Risk Management in Islamic Finance

Prepared: Mamarayimov Erkin

student number: 22400012

Namseoul University
2024
 Introduction to Risk Management in
Islamic Finance

Risk management is a critical component of Islamic finance, a system of

banking and investment that adheres to the principles of Sharia law.
Unlike conventional finance, Islamic finance prohibits the charging of
interest (riba) and speculative practices, instead promoting risk-sharing
and ethical investments. To navigate the unique challenges of this
industry, Islamic financial institutions have developed specialized risk
management techniques that align with their religious and ethical
framework.
 Principles of Islamic Finance
Focus on Real Economic Activity Prohibition of Riba (Interest)
Islamic finance emphasizes the direct One of the core principles of Islamic
financing of real economic activities, such finance is the prohibition of riba, which is
as trade, manufacturing, and investment in broadly defined as any form of interest or
tangible assets. This is in contrast to usury. This prohibition is rooted in the
conventional finance, which often involves teachings of Islam, which view the
speculative activities and derivative charging of interest as unethical and
instruments that can lead to excessive risk- exploitative. Instead, Islamic finance
taking and financial instability. By promotes the use of profit-and-loss sharing
focusing on real economic activity, Islamic arrangements, such as Mudarabah and
finance aims to promote sustainable Musharakah, as a means of financing
economic growth and development. economic activities.

Risk-Sharing and Asset-Backed Ethical and Socially Responsible

Financing Investing
Islamic finance is based on the principle of Islamic finance promotes ethical and
risk-sharing, where both the provider of socially responsible investing by
capital and the user of capital share in the prohibiting investments in industries or
risks and rewards of an economic activity. activities deemed haram (forbidden) under
This is in contrast to conventional finance, Islamic law, such as gambling, alcohol,
where the lender typically bears little to no and weapons. Additionally, Islamic finance
risk. Islamic finance also requires that emphasizes the importance of promoting
financial transactions be asset-backed, social welfare and equitable wealth
meaning that the financing must be linked distribution, aligning with the broader
to a tangible asset or underlying physical principles of Islamic economics.
activity.
 Mudarabah (Profit-Sharing) Contracts

Mudarabah is derived from the Arabic word ‘daraaba’ which

means partnership or profit sharing. Mudarabah is defined as
an agreement between two parties where one party provides
capital while the other manages the investment activities. Both
parties share the profits as well as any potential losses
according to their agreed ratio. In a Mudarabah contract, the
party providing capital is called ‘Rabb-ul-maal’, the managing
party is known as ‘Mudarib’, and the investment is called ‘Raas-
ul-Maal’. Mudarabah in Islamic banking is widely used to
structure bank deposit accounts, and it is also used in
combination with other Islamic financial contracts.
Mudarabah contract in Islamic finance is sometimes used by
individuals who seek to invest in businesses to make their
money work harder for them. Mudaraba can also be used by
banks or other large organizations that want to diversify their
investment portfolio by investing in small businesses across
various countries and sectors. Under the Mudarabah Contract:
Investor and Working Partner decide to enter a business
1.
venture.
The investor provides capital to run the business, and the
2.
Working Partner is responsible to run and manage the business
through his expertise.
Subsequently, if the venture is successful and generates profit,
3.
this profit is distributed among both partners, on a pre-
determined ratio.
Key Principles of Mudarabah in Islamic Banking Types of Mudarabah
A. SHARED RISK AND PROFIT IN MUDARABAH 1. RESTRICTED MUDARABAH
B. LOSS ABSORPTION 2. UNRESTRICTED MUDARABAH

