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RISK MANAGEMENT IN ISLAMIC BANKING AND FINANCE

Islamic Banking and Finance

BNFN 4302

Instructor: Mr. Masood Aijazi

29th April, 2018

Halah Bahanshal-1510635

Yusra Bashanfar-1410057

Islamic Financial industry has shown tremendous growth over the past decade but the management of risk is still an unresolved issue amongst practitioners in this industry. Therefore, professional risk management has increasingly gained importance in the context of Islamic financial institutions, in their attempts to adapt to the challenges and issues brought about by globalization. The research is an attempt to examine an overview of Risk: What is Risk? It’s meaning in Islam and the different categories of risks. It also attempted to determine specific and general risks faced by financial institutions including Equity Investment Risk, Market Risk, Liquidity Risk, Leased Asset Value Risk, Fiduciary risk and displaced commercial risk. Further, a proposed risk management process is reviewed in this paper to assist Islamic financial institutions in the avoidance and eliminations of risks. The paper attempts at having a continuous elaboration on the risk management and mitigation techniques that are available in Islamic finance currently with reference to many previous researches conducted in this area.

Contents Abstract 1 Introduction 2 The Meaning of Risk 3 Types of Risks 4 Equity Investment Risk 4 Market Risk 4 Mark-up Risk 4 Price Risk 5 Liquidity Risk 5 Credit Risk 5 Operational Risk 6 Legal risk 6 Leased Asset Value Risk 6 Fiduciary risk 7 Displaced commercial risk 7 Risk Management and Mitigation Techniques 10 Collateral 10 Guarantees 10 Loan Loss Reserve 11 Risk adjusted rate of return (RAROC) 12 Value at Risk (VaR) 12 Derivatives 13 Forwards 13 Islamic Swaps 15 Options 17 Conclusion and Recommendation 18 References 20

Islamic banks were established under diverse social and economic environments. It first started in Egypt as a small trial rural banking, and now it reached to a level spreading both locally and internationally that is committed to offering a wide range of Islamic banking practices and services. Because of the their operational success and its appeal to many Muslims as an alternative to conventional practices as well; Islamic banking showed a trend of spreading from east to west, from Indonesia and Malaysia towards Europe and America; However, according to Swartz (2013) “Islamic financial markets are, however, still in the infant stage of development. More work is needed in order to better account, for example, for liquidity risk exposure, and Islamic banks still have to face other challenges”.

Islamic Banking industry is somewhat new, the integrated risks Islamic banks face are of two types. First, the risks that are similar to those faced by conventional counterparties. Second, risks that are unique to Islamic banks which require their compliance with Shariah. Thus, Risk management in Islamic banks shows a difference from their conventional counterparties because some of the mitigation techniques are unlawful according to Shariah (Khan & Ahmed, n,d). In this paper, the meaning of risk is first discussed, followed by a brief explanation for the types of risks faced by Islamic financial institutions. Secondly, Risk Management process is discussed and elaborated more. The third section talks about the risk management and mitigation techniques: including Risk Adjusted Rate of Return, Value at Risk, and the use of derivatives. Towards the end, the authors summed up the paper and gave the recommendation needed.

When it comes to discussing Risk, it is worthwhile to clear up the meaning of the two terms: risk and gharar (uncertainty). As visible to many, no clear differences exist between the two terms, and some express gharar as risk. However, the best term in Arabic that describes Risk is khatar. According to Swartz (2013), “Risk refers to the events that can be associated with given probability while uncertainty refers to the events for which probability assessment is not possible” p. 3800. By considering the technical meaning of gharar, we can recognize that there is a slight difference between these two: risk and gharar. Ibn Taymiyyah (728H-1328G) defined risk (khatar) as follows: “Risk falls into two categories: commercial risk, where one would buy a commodity in order to sell it for profit, and rely on Allah for that. This risk is necessary for merchants … and although one might lose sometimes this is the nature of trade. The other type of risk is that of gambling, which implies eating people’s wealth for nothing. This is the type that Allah and His Messenger (PBUH) have prohibited.” The exact meaning of gharar is danger, deception, illusion, and conceit that is derived from the Arabic verb gharra, which means to deceive, to delude, and to mislead. Gharar is the thing that is prohibited in Islam but however Risk is not; because if so every commercial transaction will be unlawful in the eyes of Islam. Thus, Risk is different from gharar.

