This document discusses risk management principles for Islamic finance as outlined by the Islamic Financial Services Board (IFSB). It provides an overview of the IFSB's objectives to promote prudent and transparent Islamic financial services through international standards. The key risks for Islamic financial institutions are identified as equity investment, rate of return, displaced commercial, operational, and Shariah compliance risks. The document outlines guiding principles for managing each of these risks, focusing on credit, market, liquidity, and operational risks. The principles emphasize comprehensive risk management and reporting processes, Shariah compliance, and protecting the interests of fund providers.

1. RISK MANAGEMENT
IN
ISLAMIC FINANCE
Mahyuddin Khalid

2. IFSB’s Guiding Principles of Risk Management
Content
Approach
Key objective
Guiding principles for the management
of risk on specific features of IIFS
products and services:
• Equity investment risk
• Rate of return risk
• Displaced commercial risk
• Operational risk
• Shariah compliance risk
• Fiduciary risk
Learning Outcome
• Objectives of the IFSB
• An overview of the IFSB’s guiding
principles of risk management and
Capital Adequacy Standard (CAS) for IIFS
• Experience in the development of the
standard and expected challenges in its
implementation process
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3. Objectives of the IFSB
Article 4 of the Articles of Agreement outlines the
objectives of the IFSB, which include, among others:
 To promote the development of a prudent and transparent
Islamic financial services industry by introducing new, or adapting
existing, international standards consistent with Shari’a principles,
and recommend them for adoption.
 To provide guidance on the effective supervision and regulation
of institutions offering Islamic financial products and to develop
the criteria for identifying, measuring, managing and disclosing
risks, taking into account international standards for valuation,
income & expense calculation and disclosure.
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4. IFSB Approach in Risk Management
Rather than prescriptive procedures, the approach that has
been taken by the IFSB is principle-based approach,
applied to accommodate continuous improvement in the
infrastructures, methodologies and system as theory and
technology permit
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5. In identifying the risks to which IIFS are exposed, as an
initial step is to identify inherent risks which include the
following 2 risks:
 Primary risks, i.e. The exposures deliberately entered into for
business reasons when an IIFS decides to offer A certain type of
service; and
 Consequential (or operational) risks, i.e. The exposures that are
not actively taken but which are incurred as A result of business
undertaken by the IIFS
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6. Approaches In Risk Sharing
Approaches used in Risk sharing will be in line with the risk
management principles which have been set by Islamic
Financial Services Board (IFSB).
The principle provides a set of guidelines of best practice
for establishing and implementing effectives risk
management in Financial Institutions that offer services in
accordance to Shariah rules and principle of risk
management has been set which each principle will
provide practical aspect in managing the risks underlying
the business objectives that each Islamic Financial
Institutions (IFI) may adapt.
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7. Key objective of Guiding Principles of Risk
Management
The IIFS are expected to view the management of these
risks from a holistic perspectives
The guiding principles define a common terminology of
key risk categories to which IIFS are exposed, acting as:
 a common language for further development of regulatory
financial requirements
 a stimulant to the progress of risk management practices
required in Islamic financial services industry
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8. Key objective of Guiding Principles of Risk
Management
For example
 Rate Of Return Risk is essentially the risk with regard to the result
of an investment at the end of the investment-holding period. We
cannot exactly predetermine such results
 Displaced Commercial Risk could be the consequence of the rate
of return risk whereby IIFS may be under market pressure to pay
a return that exceeds the rate that has been earned on assets
financed by IAH
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9. Key objective of Guiding Principles of Risk
Management
At present, in many jurisdictions, the consequence of the
rate of return risk is considered as part of the strategic risk,
hence is left to the individual IIFS to decide. In some
jurisdictions, guidelines on the rate of return risk including
on the use of profit equalisation reserve (PER) exist.
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10. The Unique Risk of the Islamic Banks
Credit Risk
Benchmark Risk
Rate of Return Risk
Liquidity Risk
Operational Risk
Legal Risk
Withdrawal Risk
Fiduciary Risk
Displaced Commercial Risk
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11. Risk Classifications
 Financial risks include:
 Market risk, the risk originating in instruments and assets traded in
well-defined markets
 Interest rate risk, the exposure of a bank’s financial conditions to
movements of interest rate.
 Credit risk, the risk that counterparty will fail to meet its obligations
timely and fully in accordance with the agreed terms
 Non-financial risks include:
 Operational risk, the risk that arises due to insufficient liquidity for
normal operating requirements reducing the ability of banks to meet its
liabilities when it falls due.
 Regulatory risk, the risk that arises from changes in regulatory
framework of the country
 Legal risk, the risk relate to risks of unenforceability of financial
contracts
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12. General Principles
Principles 1:
 IFI should have a comprehensive risk management and reporting
process in place. The process should consider appropriate steps
to comply with shariah rules and principles and to ensure the
adequacy of relevant risk reporting to the supervisory authority.
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13. Credit Risk
 Principles 2
 IFI should have a strategy for financing; the instruments used must be
in compliance with Shariah, whereby it recognizes the potential credit
exposures that may arise at different stages of the various
arrangements.
 Principles 3
 IFI shall carry out a due diligence review in respect of counterparties
prior to deciding on the choice of an appropriate Islamic financing
instruments.
 Principles 4
 IFI should have appropriate methodologies for measuring and
reporting the credit risk exposures arising under each Islamic financing
instrument.
 Principles 5
 IFI shall have in place shariah- compliant credit risk mitigating
techniques appropriate for each Islamic financing instrument.
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14. Investment Risk
 Principles 6
 IFI should have appropriate strategies in place for risk management and
reporting processes in respect of the risk characteristics of equity
investments, including Mudharabah and Musharakah investments.
 Principles 7
 IFI must ensure their valuation methodologies are appropriate and
consistent, and they should conduct the assessment on the potential
impacts of their methods on profit calculation and allocations. The
methods shall be mutually agreed between IFI and Mudarib and/or
Musharakah partners.
 Principles 8
 IFI shall, in respects of their equity investment activities, including
extension redemption conditions for Mudharabah and Musharakah
investments, exit strategies should be defined and established and
must subject to the approval of the institution’s Shariah Board.
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15. Market Risk
Principles 9
 In respect of all assets held, IFI shall have an appropriate
framework for market risk management (including reporting) and
also those that do not have a ready market and/or are exposed to
high price volatility.
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16. Liquidity Risk
Principles 10
 IFI shall have in place a liquidity management framework
(including reporting) taking into account separately and on an
overall basis their liquidity exposures in respect of each category
of current accounts, restricted investment accounts.
Principles 11
 IFI shall assume liquidity risk commensurate with their ability to
have sufficient resources to Shariah-compliant funds.
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17. Rate of Return risk
Principles 12
 A comprehensive risk management and reporting process should
be established by IFI in order to assess the potential impacts of
market factors affecting rates of return on assets in comparison
with the expected rates of return for investments account holders
(IAH).
Principles 13
 IFI must ensure that an appropriate framework for managing
displaced commercial risk is in place, where applicable.
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18. Operational Risk
Principles 14
 IFI should have in place adequate system and controls, including
Shariah Board or Advisor, to ensure compliance with Shariah rules
ad principles.
Principles 15
 IFI shall have in place appropriate mechanism to safeguard the
interests of all fund providers.
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19. Mahyuddin Khalid
End of Chapter
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