Risk Management

REVIEW by Alberto Brugnoni

The notion of risk has been at the very centre of the Islamic understanding of financial relations since their inception. Michael Mahlknecht’s latest 'Executive Report on Islamic Capital Markets and Risk Management' is a timely, fascinating and well-written traveling experience through this old issue that has resurfaced as one of the hottest and most debated questions of today’s Islamic finance. While in conventional finance the canvas of the risk carries only a financial dimension in Islamic finance it covers many extra elements due to its participation, purpose, contractual design and specific legal, governance and liquidity requirements. This issue is compounded by a deficient legal framework and the existence of relatively fewer standards and procedures. Today the issue at stake is nothing less than the choice and implementation of the appropriate policies and mechanisms that should be adopted to ultimately prevent crises similar to the one experienced by the conventional financial system. The Islamic finance industry is particularly at risk as it has relative weak foundations and plays a marginal role in international finance. At the same time it carries a centuries-old value proposition that spans the globe and attracts attention

One should salute the courage of the author that opens his compelling study by walking us through the highly controversial topic of Islamic derivatives. Drawing from his in-depth technical knowledge and first hand experience he shows us how the use of exotic instruments can possibly fulfil the higher aims of Islamic finance. The ensuing informative and well researched chapters give a respite by presenting more standard instruments as Sukuk and funds before plunging us back in rough waters by analyzing Islamic structured products. This sector, even more controversial than derivatives, has damaged the reputation of some institutions and has exposed Islamic finance to the accusation of mimicking conventional finance and sacrificing its noble ends for the sake of over-sophistication and short-term gains. Zooming in on risk, the author focuses on the contracts and the institutions by analyzing and discussing the unique mix that Islamic institutions face. For example, credit risk is higher in Islamic banking owing to the reduced availability of legal recourse for defaults and operational risks sees the added dimension of Shariah risk. The author quite rightly points out the pivotal role that the Islamic Financial Services Board and the Accounting and Auditing Organization for Islamic Financial Institutions must play in issuing standards for corporate governance and risk management

The institutional framework provided by Basel II and the specifics of Islamic capital adequacy requirements are briefly touched upon. Suffice here to say that liquidity risk is higher in Islamic finance due to the non-existence of money markets and to the limited recourse to overnight borrowing. In the second part of his work the author embarks on a highly technical analysis of the risks implied in the use of each capital markets instruments available to Islamic finance practitioners and on the solutions available to managed or mitigate these risks. This section is a ready-to-use manual for practitioners wishing to sharpen their skills

The responsibility falls now on the shoulders of the scholars to use the wealth of information provided by the author to insure that derivative, quasi derivative and structured instruments comply not only with the letter but with the spirit of the Shariah. On the one hand Islamic banking is based on a few basic contracts and they can quite rightly be used to create products as desired. But on the other hand they must be structured with the goal of risk sharing, wealth distribution, social justice and sustainable development. Failing to do so will result in Islamic finance losing credibility and appeal and being seeing as another marketing tool

Islamic Capital Markets and Risk Management makes a genuine contribution to the Shariah compliance risk management debate and is a must read for academicians and practitioners alike that wish to widen the scope of Islamic finance. By proposing to take into consideration modern market conditions while keeping a firm eye on the spirit of Shariah Michael Mahlknecht has given us a good example of how the classical concept of ijtihad is still alive and can work in today’s world