Risk Management under Shariah Law: Products, Techniques and Competitiveness

©2015 Textbook 62 Pages


This research provides insights on the competitiveness of the Islamic financial industry in relation to conventional finance in the future term by investigating the development and standardization of Islamic finance risk management products and techniques. Additionally, it examines whether Shariah law impedes the innovation and standardization of these products and techniques. The investigation of the topic is carried out on the basis of a descriptive analysis of topic-related literature and internet publications. Furthermore, it is supported by analytical facts and figures from recent studies and financial reports. At the end, the research concludes that the classical Islamic scholars, and not Shariah law, impede the innovation and standardization of Shariah-compliant risk management products and techniques. Despite that issue, the Islamic financial industry with its risk management products and techniques is already competing with conventional finance in the international market as it starts at the point where conventional finance is trying to reach: zero interest rates to stimulate the economies and pure risk management products and techniques, which are not used for speculation


Table Of Contents

1. Introduction
"Big interest, no interest" is how The Economist referred to the booming market of Islamic
financial products in September 2014.
Indeed, the principles of Islamic finance, which can be
found in Shariah law, classify Islamic financing as a financial system based on the strict
prohibition of receiving or paying interest. These principles aim at providing a fair
distribution of wealth in society and encouraging social justice.
The concept of Islamic
finance highlights the Islamic financial industry as an interesting system of financial
intermediation for all market participants including devoted Muslims and especially those
who suffered losses during the 2008/2009 financial crisis. These participants know that the
industry is not limited to banking, but also includes the Islamic Capital and Money Market
According to Ali and Lovells (2014), in conventional finance, banks lend money for money
(interest) in accordance with the concept of time value of money. Basically, risk can be seen
as a one-way street where the borrower bears it all. However, in Islamic finance, renting
money is prohibited and the concept of time value of money does not exist. Profit in Islamic
finance can be made by selling or leasing an asset, or by investing in enterprises to trade
assets on a profit and loss sharing basis. Such transactions are achieved by concluding
different types of Shariah-compliant contracts.
From these points one can understand that unlike conventional finance, the risk in Islamic
finance can be thought of as a multi-way street that is shared between all involved parties in
any financial transaction. Therefore, proper risk management is important for the mitigation
of loss exposures and the protection of profits.
As the Islamic financial industry began to
evolve in the 1970s, risk management was limited only to cash management because of the
small size of most of the Islamic financial institutions (IFIs) at that time. The rapid growth of
the industry, however, has increased the demand of market participants for advanced risk
management products and techniques aimed at mitigating loss exposure and facilitating
financial transactions.
Numerous studies have been conducted on risk management products and techniques in
Islamic finance. Yet,
the Islamic financial industry is still young compared to conventional
finance. In the last decade, IFIs have been developing many new risk management products
Cp. The Economist (2014).
Cp. Kettel (2011) a, p. 14 ff; cp. Mahlknecht (2009), p. 17 ff.
Cp. Oseni/Hassan (2011), p. 92; cp. Mahlknecht (2009), p. 61 ff.
Cp. Ali/Lovells (2014), p. 19 ff.
Cp. Greuning/Iqbal (2008), p. 3, 10, 145.

and techniques, especially after they have gained valuable experience in financial markets and
have learned many lessons from the 2008/2009 financial crisis.
Many of these products and
techniques have been criticised by Islamic scholars, or even sometimes have been banned for
not being Shariah-compliant. Hence, the purpose of this research is to investigate and search
for the most current and developed risk management products and techniques that have been
confirmed by the majority of Islamic scholars and/or standardized by Islamic regulatory
bodies, and therefore utilized by IFIs. The investigation will be based on recent primary and
secondary data sources such as literature and internet publications dating from year 2007 to
the present year 2014.
The risk management products and techniques that will be displayed
in this research will then be compiled and discussed for the first time in one research. This
will create insights into the competitiveness of the Islamic financial industry in relation to
conventional finance in the future term, meaning the next 5 to 10 years. The arguments will
be supported by analytical facts and figures from studies and financial reports. Important to
note is that due to the short history of the recently developed and/or standardized products
(year 2007 to 2014) contained within this work, there is not enough data existing yet for a
useful econometrical analysis of their influence on the performance of the Islamic financial
Cp. Kayed (2011), p. 361 ff.
The research started in October 2014.