There are many reasons behind why Risk exists in any transaction. Reasons vary from being natural such as volcanoes, earthquakes to being a man-made such as market factors, theft among others. Thus, the contract is not considered invalid if risk exists alone, because the existence of all of these risks is unavoidable in everyday transactions. However, if an element of gharar exists in any transaction the contract is deemed invalid. At the end, Risk is an element that is difficult to be controlled or avoided while gharar is within peoples control and it can be avoided (Swartz, 2012).

Islamic banking and finance needs to create value for their participants and clients, and to create this value senior management must consider the risks that they usually face. After that they need to maintain, control, and manage these risks to reduce it and reach at the lowest possible risk.

Market risk is known as systematic risk or market systematic risk that is generated from the fluctuation of market prices. The market risk arises from the possible loss that could be experienced by investors due to fluctuations in prices. The volatility of asset market value results in market risk, especially for transaction that includes either future delivery or deferred payment such as salam or murabahah contract. In addition to that, foreign exchange transactions as it is not fixed meaning that the prices fluctuate resulting in income fluctuation. Consequently, market risk is the movements or changes in prices of many things such as commodity (Helmy, 2012).

The Islamic banks give a mark-up rate in murabaha contracts for a fixed period, while the benchmark rate may vary; meaning that the predominant mark-up rate may increase behind the rate the bank has locked into a contract, resulting that the bank is incapable to benefit from the higher rate in the market. Because of the non-availability of an Islamic index of rate of return, the Islamic bank usually use the London Interbank Offered Rate (LIBOR) as a benchmark meaning that they align their market risk with the movement in LIBOR rates (Helmy, 2012).

The Islamic banks face price risk in the case of forward sale (bay’ al-salam), that is during the commodities delivering period and its sale at the current market price as well. This risk is like the market risk of a forward contract in conventional banks in the case that it is not hedged properly (Helmy, 2012).

Hassan, kayed & Oseni (2013) reported that liquidity risk is the possible expected loss by Islamic finance institution which arises due to the insufficient liquidity to meet normal operating obligations and operating needs. The liquidity risk is the difficulty that Islamic finance face to meet its liability through selling assets where its market value had fallen. It is a type of systematic risk where the Islamic bank be in a case of not being able to meet expected and unexpected cash flow needs. Cash flow includes the portfolio asset of financial institution where they are enabling to liquidate these assets at appropriate maturity and rates causing liquidity risk. The liquidity risk can be caused by incorrect judgment and complacency, unanticipated change in cost capital, abnormal behaviour of financial markets, range of assumptions used, risk activation by secondary sources, breakdown of payment systems, macroeconomic imbalances, financial infrastructure deficiency, and contractual forms.

Credit risk associated with the loss of income when the counterparty delay the payment that agreed on the contract. The probability of credit risk underlies all Islamic modes of finance. To demonstrate, murabaha contracts credit risk increases when the counterparty default in paying the full debt on time. Un-payment of debt can be due to either external systematic sources or to internal financial causes, or an outcome of moral hazard (wilful default). Moral hazard should be distinguished purely as Islam does not allow restructuring debt through compensation unless it is a situation of wilful default. For the profit-sharing modes like mudarabah and musharakah contracts, the credit risk situation occurs when the entrepreneur does not pay off the share of the bank when it is due. This problem might increase due to the asymmetric information problem, as the banks do not have adequate information on the actual profit of the firm (Ahmed & Khan, n.d).

It is the risk associated with the execution of the business. This risk arises from the direct or indirect loss resulting from inadequate or failed internal processes, people, and technology or from external events. This risk includes the legal risk however it is exclude the reputation risk or risk associated from strategic decision. Operational risk may result from unqualified professionals who manage Islamic bank operations. Also it can be due to non-compliance with Shariah requirement. Moreover, one example of operational risk is the computer software that is available in the market for conventional banks may not be suitable for Islamic banks due to the distinct of the Islamic business nature, so it increases the system risk of improving and using informational technologies in Islamic banks (Ahmed & Khan, n.d).

