Issues and Challenges 383
statistical and quantitative models. The analysis is well supported by con-
siderable historical data for each asset class to assist in understanding past
behavior and to forecast future performance. Such models are driven by
comparable benchmarks, arbitrage - free strategies, hedging mechanisms,
and — most importantly — reference points for returns for different maturity
structures in the debt market. With these tools, the SAA process helps in
constructing an optimal portfolio of different asset classes to achieve target
investment objectives at acceptable levels of risk.
Constructing a meaningful SAA framework in Islamic fi nance is a chal-
lenge. First, a fi xed-income debt market — other than the limited and illiq-
uid sukuk market — does not exist. Therefore, the SAA framework would
have to resort to using proxies from conventional debt markets, which may
not be an ideal situation. Second, there are no Shari’ah - compliant bench-
marks against which an SAA strategy can be devised. Although a number
of such benchmarks are available in the equity asset class, they have yet
to be developed for fi xed-income markets. Third, given the prohibition of
interest, and thus of pure debt security, an SAA framework would have to
work with other asset classes with distinct risk/return profi les. For exam-
ple, it would require the development of mudarabah arrangements where
the manager can deploy funds in a customized fashion, which are hard to
model. The highly customized nature of fi nancial assets adds to the com-
plexity of modeling.
All of these factors mean that the SAA framework will require a more
complex design and therefore extensive quantitative modeling. In the
absence of a meaningful SAA framework, the investor will be exposed to
unknown risks and, as a result of potentially inappropriate asset allocations,
may not be successful in achieving long - term goals.
RISK MANAGEMENT FRAMEWORK
Given their limited resources, Islamic banks are often unable to afford high -
cost management information systems or the technology to assess and
monitor risk in a timely fashion, which means that their risk exposure is
high. IFIs need to adopt appropriate risk management, not only for their
own portfolio but for that of their clients. Diversifi cation and risk manage-
ment are closely associated with the degree of market incompleteness. In
highly incomplete markets, fi nancial intermediaries are in a better position
to provide diversifi cation and risk management than the investors for whom
they act.
Exposure can also be reduced by working closely with clients to reduce
their exposure, which will ultimately reduce the intermediary’s exposure.
In other words, if the debtor of the bank has lower fi nancial risk, this
will result in better quality credit for the bank. Furthermore, monitoring
becomes vital in cases where Islamic banks invest in equity - based instru-
ments because an institution with limited resources may not be equipped to