1.1 Problem Statement
As of 2014, Shariah-compliant assets within commercial banks are globally set to reach and
go beyond US$2 trillion with 17.6% average annual growth. This is 50% faster than the
average annual growth of conventional financial assets.
Despite this, leading Islamic banks
reported around 19% lower ROE (i.e. 12.6% vs. 15%) than their comparable conventional
peers in the last four years. They claimed that the lower ROE is due to higher expenses.
Logically, this might be acceptable for banks that share profits and losses with both their
depositors and clients. However, in 2014, a study conducted on 2.25 million Islamic bank
depositors concluded that the majority of these depositors are not satisfied with the
performance of their Islamic banks. According to the study this was due to the lack of
advanced Islamic financial products, especially for risk management purposes. Moreover,
according to Ernst and Young (2012), a well-executed transformation program was started in
2012 to improve the profitability of Islamic banks by approximately 25% in 2015 by
overcoming the afore mentioned 19% decrease in ROE. The transformation program was set
to improve the weak risk culture and encourage developing and standardizing Islamic
financial products and techniques that serve the sole purpose of risk management.
For this
program to succeed in 2015 as planned, the new products and techniques should have
appeared latest by 2014. Indeed, as the research for this research began in 2014 and was
planned to carry over into 2015, allowing for an appropriate time for analysis, the following
two research questions are posed:
(i) What are the Islamic risk management products and techniques that have been developed
and/or standardized in the last years until today in 2014, and does Shariah law impede their
innovation and standardization?
(ii) Could these products and techniques truly help in moving the Islamic financial industry to
the next level at which it can compete with conventional finance?
Cp. Ernst & Young (2013), p. 18 ff; cp. Al Jazeera (2014) a.
Cp. ibid.
Cp. Ernst & Young (2012), p. 6 ff; cp. Al Jazeera (2014) a.

1.2 Research Objective
The research objective is divided into two complimentary parts as follows:
General Objective:
This paper aims at providing insights on the competitiveness of the Islamic financial industry
in relation to conventional finance in the future term by investigating the development and
standardization of Islamic finance risk management products and techniques, and by
comparing them with their conventional alternatives.
Specific Objectives:
· To outline the theoretical framework of Islamic finance in favour of underlining the
conditional principles and concepts for the development of Islamic financial products
and techniques.
· To define the main distinctions between Islamic and conventional finance and the
major products they offer.
· To introduce specific risks that expose IFIs to losses and cause them hardships when
competing with conventional finance.
· To discuss the objections of Islamic scholars on using conventional products to
mitigate loss exposures that put Islamic finance in a disadvantaged position within
conventional finance.
· To discuss the proposed solutions to develop Islamic risk mitigation products and
techniques and highlight the obstacles that impede their innovation and
· To compile and discuss the recently developed and/or standardized Islamic risk
management products and techniques.
· To analyse the influence of the recently developed and/or standardized Islamic risk
management products and techniques on the competitiveness of the Islamic financial
1.3 Research Structure
This research is divided into five complementary chapters. Each chapter covers a specific
aspect of the investigated topic:

