Chapter 2 clarified that not all financial institutions are equally vulnerable to failure during financial crises and that the most vulnerable institutions are those exposed to liquidity and credit risk; prone to excessive risk-taking, and unable to sell their assets or obtain liquidity from local sources as a means of returning to target leverage. Although Chapter 3 then revealed that Islamic financial institutions do not possess better risk management models and Islamic regulators cannot readily identify the different categories of risk emerging from the Islamic financial market, Islamic banks are able to provide capital and generate profits using PLS equity-based schemes with a low total risk load. This is especially the case where the banks use sales-based and lease asset-based contracts to mitigate the liquidity, market and credit risk arising from equity-based schemes.
Additionally, the exposure brought about by the above-mentioned schemes is limited. The special credit risk embedded in Mudarabah investments and Musharakah transactions is
465 See M Ayub, Understanding Islamic Finance (John Wiley & Sons 2010) 374-375. 466 I Warde, note 132 above, 152.
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mitigated by the counterparty’s duty of utmost good faith and mutual trust, which are sustained by the belief that contracts are trade instruments endorsed by the Holy Scriptures. Thus, since Mudarabah and Musharakah contracts are essentially Ubberimae Fidei or good faith contracts, they are based on full disclosure and transparency on the part of the Mudarib
and the alignment of the parties’ interests. It follows that the risk of moral hazards and of agency and information failure or asymmetry are mitigated. Equally, credit risk will only be enhanced, if the bank fails to conduct a suitable risk analysis prior to entering into an agreement, or of it fails to monitor the Mudarib. This risk will be even lower in Musharakah
transactions, where the bank participates in the actual project management; making it easier to assess and manage credit risk. The most serious risks facing banks that use these PLS equity-based schemes comprise liquidity risk, market risk and rate of return risk.
However, banks may use a sales-based instrument, such as the Murabahah to manage illiquidity. This takes place in a way that is similar to the interbank deposit transactions of conventional banks. For instance, the bank buys the asset from a broker at cost and sells it to a client bank at cost-plus, based on deferred payment. The latter then sells the asset on to another broker at cost and the transaction may subsequently be reversed, if the investing bank faces liquidity issues. The bank may also use a lease asset-based instrument, such as the
Ijara. It will consequently enter into an equity-based agreement, with a tangible asset as its subject; paying for the asset and entering into a parallel Ijara contract at a mark-up with an SPV for the lease of the asset. This will ensure that the Ijara contract absorbs any shocks from the equity-based agreement.
Irrespective of the above, a very important risk confronted by Islamic banks and one that is not mitigated by the above-mentioned instruments is rate of return risk, relating to the benchmark rate risk. This is because these instruments do not allow banks to reprice asset- liability mismatches. The risk of returns deviating from what depositors or investment account holders expect is heightened by the fact that the latter often expect returns that are similar to benchmark rates. However, the use of the Murabahah to mitigate this risk is rather expensive, as demonstrated above, since the bank must forgo all or part of its share of the profits, in order to pay the depositor a rate of return on a par with the benchmark rate.
Islamic banks are in a particularly difficult position, because they can only use an Islamic tool to hedge benchmark rate risk. The hedging tools available to them are limited to the liquidity mismatch between short-term funding, and long-term financing and investing, implying that
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there are few liquid hedging tools available to them. Moreover, as noted in Chapter 3, although there are countless derivative products on the standard market, which could be used for hedging, Islamic banks cannot use derivatives, because they are not Shariah-compliant. Islamic banks therefore often use Murabahah contracts to manage liquidity risks. Thus, an appropriate tool could be the profit rate swap to the bank from fluctuations in borrowing rates. This would involve exchanging profit rates between a floating rate party and a fixed rate party, through the execution of an underlying contract.467 The Waad contract provided by each counterparty would then ensure that the swap reaches maturity.468 This is because the counterparty undertakes to enter into the relevant commodity trade. Moreover, Islamic banks may issue Sukuk certificates to ensure securitisation.
Overall risk may also be reduced or eliminated by profit equalisation reserves or investment risk reserves. These reserves offer returns that are based on the market rates of return on specific benchmarks, such as conventional deposits.469 They may also be used to redistribute the income accrued to investment funds.