Risk Management in Islamic Banking
This domain tests risks that exist only, or differently, in Islamic banking - above all Shariah non-compliance risk and displaced commercial risk - alongside credit, market, liquidity and operational risk.
Islamic-specific risks
- Shariah non-compliance risk: income earned from a structure later ruled non-compliant must be purged to charity, and the reputational damage is severe.
- Displaced commercial risk: the bank may forgo part of its mudarib share to keep depositor returns competitive, transferring value from shareholders to investment account holders.
- Rate of return risk: returns on assets and deposits are not mechanically linked, so margins and depositor returns can diverge.
- Equity investment risk: musharakah and mudarabah exposures carry genuine loss potential and need valuation and exit policies.
- Liquidity risk: unrestricted investment account holders can withdraw, and the pool may hold illiquid assets.
- Inventory and ownership risk: murabaha and ijarah expose the bank to asset risk while it owns the asset.
Mitigation
Profit equalisation reserve (PER) is set aside from profit before allocation to smooth returns; investment risk reserve (IRR) is set aside from account holders' profit to absorb future losses. Both need Shariah Board approval and disclosure. Product approval, Shariah review, exposure limits and documented exit strategies complete the framework.
Worked example
Market deposit rates rise to 6.5% while the pool can pay 6%. The bank forgoes 0.5% of its mudarib share, costing shareholders, say, PKR 12,000,000, and discloses the transfer. That is displaced commercial risk. If instead the pool suffered a real loss, PER could not be used to hide it; IRR absorbs losses only within its approved purpose.
Traps
Using PER to cover losses; treating DCR as costless; assuming conventional liquidity ratios apply unchanged; ignoring that charity payments from non-compliant income hit shareholders, not depositors.