The first chapter provides an introduction, a problem statement, the research objectives, and
the research structure.
Afterwards, chapter two outlines the theoretical framework of Islamic finance. It starts by
defining finance under Shariah law. Thereafter, it explains the principles and concepts of
Islamic finance and banking, summarizes their development, and then discusses the basic
products and services they offer. The chapter concludes by highlighting the main distinctions
between Islamic and conventional banking.
The third chapter forms the core of the research. It starts with explaining risk management
under Shariah law. Then it discusses the specific risks that are exposing Islamic financial
institutions (IFIs) to income losses and therefore causing hardships when competing with
conventional finance. The chapter continues by investigating and discussing the most current
Shariah-compliant products and techniques, which are developed and/or standardized to
mitigate specific risks. This will be achieved by adding two separate sections to specifically
discuss the developed and/or standardized liquidity and hedging products and techniques that
have been introduced to the Islamic financial industry during the last years until today in
Based on the third chapter, the fourth chapter presents the reader with analytical facts and
figures from studies and financial reports. The purpose will be in determining the extent to
which the new risk management products and techniques will succeed in moving the Islamic
financial industry to the next level at which it can compete with conventional finance.
Finally, the fifth chapter will provide conclusions to the research drawn from the investigation
and will close with a suggestion for further research.

2. Finance under Shariah Law: Theoretical Framework
Islamic finance aims at offering investment or finance opportunities that are in compliance
with religious commands derived from Shariah law. To understand Islamic finance, it is
therefore helpful to understand the five pillars of Islam, which represent the basic religious
duties of Muslims. The pillars are described throughout some parts of the Holy Quran and
were already being practiced by Muslims during Prophet Mohammad's lifetime.
The first pillar of Islam, Shahada, involves professing one's self to the existence of only one
God, and Mohammad, God's last Messenger and Prophet on earth to the people.
The second
pillar involves doing ritual prayers five times a day. The third pillar is where one pays Zakat,
which is usually in the form of obligatory charges on Muslim's account.
Furthermore, the
fourth pillar is when one fasts during the month of Ramadan. Lastly, the fifth pillar involves
Hajj. Hajj is when a Muslim pursues a pilgrimage to Mecca at least once in their lifetime.
Under the first pillar of Islam, an additional five articles of faith must be declared by
Muslims. Hence, in addition to professing one's self to the existence of only one God,
Muslims should believe in destiny, the existence of God's Angels, the holy scriptures that are
mentioned within the Quran,
all of God's Messengers and Prophets, and the Hereafter
(eternal life after death).
Any individual who fulfils the first pillar of Islam is a Muslim.
However, according to Quran, all Muslims should obey God's rules by practicing the other
four pillars and articles of faith as well, which will ensure that one is on the right track of
Shariah law consists of the moral codes and religious law of Islam. These are derived from
the Holy Quran, the teachings of Prophet Mohammad, called Sunna, and the consensus on the
analogical legal reasonings of qualified scholars in Islamic jurisprudence, called Ijtihad.
For Muslims, Shariah law governs all matters of life such as faith, worship, politics,
economics, justice, and social aspects. Muslims believe that Shariah law stands as God's laws
on earth, helping people organize their lives to achieve stability and welfare. Ultimately,
Muslims are supposed to refer to Shariah law for all of life's matters to understand what is
Cp. Gassner/Wackerbeck (2010), p. 27; cp. Kettel (2011) a, p. 1.
Not all God's Messengers on earth were Prophets at the same time.
Zakat will be explained in section 2.1.
Fasting and pilgrimage must only be applied by those who are healthy and financially able to do it.
The original scriptures (God's words), which are not corrupted.
Cp. Kettel (2011) a, p. 1 ff.
Cp. Kettel (2011) b, p. 2 ff.
Cp. Hakim (2007), p. 161.