According to Ahmed & Khan (n.d), there are many reasons for legal Islamic bank risk. First, the common law or civil law framework adopted by most countries does not include laws which assist the feature of Islamic banks products. For instance, Islamic bank main activities is trading and investing in equities like murabaha and mudarabah respectively, however these activities are forbidden for commercial banks according to banking law and regulation. Second, as contracts are not standardize, the procedure of negotiation of various aspects of a transaction are more complex and costly. Additionally, financial institutions are not protected against risks that they cannot anticipate or that may not be enforceable. Use of standardized contracts can also make transactions easier to administer and monitor after the contract is signed. Lastly, shortage of Islamic courts which can enforce Islamic contracts raises the legal risks of utilizing these contracts.

In the case of ijarah, the bank face a market risk in case of falling in the residual value of the leased asset at the expiry date of the lease contract, or due to termination of the contract in case of default (Helmy, 2012).

Ahmed & Khan (n.d) reported that breaking contracts by the Islamic bank itself can result in fiduciary risk. For example, the bank may not be able to comply totally with the Shariah requests of different contracts knowingly or unknowingly. The inability to comply with the Shariah results in loss of depositors’ trust, which in turn causes deposits withdrawals. The fiduciary risk can be also be introduced by the lower rate of return than the market, when depositors/investors interpret a low rate of return as breaching an investment contract or mismanagement of funds by the bank (AAOIFI, 1999).

This is the transformation of the risk associated with deposits to equity holders. Displaced commercial risk implies that the bank may operate in full compliance with the Shariah requirements; however, it may not be able to pay competitive rates of return as compared to its peer group of Islamic banks and the other conventional competitors. Therefore, depositors seek to withdraw their money and deposit it in other banks that provide higher return. In fact, this risk arises from other competitors’ pressure, where Islamic banks are forced to give share of its profit to pay depositors and prevent withdrawals due to lower return. Conventional banks usually try to minimize or transfer the loss to save their financial statement, whereas Islamic banks try to eliminate loss as investors and depositors will bear the loss. In addition to that Islamic banks do not invest depositors funds in risky projects as the loss opportunity is high although the riskier investments may have higher returns, hence Islamic banks invest in less risky investment because of the shortage of deposit insurance and guaranteed return. Some central banks authorize Islamic banks to hold a legal reserve to cover any depositor’s capital loss. Low risk profile does not protect the bank from any losses or lower return; hence the Islamic bank needs to employ alternatives to keep depositors interested, to compensate depositors and to keep competitive with conventional banks. Islamic bank should create special pools for reserve money like a Profit Equalization Reserve (PER) and an Investment Risk Reserve (IRR) which help them to reduce the risk of low return or losses. Those funds are reserved to regulate returns in a situation of less than anticipated results (Fleifel, 2009)

Risk can be classified into different categories. The most important ones are the following (Introduction to Islamic Muamalat Learning Outcomes, n.d):

1. Pure Risk versus Speculative Risk

2. Fundamental Risk versus Particular Risk

Risk identification

Risk identification denotes the process of classifying, evaluating, reviewing and forecasting possible risks. The main purpose behind risk identification is to identify risks one company is exposed to and then risks are classified and documented. At the end of this process, a list of categorized risk is provided.

Risk evaluation is the process of studying the impact and results of each risk and assessing the possible expected resulting losses as well. Thus, resources will be utilized in order to take the needed actions and practices. To evaluate or assess the impact of the risk, the firm must consider these two factors according to the Introduction to Islamic Muamalat Learning Outcomes, (n.d), p. 21:

a. Risk Frequency:

“Refers to the number of times a loss producing event will occur during a given time period (probability of its occurrence)”.

b. Risk Severity

“Refers to the cost or amount of loss, in money terms, arising from a loss producing event”.

As soon as risks have been identified and evaluated entirely, here comes the need to develop a risk management plan using the most suitable and applicable risk handling method. The firm should bear in mind the cost and the effectiveness of each method before final decision is made. Risk handling methods includes Risk Avoidance, Risk Control, and Risk Retention among others.

This step comprises periodical reviews, supervising the implementation process and revising the plan in response to any changes in the business and economic environment as well. Periodical reviews assist in identifying any deficiencies or adjustments and also ensure attaining the objectives of the plan. Reviews should be done at least once a year to ensure successfulness of the program.