C. TRANSPARENCY AND TRUST

D. FREEDOM OF MUDARABA CONTRACT
E. PROHIBITION OF FIXED RETURNS
F. MUDARABA ADHERENCE TO SHARIAH PRINCIPLES

Mudarabah Examples and Applications

I. MUDARABAH-BASED CURRENT
ACCOUNTS
II. MUDARABAH-BASED SAVING
ACCOUNTS
III. PROJECT FINANCING THROUGH
MUDARABAH
Profit Distribution in Mudarabah How to Terminate a Mudarabah
Contract?
Guidelines regarding the distribution of profit The Mudarabah contract is flexible in terms of
in a Mudarabah agreement can be outlined as termination, allowing either the financier or the
follows. entrepreneur the liberty to end it at any moment,
provided notice is given. During the process of
•Parties must agree on the profit ratio, at the
terminating a Mudaraba contract, there are
beginning. certain key aspects to bear in mind.:
•Parties can share the profit, at any ratio they •If assets are in cash form and some profit has
agree upon. been earned, it will be distributed among
•In case parties enter into a Mudarabah parties, according to the agreed ratio.
agreement without mentioning the exact •If assets are not in cash form, Working Partner
proportions of the profit, it will be assumed may sell and liquidate them, to determine the
that they will share the profit in equal ratios. actual profit. However, constructive liquidation
•Apart from the agreed profit, a working can also be conducted.
partner cannot claim any salary or •If the period of the contract is fixed, all parties
remuneration. are responsible for completing it.
•Parties cannot allocate a lump sum amount as •The capital of the investor will be returned to
profit for any party. the investor, and the remaining amount will be
•Losses shall be only sustained by the considered a profit. This profit will be
Investor; unless it is due to the negligence and distributed according to the agreed ratio.
willful misconduct of the working partner.
 Musharakah (Partnership) Contracts
Musharakah is a type of Islamic banking contract that involves two or more parties coming together to form a partnership. The term
Musharaka translates to ‘sharing’ or ‘partnership’ in Arabic. Its root word is Shirkah, which means “Being a Partner”. Under this
contract, all parties contribute capital towards a venture and share the profits or losses according to their investment ratio. Unlike
conventional financing, where interest is charged on the loan amount, Musharaka is based on the principle of risk-sharing. This
means that all parties involved in the contract share the risks and rewards of the venture equally. Musharakah Contract is a popular
financing option in Islamic finance because it offers an alternative to conventional interest-based financing that is prohibited in
Islamic law.
“And, verily, many partners oppress one another, except those who believe, and do righteous good deeds, and they are few. The
above reminds the partners to bind themselves to ethical values in dealing with each other”. (Al-Quran Surah Sad, Ayah 24!)
This verse generally indicates the validity of Musharakah and it specifically underlines the rule of Islamic inheritance. However, in a
general context, Muslim jurists have regarded the text as containing, the general permissibility of any form of partnership. The
below verse is normally quoted to support Musharakah
“Now send one of you with this your silver coin unto the city, and let him see what food is purest there, and bring you a supply
thereof. Let him be courteous, and let no man know of you”. (Al-Quran Surah Al-Kahf, Ayah
19!)
 Differences between Musharakah and Conventional Financing:
Musharakah is different from conventional financing in several ways. Conventional financing involves
borrowing money from a lender and paying back the loan with interest. This is considered Haram, or
forbidden, in Islam, as it involves the payment of interest, which is considered exploitative and unfair.
Musharakah, on the other hand, is a partnership-based investment model, where partners contribute capital
and share both profits and losses. The profits are shared in proportion to the amount of capital contributed
by each partner, and the losses are shared in proportion to the amount of capital contributed. This model
promotes fairness and equality, as partners share both the risks and rewards.
Another difference between Musharakah and conventional financing is the level of involvement of partners.
In conventional financing, the lender is not involved in the operation of the business or project. However, in
Musharakah, partners are actively involved in the project, and decisions are made collectively.
 Benefits of Musharakah
1. PROFIT & LOSS SHARING
2. ETHICAL NATURE
3. ENCOURAGES
ENTREPRENEURSHIP

Types of Musharakah
• Permanent
• Diminishing.
 Important Rules Related to Musharakah:
 Partner cannot do any work or activity when there is an apparent loss of business.
 One partner may be a sleeping partner and the other a working partner.
 Any other person may be employed with the mutual consent of all partners. The salary will be accounted
from the business expenses, and part of the profit may also be given as an incentive besides salary.
 Any partner may be employed by the business. In this case, his ratio of profit may be increased, or a salary
may be given.
 Profit can be distributed at any mutually agreed ratio.
 The ratio of profit may differ from the ratio of capital or investment.
 The ratio of profit of a sleeping partner cannot exceed the ratio of his investment.
 Losses must be suffered, according to the ratio of investment.
 Since the capital and asset of Shirkah is trust, if a loss is occurred due to the negligence of a partner, only
that particular partner will be responsible for the loss, not other partners.
 Every partner can promise to purchase the share of another partner at Market Price, or at an agreed price at
the time of sale. It is not allowed to agree to a fixed price at the time of promise.
 If capital is in the shape of a commodity, its market value at the time of entering into a partnership will be
taken.
 Capital must be specified and existing. Debt cannot be capital, unless it is a nominal part of the capital, for
example: in the case of a merger of companies.
 Rules for Profit Distribution
EXAMPLE:
 The agreed percentage must be a percentage of profit, not
 Here, for example, the profit ratio for the first 6 months
of capital.
will be 50-50, and then it will be 30-70.
 Partners cannot give any guarantee for the payment of
 The ratio of profit among the partners can also be
profit or capital.
changed, according to the profit earned. For example,
 Third-party can guarantee the profit or capital, under the
Ratio will be 50-50 if the profit earned is up to one
following conditions:
million dollars, and it will be 40-60 if it is above one
 If it has no relation to the business; million.
 Guarantee is not a part of the Shirkah Agreement; and;  Partners may agree that any profit above a certain ceiling
 Third-party does not charge any fee for the guarantee. will belong to a particular partner.