allowed, disliked, and forbidden by God. Therefore, in the faith and belief of Muslims, all
economical and financial activities must be Shariah-compliant.
In the majority of Islamic countries or in countries where the majority of the population is
Muslim, Shariah law is incorporated into civil law. However, in most aspects, civil law is still
dominant over Shariah law in these countries, allowing the Western banking system, which
includes the receipt or payment of financial interest, to continue penetrating their financial
markets. Therefore, in order to avoid the conflict between the two legal systems regarding the
fundamentals of economic freedom, Shariah law is usually only applicable at institutional
level, and only in few countries it is applicable at a federal level, as is the case in Libya.
The lack of Islamic courts in some countries, specialized in Islamic finance, exposes
individuals and institutions that are practicing finance under Shariah law to legal risk. Hence,
both Shariah law and civil law govern the majority of IFIs around the globe. However, in the
absence of Islamic courts, countries that have adopted only civil law cannot enforce and
support the unique features in the Islamic financial contracts. In contrast, the ruling civil
regulations and banking law in most jurisdictions forbid the unique features of the Islamic
financial activities.
Therefore, the legal risk can lead to governance risk at institutional level
where financial losses accumulate.
Cp. Ashrati (2008), p. 7 ff; cp. Kettel (2011) a, p. 14 ff.
Cp. Majed (2011); cp. Bälz/Greco (2014).
Cp. Ahmed/Khan (2007), p. 146.
Cp. Greuning/Iqbal (2008), p. 179; cp. Ali/Lovells (2014), p. 19 ff.

2.1 Islamic Finance and Banking Principles
The principles of Islamic Finance and Banking are derived from Shariah law. They are as
The Prohibition of Interest (Riba)
As commonly agreed upon by contemporary scholars of Islamic jurisprudence (Fiqh), the
prohibition of receipt or payment of financial interest, or Riba, is the nucleus of the Islamic
financial system.
Strong evidence of this can be found directly within the afore mentioned
documents, the Quran and Sunna. Interesting to note, the prohibition of interest is also
supported by other holy scriptures that are mentioned in the Quran and belong to Abrahamic
religions (Judaism, Christianity, and Islam).
Scholars of Islamic jurisprudence who agree on the prohibition of interest refer to four
different chapters in Quran.
These are: Chapter 2 (Al Baqarah, Verses 275-281), Chapter 3
(Al Imran, Verse 130), Chapter 4 (Al Nisaa, Verse 161) and Chapter 30 (Ar-Rum, Verses 38-
39). From these Verses and especially from Verse 275 in Chapter 2, it can be concluded that
God has permitted trade but forbidden interest. Therefore, Muslims believe that they are
allowed to profit through trading and investing.
The first and foremost priority according to Islam and its teaching on economics is justice and
equity. The Islamic financial system should be able to create a balanced relationship between
an individual and society by creating equal opportunities and removing obstacles equally for
every member of the society.
Therefore, in the view of Islamic scholars, God has prohibited
interest because it is an unfair earning that does not share the risk of capital
erosion with the
. It is a rather predetermined positive return charged on the principle by the party,
which ultimately exploits the money supply. On the other hand, God has permitted profit
through trading because it is a reward for utilizing money, which could end in a positive,
neutral, or negative return.
Within Shariah law, the differences between interest (Riba) and
profit are explicitly manifested.
The Prohibition of Gambling and Unnecessary Excessive Speculation (Maysir and
Cp. Algaoud/Lewis (2007), p. 38 ff.
Cp. Mahlknecht (2009), p. 17 ff; cp. Choudhury (2007), p. 26 ff.
See Appendix 1.
Cp. Ashrati (2008), p. 22 ff.
Cp. Greuning/Iqbal (2008), p. 5.
Cp. Kayed (2011), p. 369.
See Appendix 2.