Many risk measurement and mitigation techniques have evolved recently. Some of these techniques are used to mitigate specific risks while others are meant to deal with overall risk of a firm. In this section we outline some contemporary techniques used by well-established financial institutions in the process of risk management and mitigation.

Collateral is an important security against credit loss. It is used by Islamic banks to secure finance as al-Rahn, an asset as a security in a deferred obligation, is allowed in shariah. According to Islamic finance principles, there are many things are not eligible to use as a collateral such as debt due from a third party, perishable commodities and something which is not prevented by the Islamic law as an asset, such as an interest-based financial instrument. However, on the other hand, there are many eligible assets that can be used as collateral such as cash, tangible assets, gold, silver and other precious commodities, shares in equities and debt due from the finance provider to the finance user. Hence, the industry-wide general quality of collateral on two things: number of institutional characteristics of the environment and the products offered by the industry. In fact, improving both the infrastructure of the institution and the Islamic banking product can be instrumental in boosting collateral quality and decreasing credit risks (Ahmed & Khan, n.d).

Guarantees is a complementary method to collateral in improving the credit quality. Conventional Guarantees are highly important materials to monitor credit risk in conventional banks and in fact some Islamic banks do use commercial guarantees despite the fact that it is against general fiqh understanding. According to fiqh, a third party can provide guarantees as a benevolent act and on the basis of a service charge for actual expenses. Due to the shortage of consensus, thus, the tool is not actively used in the Islamic banking industry (Ahmed & Khan, n.d).

According to Ahmed & Khan (n.d), sufficient loan loss reserves display safeguard against estimated credit losses. The effectiveness of these reserves relies on the credibility of the systems in place for calculating the expected losses. Recent developments in credit risk management techniques have enabled large traditional banks to recognize their estimated losses correctly. The Islamic banks are also requested to maintain the mandatory loan loss reserves subject to the regulatory requirements in different jurisdictions. However, the Islamic finance modes are varied and heterogeneous as compared to the interest-based credit, thus requiring more rigorous and credible systems for estimated loss calculation.

Moreover, to compare the risks of different institutions, there is also a need for regular standards for loss recognition across modes of finance, financial institutions and regulatory jurisdictions. The AAOIFI Standards No. 1 provides the foundation of income and loss recognition for the Islamic finance modes. However, banks and regulatory organizations do not apply these standards except for a few institutions. In addition to the mandatory reserves, some Islamic banks have also established investment protection reserves. For example, the Jordan Islamic Bank has pioneered the establishment of these reserves, which are established with the contributions of investment depositors and bank owners. The reserves are aimed at providing protection to capital as well as investment deposits against any risk of loss including default, thereby minimizing withdrawal risk (Ahmed & Khan, n.d).

GAP models focuses on managing and handling net interest income over different time intervals. After the time interval has been selected, assets and liabilities are gathered and grouped into these time buckets according to maturity (for fixed rates) or first possible repricing time (for flexible rates). Rate sensitive assets (RSAs) are assets that can be repriced and rate sensitive liabilities (RSLs) are liabilities that can be repriced as well. Therefore, GAP for a specific time interval is calculated as the difference between rate sensitive assets (RSAs) and rate sensitive liabilities (RSLs):

GAP = RSAs – RSLs

GAP provides the firm with information about the effect of changes in interest rate on the net interest income. For instance, when the rate sensitive assets exceed liabilities, GAP will be positive. Hence, when future market interest rate increases, net interest income will increase as well because the change in interest income is greater than the change in interest expenses. The same will happen if future market interest rates decline and GAP is positive, resulting in reducing the net interest income (Khan & Ahmed, 2001).

According to Khan and Ahmed (2001), Risk adjusted rate of return (RAROC) was developed by Bankers Trust in the late 1970s. In RAROC, Risk resulted from the trade-off between risk and reward of different assets and activities is quantified. RAROC was considered a prominent methodology used to measure performance by the end of the 1990s. It allowed firms to measure all related risks and provided manager with a tool to measure risk/return trade-off in different assets and thus making better decisions. The companies’ economic capital protects financial institutions against any unexpected losses, thus, it is important that capital is efficiently allocated for the several risks that these institutions may face. In fact, RAROC analysis determines the amount of economic capital needed by different products and it as well determines the total return on capital of a firm. RAROC is used by Islamic banks to assign capital to the different modes of Islamic financing as Islamic financial instruments have various risk profiles, such as murabahah is considered less risky mode as compared to mudarabah and musharakah (Abdul Rehman, 2016). Although RAROC is used to estimate the capital requirements for market, credit and operational risks; it is also used as an integrated risk management tool. RAROC is determined as,

RAROC = Risk-adjusted Return / Risk Capital; where

· risk-adjusted return equals total revenues less expenses and expected losses (EL)

· risk capital is that reserved to cover the unexpected loss given the confidence level.

