Credit and Risk Management in an Islamic Bank
This domain tests the risk taxonomy unique to Islamic banking and the mitigation tools permitted under Sharia.
Risk categories
- Credit risk - murabaha and ijarah receivables, salam and istisna counterparty exposure.
- Equity investment risk - loss exposure in musharaka and mudaraba, where there is no fixed return to service.
- Rate of return risk - the mismatch between asset returns and the benchmark expectations of depositors.
- Displaced commercial risk - the commercial pressure to forgo the bank's share or use reserves to keep IAH returns competitive.
- Market and inventory risk - commodity or asset held between purchase and sale.
- Liquidity risk - limited sharia-compliant HQLA and no conventional discount window.
- Sharia non-compliance risk - a breach that causes income to be unrecognised.
- Operational and fiduciary risk.
Mitigation
Credit scoring, collateral, guarantees (kafala), takaful on financed assets, maturity matching, sukuk and commodity-murabaha buffers. Under IFSB capital standards, murabaha receivables attract a standard credit risk weight, while musharaka and mudaraba require a capital charge for equity investment risk, with the treatment of unrestricted IAH funds calibrated through supervisory parameters.
Worked example
Depositors hold 60% of funding; market returns rise and IAH returns fall 100 bps below peers. The bank uses $2m of PER to top up returns and forgoes its own share. Reasoning: this is displaced commercial risk, not market risk. The smoothing is permitted if disclosed and SSB-approved, but persistent use may mask solvency weakness and misstate profit.
Traps
Calling DCR a market risk; ignoring equity investment risk in musharaka; assuming IFSB standards are binding law.