The word Maysir in Quran and Sunna embraces all gambling activities wherein the gambler
strives to amass wealth without effort. As for Gharar, this term was mentioned only in the
teachings of Prophet Mohammad. In business terms, Gharar means to undertake an
excessively risky transaction that can be avoided, and therefore it is then possibly forbidden.
Hence, while gambling is clearly forbidden in Quran and Sunna, speculation is not. This is
because minor speculation could be seen rather as a risk and therefore it is permitted.
On the other hand, according to Ali and Lovells (2014), the volume of the activity does not
alter its characterisation, concluding that excessive speculation could also be seen as
gambling in Islam when important elements of the contract are not specified or when the
subject matter itself is not properly identified. One example includes the market for financial
derivatives where excessive speculation is practiced. However, there are exceptions to minor
speculations when it comes to contracts covering agricultural products, which need to grow
and be harvested, or manufacturing products, which still need to be produced.
In section
3.4.1, two exceptional contracts (Salam and Istisnah) will be discussed.
Business Transactions must be Shariah-Compliant (Halal)
According to Shariah law, Islamic investors and Islamic financial institutions (IFIs) are
allowed to invest only in Shariah-compliant activities. Any another business activity that is
forbidden by Shariah law is called Haram and must be sorted out. Companies that partake in
Haram activities according to Shariah law mainly include: companies offering conventional
financial services, companies in the gambling industry, companies in the alcoholic beverage
industry, and those that have anything to do with the consumption of pork products and adult
entertainment (night clubs, pornography, casinos, etc.).
After sorting out the companies that partake in Haram business activities, Islamic investors or
IFIs should calculate some Islamic indices for the remaining companies before injecting their
capital into them.
The Accounting and Auditing Organization of Islamic Financial
Institutions (AAOIFI) provides these indices, which slightly differ from other Islamic index
providers. Two examples of the indices provided by the AAOIFI are compiled below in Table
Cp. Gassner/Wackerbeck (2010), p. 38 ff; cp. Algaoud/Lewis (2007), p. 39 ff.
Cp. Ali/Lovells (2014), p. 11 ff.
Cp. Azami/Siddiqui (2011), p. 128 ff; cp. Kettel (2011) a, p. 23.
Cp. Gassner/Wackerbeck (2010), p. 162.

Table 1: Islamic Indices for Equity Investments. (Source: Gassner and Wackerbeck-
Conformity by Shariah Supervisory Board (SSB)
IFIs and conventional banks that offer Islamic financial products and services are required to
establish a SSB, which is a board that is completely independent from the other organs within
the same institution. The SSB should include at least three Shariah scholars with the
responsibility of ensuring the compliance of all business and non-business transactions within
Shariah law. Furthermore, the SSB is tasked to offer advising and correct those transactions
that deviate from the restrictions of Shariah law.
Payment of Zakat is Obligatory
Islamic tax or Zakat is the third pillar of Islam and it is of great importance to achieve welfare
in Islamic economies and Muslim societies. Zakat is an obligatory charge on every liquid
capital owner, private or commercial, who did not utilize his or her capital for one complete
year for something productive or for direct investment.
Such unutilized capital should weigh
at least 85 grams of Gold, the approximate equivalent of 2,552.
Zakat is usually collected
by certain Muslim individuals, Islamic institutions or Mosques to be distributed to poor
people. However, Zakat payers could choose to directly transfer the amount they are paying to
the poor people by themselves.
According to Shariah law, the amount of Zakat is determined on an annual basis and consists
of 2.5% of an individual's or a company's unutilized capital.
Therefore, it could be
concluded that Zakat is the most important instrument for the redistribution of wealth in
Muslim societies.
Moreover, Zakat could be considered as a motivating instrument for
Muslim wealth owners because it encourages them to think actively, take risks, and utilize
Kügler (2009), p. 16 ff.
Cp. Gassner/Wackerbeck (2010), p. 31 ff.
Cp. Gold.de (2014).
Cp. Ecke (2012), p. 12 ff.
Cp. Ashrati (2008), p. 10.
Cp. Algaoud/Lewis (2007), p. 40.