Value at Risk (VaR) is one of the newly developed risk management tools. VaR is a very popular method because it is easy to be implemented and majorly accepted by top management. VaR according to Khan & Ahmed (2001) “a quantile measure to quantify the risk for financial institution” p. 42. Under normal market conditions, VaR indicate the worst expected loss a firm can incur at specific time horizon and at a given level of confidence. VaR designate financial risk in a portfolio into a simple number. VaR includes many other risks like foreign currency risk, commodities, and equities; although it is used mainly to measure market risk. VaR has many variations and can be estimated in different ways, below one of them is explained.

Assume that an amount A0 is invested at a rate of return of r, so that after a year the value of portfolio is A= A0 (1+r). The expected rate of return from the portfolio is µ with standard deviation σ. VAR answers the question of how much can the portfolio lose in a certain time period t (e.g., month). To compute this, we construct the probability distribution of the returns r. We then choose a confidence level c (say 95) percent. VaR tells us what is the loss (A*) that will not be exceeded c percent of the cases in the given period t. In other words, we want to find the loss that has a probability of 1-c percent of occurrence in the time period t. Note that there is a rate of return r* corresponding to A*. Depending on the basis of comparison, VaR can be estimated in the absolute and relative sense. Absolute VaR is the loss relative to zero and relative VaR is the loss compared to the mean µ (Khan & Ahmed, 2001, P.43).

Over the past centuries, Derivative are commonly used as a measure of protection, and as a minimizer for risk exposure. As we know, today financial institutions are more vulnerable to risk exposure, thus, financial institutions do their best to mitigate those risks and operate efficiently. With financial innovation, newer and more updated products are developed to achieve stability and sustainability. In the past years, Derivatives were and are still commonly used as a measure of protection, and as a minimizer for risk exposure. However, those instruments are not compliant with shariah principles and thus can be not be utilized by Islamic institutions because in shariah law, all contracts must be free from riba (interest), rishwah (corruption), maisir (gambling), gharar (unnecessary risk) any corruptive measure. Therefore, there was a need for conventional like derivative but that are compliant with shariah where some are explained below.

Islamic Foreign Exchange Forward

FX Swap is a derivative instrument that has a precise objective of hedging against risk of fluctuation in currency exchange rate. Islamic Foreign Exchange forward is the Islamic substitute to the conventional FX forward. In this context, Islamic Foreign Exchange forwards is based on wa’ad (Undertaking) and tawarruq Islamic principles so as to imitate conventional FX forward but in a way that is complying to Shariah. The IIFM IFX Forward templates are based on the wa‘ad structure (Zahan & knett, 2011). A wa'ad in this case is a promise made by one party (the Buyer) to the other party (the Seller) that, if the Seller decided to exercise the Wa'ad or what’s called undertaking the wa'ad, the Buyer will fulfil the promise, that is in this case: entering into the transaction under which he will buy from the Seller one currency in exchange for another currency on the relevant settlement date. The concept of wa’ad arises at dealing date when the client promises or commits himself for an exchange of a specified amount of money on a specified date. The wa‘ad need to exist in each IFX Forward transaction. If and the Seller decided to exercise the relevant wa‘ad on the relevant Exercise Date (by the Seller sending an Exercise Notice), the Buyer is then required to purchase a specified amount of one currency in exchange for a specified amount of another currency. The terms of the contract are the Offer and Acceptance of the Buyer and Seller.

There are two common IFX structures developed by IIFM which are commonly used as a Shari‘ah compliant hedging tool:

1- Two unilateral and Independent Wa‘ad based structure.

2- Single Binding Wa‘ad based structure.

