292 AN INTRODUCTION TO ISLAMIC FINANCE
■ (^) The costs and risks in monitoring equity - type contracts and the associ-
ated legal risks.
People risk is another kind of operational risk and arises from incompe-
tence or fraud that leads to potential losses. For instance, an internal - control
problem cost the Dubai Islamic Bank US$50 million in 1998 when a bank
offi cial did not comply with the bank’s credit terms. This also resulted in
a run on its deposits of US$138 million, representing 7 percent of its total
deposits, in just one day (Warde 2000).
Operational risk is considered high on the list of exposures of Islamic
banks. A survey conducted by Khan and Ahmed (2001) shows that the
managers of Islamic banks perceived operational risk as the most criti-
cal after mark - up risk. The survey found that operational risk is lower in
fi xed - income assets of murabahah and ijarah and one of the highest in the
deferred - sale contracts of salam and istisna’. These rankings of the instru-
ments indicate which contracts the banks fi nd more complex and diffi cult
to implement.
Fiduciary Risk
Fiduciary risk is the risk that arises from an institution’s failure to perform
in accordance with explicit and implicit standards applicable to its fi duciary
responsibilities. Fiduciary risk gives rise to the risk of having to face legal
action in a situation where the bank breaches its fi duciary responsibility
toward depositors and shareholders. As fi duciary agents, Islamic banks are
expected to act in the best interests of investors/depositors and shareholders.
If and when there is divergence between these expectations and its actions,
the bank is exposed to fi duciary risk.
The following are some examples of fi duciary risk:
■ (^) In the case of a partnership - based investment in the form of mudarabah
and musharakah on the assets side, the bank is expected to perform
adequate screening and monitoring of projects and any negligence in
this regard — deliberate or inadvertent — can lead to fi duciary risk. It
becomes incumbent upon management to perform due diligence before
committing the investors/depositors’ funds.
■ (^) The mismanagement of funds of current - account holders, which are
accepted on a trust (amanah) basis, can expose the bank to fi duciary
risk as well. It is a common practice of Islamic banks to utilize such
funds without any obligation to share the profi ts. However, in a case of
heavy losses on the investments fi nanced by these funds, the depositors
can lose confi dence in the bank and this can lead to their seeking legal
redress.
■ (^) Mismanagement that leads to the incurring of unnecessary expenses, or
allocating excessive expenses to investment account holders is a breach
of the implicit contract to act in a transparent fashion.