Risk management: What to do and what not to do?
In finance, the risk is the probability that the real outcome will be different from the predicted and expected results. The concept of ‘risk and return’ is that, the more the risk, the higher the expected returns. This is to compensate the investors for higher volatility.
In this feature article, we will discuss risk management and the major risks that Islamic banks face in their commercial operations and the ways in which they mitigate those risks.
Credit risk management:
This kind of risk is generically defined as the risk in which the counterparty fails to meet the obligations in accordance with the contract. This also includes the risk arising in the settlement of transactions.
But as Islamic financing is asset-backed and adequately collateralized, also, the title of ownership remains with the bank in Ijarah and Murabaha till the actual transaction is made. Thus, an Islamic bank has the choice of foreclosing the property or asset in the case of default.
How to manage credit risks:
1. Consider assets as collateral-
Any asset or property owned by the client can be considered as collateral. Though the ownership of the asset will be the client’s, he won’t be able to sell it without the financial institutions’ permission.
2. Third party guarantee-
If the client’s guarantee is not reliable, then the financial institution can ask for a third-party guarantee.
Takaful is used to ensure an asset, be it movable or immovable. The cost of insurance is added back to the sale price or the rentals.
4. Hamish Jiddyah-
This is used as an alternative to the down payment and security deposit. It could also be used as a partial settlement price for the sale of the property. Though, any amount received in this at the initiation of the contract cannot be considered as income for that period.
Market risk management:
This kind of risk refers to risks coming from adverse shifting in interest rates, commodity prices and FX rates. This risk is also present in Murabaha, Ijarah, and Salam.
How to manage market risks:
1. Permissible parallel contract-
To reduce the storage risk and avoid inventory pricings, parallel contracts can be done for the same date in the case of Salam.
2. Binding promise-
A binding promise which is one-sided can be considered to ensure contract enforcement. It can be considered also to guarantee seriousness on the client’s end before the financial institutions invest depositor’s funds for providing financing.
Equity risk management:
This kind of risk refers to sudden negative changes in the market value of equity which is held for investment purposes. It includes Mudarabah and Musharakah.
How to manage equity risks:
1. Diversify capital contribution
2. Use restricted Mudarabah
3. Use Musharakah more if possible
4. Plan exit strategies minutely
Liquidity risk management:
This kind of risk is the potential loss to the Islamic banks. This comes from their inability to fulfill their obligations due to severe losses.
How to manage liquidity risks:
1. Increase non-remunerative deposits which will reduce the cost of raising funds from the clients. It is better to have a widespread deposit base.
2. It is better to finance marketable properties on a priority basis that have a secondary market. Also, which are standardized and very much used in the real sector of the economy.
Every saving and investment has different risks and returns. One must focus and analyse minutely before investing. Risk management is the key to successful investment.