For the two unilateral and independent Wa‘ad structure, each party needs to execute a Wa‘ad while for the single binding Wa‘ad Structure, only one party needs to execute a Wa‘ad. Below given an illustrative example as per (IIFM/ISDA Islamic Foreign Exchange Forward (IFX) Standard Templates Wa‘ad based Structures, n.d)

Two unilateral Wa‘ad structure.

Scenario 1: on the Exercise Date if USD/GBP Spot Rate is < 1.51, the Customer exercises its rights under Wa’ad 1, so that on the Settlement Date, the Bank buys GBP 1 million in exchange for USD 1.51 million.

Scenario 2: on the Exercise Date, if USD/GBP Spot Rate is > 1.51 (i.e. Forward Rate of 0.66 > GBP/USD Spot Rate), the Bank exercises its rights under Wa’ad 2, so that on the Settlement Date, the Customer buys USD 1.51 million for GBP 1 million.

Single Wa‘ad structure

On the Exercise Date, the Bank exercises its rights under the Wa’ad, so that the Customer buys GBP 1 million in exchange for USD 1.51 million. Although for Shari’ah related reasons the Bank is not strictly under an obligation to exercise its rights under the Wa’ad, given that this is an IFX Forward product the expectation is that it would do so.

Islamic finance as conventional finance is exposed to the risks of market volatility and fluctuation either in currency rate market or interest rate market. Accordingly, Islamic swaps are organized in a way to successfully operate as a hedging mechanism in Islamic finance. Islamic swaps are hybrid contract that are practised in a similar way to conventional swap, thus attaining the same objectives as conventional swap contracts. What is more important is that swaps are structured to be compliant with the Islamic commercial jurisprudence principles: Shariah requirements. This denotes the importance of ensuring that contracts are free from riba (usury), gharar (excessive ambiguity) and any element of gambling in the transactions. There are several types of financial swaps that are commonly used in the conventional financial system. In fact, there are three main instruments of Islamic swaps developed in a compliant way with Shariah laws and principles; those are FX Swap, Cross Currency Swap, and Profit Rate Swap.

Islamic profit rate swap

A profit rate swap is the best alternative to conventional interest rate swap “under which the parties agree to exchange periodic fixed and floating payments by reference to a pre-agreed notional amount” (Islamic Derivatives: Theory and Practice, n.d, p.137). Like many conventional derivative products, the conventional interest rate swap is not allowed in the shariah rules as it contradicts the shariah principles prohibiting riba, maisir and gharar. Here comes the role of profit rate swap which is similar to conventional interest rate swap but in a shariah compliant way. A profit rate swap uses both the primary (Term) Murabaha and reciprocal murabaha transactions. A term murabaha is used to generate fixed payments comprising both a cost price and a fixed profit element. The series of corresponding reverse murabaha contracts are used to generate the floating leg payments (the cost price element under each of these reverse murabaha contracts is fixed but the profit element is floating).

(i) The Primary (Term) Murabaha

The floating rate payer will start the process by purchasing goods from a commodity broker and then those goods will be sold to the swap counterparty (the Fixed Rate Payer). The value/ price of the good purchased and sold is pre-agreed between parties and commodities are delivered on the same date as the transaction date. Once the Fixed Rate Payer receives the commodity, he will on-sell this commodity to a different broker and gets cash on sale. Then the Fixed Rate Payer will pay in instalments for the goods he purchased from the floating rate payer based on a term Murabaha. Instalments are made on a series of pre-agreed payment dates, where each instalment includes cost price element and a fixed profit portion.

(ii) The series of sequential Secondary Reverse Murabaha Contracts (SRMCs)

In conventional context, a contract exists between the Floating and fixed Rate Payer, where the Floating Rate Payer approves to pay a variable amount (linked, for example, to LIBOR) to the Fixed Rate Payer on certain pre-specified dates is considered unlawful in the eyes of Shariah. Thus, SRMCs arise to solve this problem in which floating rate payment is linked to an underlying purchase and sale of commodities (Islamic Derivatives: Theory and Practice, n.d).

Options are one most powerful instrument that is used as risk management tool. Yet, trading in options is prohibited based on the resolution of the Islamic Fiqh Academy. For that reason, the usage of options by the Islamic banks as risk management tools is restricted and narrow to some degree. However, below explained some forms of options that are mostly used.

