is less uncertainty in the
rate of return earned on their investments if investments are held till matu-
rity. Since Islamic banks have a mix of mark - up based and equity - based
investments, this uncertainty is higher. Secondly, the return on deposits in
conventional banks is predetermined; in contrast, the returns on deposits
in Islamic banks are expected but not pre - agreed. In addition, returns on
some investments — those based on equity partnerships, for example — are
not known accurately until the end of the investment period. If, during this
period, the prevailing yield levels or expected rates of returns in the market
change, then the investors may expect similar yields from the bank.
It therefore becomes the responsibility of Islamic banks to manage the
expectations of their investment account holders/depositors, which makes
the rate - of - return risk also a strategic risk issue as part of the business envi-
ronment. Two sub - categories of rate - of - return risk have been identifi ed, as
follows:
Displaced commercial risk: This was fi rst identifi ed by the AAOIFI as
the risk that arises when an Islamic bank is under pressure to pay its invest-
ment depositors a rate of return higher than what should be payable under
the “actual” terms of the investment contract. This may occur when the
bank has underperformed during a period and was unable to generate ade-
quate profi ts for distribution to the account holders.
To mitigate this risk, banks may decide to waive their portion of profi ts
in order to dissuade depositors from withdrawing their funds and investing
elsewhere. An extreme example was the action by the International Islamic
Bank for Investment & Development in Egypt, which distributed all of its