 Different partners may be given different weightings,  If partners are investing and withdrawing money from
according to the amount, and period of their investment. business almost every day, then the profit will be

 Partners can agree to share their profit differently, at distributed on a daily product basis, on average balance.

different times.
 Musharakah Rules Regarding Musharakah Rules for
Ratio Of Profit Sharing of Loss
 According to Imam Malik and Shafi: Each o According to Imam Abu Hanifa and
partner’s profit should be exactly according to Ahmed: the Ratio of the profit may
his ratio of investment; differ, but the ratio of loss must be

 According to Imam Ahmad: The ratio of profit divided exactly in accordance with the

may differ from the ratio of investment if it is capital invested;

agreed between the partners with their free o According to Imam Shafi: the Ratio of
consent; and; a partner in profit and loss must

 According to Imam Abu Hanifa: the Ratio of conform to his ratio of investment;

profit may differ from the ratio of investment in

normal conditions.
Difference Between Musharakah and Mudarabah with
Example:
While Musharakah and Mudaraba are both
key Islamic financing modes, they differ in how capital is
contributed and profits are divided. In a Musharakah contract, all
partners contribute capital and share in the profits and losses,
whereas in a Mudarabah, only the financier provides the capital,
and the working partner provides expertise and effort.
EXAMPLE:
As an example, consider a business project that needs $100,000
for start-up. In a Musharakah agreement, two partners might
contribute equally, each investing $50,000. They agree upon a
profit-sharing ratio, say 50:50, and share equally in the profits and
losses.
Contrast this with a Mudharabah agreement for the same project.
Here, one partner provides the entire $100,000 while the other
provides the entrepreneurial effort. The profit-sharing ratio might
be 60:40, with the financier receiving 60% of profits. However, if
the venture fails, the financier bears all the financial loss, while
the working partner loses the time and effort invested.
Combining Musharakah and Mudarabah in
Business Partnership:
In Islamic finance, a unique situation arises when working
partners choose to invest capital into the business in addition
to their expertise and labor. This scenario results in a
combination of the Musharakah and Mudarabah principles,
creating a hybrid model that leverages the strengths of both.
CASE STUDY:
“Ali” and “Bilal” start a Mudarbah business, and it is agreed
that “Bilal” will invest $100,000, and “Ali” will share the
profit as a working partner, on an agreed ratio. Suppose that
after some time, more investment is needed, and “Ali” adds
$50,000 with the permission of “Bilal”. So, in that case,
“Ali” will take a profit:
•As an “Investor” against his investment of $50,000; and;
•As a “Working Partner” for managing the whole business
worth $150,000.
 Takaful or Insurance in Islam

Risk Mitigation Cooperative Approach Ethical Regulatory

Takaful, the Islamic
Investment
Takaful operators are
Oversight
The Takaful industry is
The Takaful system is built on
alternative to traditional the concept of Tabarru', where required to invest the subject to regulatory
insurance, is a participants voluntarily participants' contributions oversight to ensure
cooperative risk-sharing contribute to a fund that is in Shariah-compliant compliance with Shariah
model that emphasizes used to provide mutual assets, such as sukuk principles and to protect the
mutual responsibility support and assistance. This (Islamic bonds), equities, interests of policyholders.
and social solidarity. cooperative approach ensures and real estate. This This includes the
Unlike conventional that the funds are managed ensures that the investment establishment of Shariah
insurance, which is and utilized in accordance activities are aligned with boards and the
based on the concept of with Shariah principles, which the principles of Islamic development of industry-
transferring risk, prohibit elements such as finance, which emphasize specific guidelines and
Takaful operates on the interest, uncertainty, and ethical and socially standards to govern the
principle of shared gambling. responsible practices. operations of Takaful
responsibility, where providers.
members contribute to a
common pool to assist
each other in times of
need.
 Regulatory Frameworks in Islamic
Finance
The development of robust regulatory frameworks is critical to the stability and growth of the Islamic finance industry. Islamic
financial institutions must adhere to Sharia principles, which govern everything from permissible investment activities to profit-and-
loss sharing arrangements. Regulatory bodies such as the Islamic Financial Services Board (IFSB) and the Accounting and Auditing
Organization for Islamic Financial Institutions (AAOIFI) have established international standards and guidelines to promote
consistency and transparency across the industry.
Regulatory Body Key Responsibilities
Islamic Financial Services Board (IFSB) Publishes prudential standards and guidelines for Islamic banks,
takaful operators, and capital market institutions. Promotes the
implementation of global regulatory and supervisory practices .