Bai’ al-tawrid with khiyar al-shart

In bai’ al-tawrid contracts both parties are exposed to price risk. That is immediately after the parties had signed the contract of fixed price and quantity, a change in the market price of that commodity may be faced. The buyer will be at a loss if he continues with the contract given the market price declines. For the seller, if market price rises, the seller will lose by continuing with the contract. Thus, in such contracts of continuous-supply purchase, a khiyar al-shart (option of condition) for cancelling or revoking the contract will enhance justcity and will reduce the risk for both parties as well (Ahmed & Khan, n.d). Khiyar al-shart according to Obaidullah (1998), “is an option that is in the nature of a condition stipulated in the contract. It provides a right to either of the parties, or both, or even to a third party to confirm or to cancel the contract within a stipulated time period” p.77. In this context, the involved party gets some time period for re-evaluation of the benefits and costs involved, before giving final confirmation or assertion to the contract. In fact, there is a consensus among jurists from all the major school regarding the permissibility of khiyar al-shart. The permissibility of such options is inferred directly from the following hadith of the holy prophet (PBUH) reported by al-Bukhari and Muslim. When Habban Ibn Munqidh complained to the holy prophet (peace be upon him) that he was the victim of frequent fraud in some earlier transactions, the holy prophet (PBUH) is reported to have said “When you conclude a sale you may say that there must be no fraud and you reserve for yourself an option lasting three days.” (Obaidullah, 1998)

Bay al-arbun

Bay al-arbun indicates a sale contract between a buyer and a seller in which an amount of money is deposited faithfully by the buyer and this amount represents part of the total amount to be paid and if, however, the buyer fails to ratify the contract he will lose the amount deposited which the seller can retain. Bay al-arbun is similar to call option in which deposit or premiums are not returned to the buyer by the seller in the case the former does not exercise the option or confirm the contract. Nevertheless, for the call option, even if the buyer does exercise the option and the contract is confirmed, premiums will be lost. While for bay al-arbun the initial deposit (premium) paid is considered as a part of the sale price when the contract is confirmed. Arbun is mostly used by Islamic funds as a way to reduce portfolio risks, known nowadays in the Islamic financial markets as the principal protected funds (PPFs). The PPF roughly works like that: the total fund raised is divided where 97 percent of it is invested in low-risk but liquid murabaha, and it gives lower return. The left over 3 percent of the fund is invested in arbun contract, where down payment is made for the purpose of purchasing common stocks in a future date. The fund managers go for this transaction when he expects that prices will be in the rise. If the future price of the stock increases as expected by the fund manager, the arbun is utilized by liquidating the murabaha transactions. Otherwise, the arbun lapses, incurring a 3 per cent cost on the funds. However, fund manager compensate for this cost by the returns generated from murabaha transactions. In this context, arbun can be used efficiently to protect investors from unfavourable market conditions (Risk) and as well gain when market condition is favourable (Ahmed & Khan, n.d).

Risk - return trade off theory is a fact that Islamic financial institutions face like their conventional counterparties. In fact, Islamic financial institutions face more risks than conventional banks because of the requirements of the Shariah principles. Thus, Islamic Financial institutions are in greater pressure to control and mitigate risks to gain an acceptable return. Risk mitigation techniques that are commonly used by conventional banks are not Shariah compliant; however, despite of that scholars and knowledgeable people in both Shariah and finance worked on the development of new Shariah- compliant products. In addition, with financial innovation and development, Islamic financial institutions now have a broad range of products as well as techniques that are Shariah compliant to avoid, transfer and mitigate risks.

In conclusion, we recommend Islamic financial institutions to understand the expected risks they will face thoroughly, and then use one of the above risk mitigation or a combination of them to ensure that risk is avoided, reduced and even mitigated. Thus, if those proved to be efficient, higher return can be realized because of the risk and return trade-off. Moreover, Islamic financial institutions should ensure their compliance with Shariah laws and principles so not to upset customers who are now more aware of the Islamic financial system. One more point to bear in mind is that despite of the more types of risks that Islamic banks face than their counterparties, Islamic banking and finance is now more and more developing as well as growing and more innovation is coming into this field which will further enhance the industry.

Abdul Rehman, A. (2016). A Comparative Study of Risk Management Practices between