By: Hassan Ahmed Yusuf is the operational risk manager at Masraf Al Rayan.
Islamic banking and finance has experienced tremendous multidimensional growth in the last 30 years and this is clear from the product engineering that has fl ooded the market. Since the inception of Islamic banking and fi nance, the focus has been on removing interest from the system, as some outlook changes and many operational changes were left intact based on the conventional system.
As we have seen from recent court cases and defaults, there is a clear shift taking place in the Islamic fi nance industry, to focus on the robust development of operational matt ers to align with Islamic finance requirements. Part of this includes understanding the risks in Islamic fi nance from a Shariah point of view as Shariah has its own mechanism to address and mitigate risks.
Sound and proper Shariah risk management starts with understanding the basic concepts of managing risks; Shariah guidelines that relate to ‘muamalat’; and how to deal with risks and its impact.
Clear and accurate understanding of these concepts and the correction of any misconception surrounding the fundamentals and assumptions of Shariah risk provides clear procedural guidelines in eliminating, mitigating or transferring Shariah risk and off ers robust, effective and efficient oversight management of Shariah risk.
Risk is an event that relates to an uncertainty with a measurable impact and risk constitutes the level of uncertainty of the event which has an unfavorable outcome or adverse consequences. In other words, the measurement of risk is essential and quantifiable; it is impractical to mitigate risk if risk cannot be measured.
Shariah risk treatment
Shariah risk is the risk that arises from a lack of compliance to Shariah rules and regulations in relation to Islamic financial institutions or any entity that undertakes Islamic financial services. Shariah is the basis of Islamic financial institutions to undertake and process their operations through binding contracts and specific formats dictated by Shariah guidelines and it is one of the fundamental distinctions between Islamic financial institutions and their conventional counterparts.
Shariah risk can appear in different places and stages throughout the process of product implementation and the intensity of the impact of Shariah risk depends on the degree of Shariah divergence in a particular stage or place in the life cycle of the product.
For example, a receivable commission was discovered to be part of a particular project approved by a Shariah board, but the commission itself was not part of the approved fees allowed by the Shariah board (there are certain fees that are not allowed by Shariah boards: including management fees, early sett lement fees, commitment fees, extension fees, administration fees and non-utilization fees). The treatment of such a violation involves cancelling the commission only, and it does not affect the rest of the transaction or project involved, as this type of risk has a minimum impact at this stage. However, there are certain cases that
can bring a whole institution to its knees and have a high reputational impact, although this rarely happens.
Even if this type of risk is realized (depending on the stage of risk occurrence), there are techniques and methods in Shariah for its treatment, as Shariah has an embedded mechanism to protect from adverse and negative consequences that can affect the general interests of society.
There are certain principles in Shariah that provide a direction for certain situations, based on the well-known legal maxim that necessity permits prohibitions. It is part of the fiqh to understand and deduce accordingly from the circumstances that surround the whole case. Another Shariah mechanism which is frequently used is the fiqh principle based on the famous narration “no
harm and no reciprocating harm.” Maslahaor public interest is involved to permit or prohibit something based on public benefit. For example, this can be applicable where the wealth of shareholders is wiped out or reduced to a low level due to lack of conformation to a Shariah principle. In a practical sense, this can be used for certain risks that have adverse consequences for a larger segment of society.
Another fi qh ruling that can be used is where the risk is inevitable but the effect varies depending on the outcome, and in this case Shariah encourages the acceptance of a type of risk, based on choosing the risk that has the least impact. In Islamic fi nance, this could be applied to a transaction where the acceptance of certain risks are unavoidable: such as penalty fees where the fees must be paid or the project risks cancellation.
There is another fi qh understanding where if there is a part of the transaction that is deemed impure, fiqh will judge based on the quantity that is considered impure or deemed illegal. This is based on a well-known fi qh ruling that purity, ‘tahara’, is not aff ected by a small level of impurity if it is restricted to a certain level (a known quantity).
Thus in Islamic finance, regarding investing in mutual or equity funds, if riba interest involvement is 1-5%, it doesn’t aff ect the other 95% which is considered permissible: based on the above explanation that a small impurity does not influence or affect the larger part of purity and since the percentage of impurity is well-known in financial terms, it is taken out of the transaction and it can be segregated from the rest of the transaction.
The above scenarios are given to highlight that Shariah has mechanisms to deal with risks depending on the level or stage, quantity and consequences of the event. Having a comprehensive understanding of this background may help in mitigating the Shariah risk, based on the stage of occurrence. It should not be thought that everything related to Shariah risk can have a ready-made answer. However, it must be stressed that Shariah risk remedies are widely available and there are a variety of options.
Shariah risk measurements
Financial products off ered by Islamic financial institutions are diff erent from those off ered by their conventional counterparts. Shariah risk elements occur in different places, such as pre- and post structuring a product and its life cycle.
The elements that constitute Shariah risk have different levels of impact subject to the article or the clause that is breached, and depend on the stages and places of risk occurrence.
The most frequent risks are in post-implementation, and some of these risk occurrences, such as missing dates in contracts can happen frequently due to of human error. Shariah dates are an essential component in Islamic finance contracts as the ownership
transfer is checked through dates: and in Islamic finance no sale can take place without the ownership right. There are tremendously rich resources available in dealing with all types of risk in Islamic banking finance, but the area urgently needs more research on how Shariah embedded mechanisms can be used by the Islamic finance industry to avoid and mitigate risk.
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