290 AN INTRODUCTION TO ISLAMIC FINANCE
as agents for investors/depositors and pass all profi ts and losses through to
them. In addition, the risk - sharing feature in which banks participate with
their counterparties and investors/depositors plays a critical role. Direct
market discipline, one of the three main pillars recently emphasized by the
Basel Committee on Banking Supervision in enhancing the stability of the
international fi nancial market, is embedded in this risk - sharing principle.
Following the theoretical model, any negative shock to an Islamic bank’s
asset returns is absorbed by both shareholders and investors/ depositors.
While depositors in the conventional system have a fi xed claim on the
returns to the bank’s assets (receiving a predetermined interest rate in addi-
tion to their guaranteed principal, irrespective of the bank’s profi tability on
its assets side), holders of profi t - sharing investment accounts in the Islamic
system share in the bank’s profi ts and losses alongside the shareholders and
are exposed to the risk of losing all or part of their initial investment. The
assets and liabilities are matched as a result of the pass - through structure.
The risks of a fi nancial intermediary are better understood when the
sources and applications of funds under management by the fi nancial inter-
mediary are viewed as sub - portfolios of distinct risk/return and maturity
profi les. Table 13.3 provides an overview of the sources and application of
funds for a hypothetical IFI. The composition and mix of different maturity
buckets on the assets side depend on each fi nancial institution, which may
select a mix to match its needs to those of its depositors.
Although, as per theory, an IFI will not be exposed to ALM risk in the
traditional sense, it will face other challenges. Rather than matching
the assets and liabilities at the balance - sheet level, the challenge becomes
one of offering a wide range of products on the liabilities side to different
classes of depositors/investors to meet their specifi c investment objectives. In
other words, the IFI will have to design funds or portfolios to meet the risk/
return objectives of its investors; otherwise, the investors would simply pre-
fer to become shareholders. Although the contractual agreement between
TABLE 13.3 Sources and application of funds
Sources (liabilities and equity) Application (assets)
Equity capital and shareholders’
reserves
Short - term trade fi nance (murabahah,
salam)Demand and safekeeping deposits
(amanah)
Regulatory cash - reserve requirement
Medium - term investment (ijarah, istisna’)Investment accounts (mudarabah)
“pass - through”
Long - term partnerships (musharakah)Special investment accounts
(mudarabah, musharakah)
Fee - based services (jo’alah, kifala, and so
forth)Source: van Greuning and Iqbal (2008)