their wealth instead of letting their capital shrink on a yearly basis through the payment of
2.2 Development of Islamic Finance and Banking
During the Islamic Golden Age, which took place between eighth and twelfth century, Islamic
Finance was practiced in the Islamic world by applying a number of Shariah-compliant
economic concepts, techniques and instruments which some refer to as "Islamic Capitalism".
This positioned Islamic merchants in Spain, the Middle East, and the Baltic States as
irreplaceable mediators for trading activities. As a result, various concepts, techniques, and
instruments of Islamic Finance were later adopted and further advanced by European
financiers and businessmen from the thirteenth century onwards.
According to Islamic
scholar Mohammad Shbir, two main motives stand behind the establishment of IFIs. The first
motive can be derived from the fact that historically conventional banks faced reluctance in
Muslim countries because their system was based on financial interest. The second motive
was that
conventional banks had faced a big failure in the 1930s, proving to be fruitless.
Therefore, the work on establishing a new financial system based on profit and loss sharing
rather than interest came into process between the 1940s and 1950s in Malaysia.
first attempt to establish an Islamic bank was in Pakistan in the 1950s followed by
another attempt in Egypt in 1963.
The latter attempt was
successful but the Islamic bank was
acquired by another bank for political reasons. However, the oil boom in Islamic countries
and the emergence of young Muslim economists led to many conferences in the 1970s which
resulted in the establishment of the first IFIs. The Islamic Development Bank and Dubai
Islamic Bank were opened in 1975, and followed few years later by other essential IFIs within
the Gulf Cooperation Council
(GCC) countries such as the AAOIFI. As cited in the last
decade, recent times have witnessed conventional banks worldwide opening Islamic banking
windows or even transforming to fully-fledged Islamic banks, showing an ever-persistent
worldwide development of Islamic finance.
Cp. Gassner/Wackerbeck (2010), p. 31.
Cp. Greuning/Iqbal (2008), p. 10; cp. Kettel (2011) b, p. 24.
Cp. Nasir (2005).
Cp. Greuning/Iqbal (2008), p. 10 ff; cp.
Kügler (2009), p. 6 ff;
cp. Ernst & Young (2013), p. 12 ff.

2.3 Islamic Finance and Banking Products
Products, services and accounts offered in Islamic finance and banking are financial models
designed to satisfy the modern needs of Muslims while being compliant with Shariah law.
There is an exhaustive list of Islamic financial models that were further developed and applied
by IFIs worldwide.
However, many of them are country specific. Thus, this section will focus
only on the base models, which have been adopted by the Islamic Financial Services Board
(IFSB) and are being offered in the majority of IFIs around the world. Such models are
referred to as "Shariah-Based Products".
2.3.1 Modes of Islamic Financing Contracts
"Contracts play a vital role in the Islamic financial system, and all financial transactions are
based on contractual agreements."
Hence, financial models are seen as contracts in Islamic
finance as discussed below:
Murabahah (Cost-plus Sales)
Murabahah is a cost-plus sales contract between a buyer and an intermediary (the bank).
Simply put, in this deferred sales contract the buyer asks the bank to buy a certain product
from a third party seller and resell it to him.
The buyer and the bank agree in advance on the
profit margin that is added up to the cost of the product and the payment method, which can
be made through a series of instalments or through a bullet payment.
This financial product forms more than 75% of
IFI's financial transactions.
At a first
glance, this type of product seems much like charging interest. However, the differences
become clearer when taking a closer look at the contract conditions. For instance, the Islamic
bank is taking all risks associated with ownership rights of the product when entering a
Murabahah contract. Hence, the bank's profit margin is a reward for the risks taken.
Musharakah (Equity Financing/PLS-Concept)
Musharakah means sharing in formal Arabic and the meaning of the word is exactly reflected
in the mechanism of the contract, which implements the profit-and-loss sharing concept
(PLS). Under this contract, two or more parties contribute capital to finance a new or an
existing business and to manage it together. In some cases, partners could choose to assign
only one of the parties to carry out the management of the investment. In addition, all parties
Cp. Lahsasna/Hassan (2011), p. 36 ff.
Greuning/Iqbal (2008), p. 21.
Cp. ibid.
Cp. Kettel (2011) b, p. 37.
Cp. Valeva (2012), p. 193 ff.


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Title: Risk Management under Shariah Law: Products, Techniques and Competitiveness
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