296 AN INTRODUCTION TO ISLAMIC FINANCE
Quantitative Methods of Risk Measurement Risk assessment and measurement is
an art as well as a science. The increased complexity of fi nancial instruments
calls for more sophisticated risk assessment tools. While work on identify-
ing the sources of risk associated with Islamic banking has made good prog-
ress, risk measurement techniques and the models used to quantify risk need
to be applied more widely.
Sundararajan (2004) has suggested several quantitative methods for
measuring risk. For example, similar to the idea of value at risk (VaR), the
risk to investors/depositors can be quantifi ed by a measure of profi t at risk
(PaR) based on the historical profi ts and the volatility of returns. The PaR
model assumes normal distribution and can be calculated as follows:
PaR = Zα × σp × √Twhere Zα = is the constant that gives the appropriate one - tailed confi dence
interval with a probability of 1 - α for the standard normal distribution (e.g.,
Z.. .01 = 2.33 for 99% confi dence interval); T is the holding period or matu-
rity of investment account as a fraction of a month; and σp as the standard
deviation of the monthly profi t as a percentage of assets.
The PaR measure can have multiple uses. First, it can provide an indica-
tion of the level of volatility in the expected profi ts of investors/depositors.
Secondly, it can determine the level of income - smoothing reserves — the Profi t
Equalization Reserves (PER) maintained by some IFIs to mitigate displaced
■ (^) [Islamic Financial Institution] shall ensure an adequate system of
controls with appropriate checks and balances are in place. The
controls shall (a) comply with the Shari’ah rules and principles;
(b) comply with applicable regulatory and internal policies and
procedures; and (c) take into account the integrity of risk manage-
ment processes.
■ (^) [Islamic Financial Institution] shall ensure the quality and timeli-
ness of risk reporting available to regulatory authorities. In addi-
tion to a formal standardized reporting system, [Islamic Financial
Institution] shall be prepared to provide additional and voluntary
information needed to identify emerging problems possibly giving
rise to systemic risk issues. Where appropriate, the information
contained in the report shall remain confi dential and shall not be
used for public disclosure.
■ (^) [Islamic Financial Institution] shall make appropriate and timely
disclosure of information to Investment Account Holders (IAH)
so that the investors are able to assess the potential risks and
rewards of their investments and to protect their own interests in
their decision-making process. Applicable international fi nancial
reporting and auditing standards shall be used for this purpose.