Accounting and Auditing Organization for Islamic Financial Develops accounting, auditing, governance, ethics, and Sharia
Institutions (AAOIFI) standards for Islamic financial institutions. Ensures consistent
application of Sharia principles across the industry.
Central Banks and National Regulators Oversee the licensing, operations, and risk management of
Islamic banks and financial institutions within their respective
jurisdictions. Enforce compliance with local laws and regulations.

In addition to international standard-setting bodies, national regulators play a crucial role in strengthening the regulatory framework for
Islamic finance. Many countries have established dedicated Islamic banking units or divisions within their central banks to supervise
the unique requirements of Sharia-compliant institutions. These local regulators work closely with industry stakeholders to adapt
conventional banking regulations to the principles of Islamic finance, ensuring a level playing field for all financial institutions.
Challenges and Opportunities in Islamic Risk Management

Regulatory Complexities
One of the key challenges in Islamic risk management is navigating the complex regulatory landscape. As
Islamic finance continues to grow globally, varying interpretations of Sharia law and differing national
regulations can create compliance hurdles for financial institutions. Establishing standardized frameworks
and harmonizing regulations across jurisdictions is crucial to provide clarity and mitigate risks effectively.

Limited Liquidity
The relatively limited liquidity in Islamic financial markets compared to conventional ones can make it
difficult to manage risks effectively. The lack of a well-developed secondary market for Islamic financial
instruments restricts the ability to quickly buy or sell assets to adjust portfolios. Efforts to deepen Islamic
capital markets and develop innovative Sharia-compliant hedging tools are necessary to enhance liquidity
and risk management capabilities.

Talent Development
Effective risk management in Islamic finance requires specialized expertise and knowledge of Sharia
principles, product structures, and unique risk profiles. However, there is a shortage of qualified
professionals with the necessary skills and experience in this field. Investing in talent development through
specialized training programs, academic curricula, and knowledge-sharing platforms can help build a
robust pool of talent to support the growth and risk management practices of the Islamic finance industry.
Conclusion and Key Takeaways

1 Principles of Islamic Finance 2 Comprehensive Risk Management

Approaches
At the heart of risk management in
Islamic finance lie the core principles Effective risk management in Islamic
of Shariah-compliance, risk-sharing, finance requires a comprehensive
and ethical investing. These principles approach that encompasses Mudarabah,
guide the development of innovative Musharakah, and Takaful. By leveraging
financial products and services that these risk-sharing and risk-mitigating
aim to promote financial stability and instruments, Islamic financial institutions
social good. can better manage a wide range of risks,
from credit and liquidity to operational
and reputational risks.
Robust Regulatory Frameworks Opportunities for Innovation
3 The growth and sustainability of 4 As the Islamic finance sector continues
Islamic finance rely on the to evolve, there are ample opportunities
establishment of robust regulatory for innovation in risk management
frameworks that ensure Shariah- practices. Leveraging emerging
compliance, transparency, and technologies, such as blockchain and
consumer protection. Ongoing efforts fintech, can help Islamic financial
to harmonize international standards institutions enhance their risk
and best practices can further management capabilities, improve
strengthen the resilience and credibility efficiency, and better serve the needs of
of the Islamic finance industry. their clients.
 Challenges and Opportunities in Islamic Risk
Management
Regulatory Complexity
1
Navigating the diverse regulatory frameworks across Islamic finance hubs

Liquidity Management
2
Ensuring sufficient liquidity while adhering to Shariah principles

Product Innovation
3 Developing new Shariah-compliant
financial instruments for risk mitigation

The Islamic finance industry faces unique challenges in managing risks effectively while upholding the principles
of Shariah. Regulatory complexity arises from the varying interpretations and applications of Islamic law across
different jurisdictions, requiring Islamic financial institutions to navigate a diverse and evolving landscape.
Liquidity management also poses a significant hurdle, as institutions must balance the need for ample liquidity
with the requirements of Shariah-compliant financing structures like Mudarabah and Musharakah.

However, these challenges also present opportunities for innovation and growth. As the industry matures, there is
an increasing demand for novel Shariah-compliant financial instruments and risk management techniques.
Advancements in areas such as fintech, sukuk (Islamic bonds), and takaful (Islamic insurance) can help Islamic
financial institutions develop more sophisticated and effective risk mitigation strategies. By embracing these
opportunities, the Islamic finance sector can enhance its resilience, competitiveness, and appeal to a growing
global market.
 Conclusion
5 3 2
Key Principles Main Contracts Regulatory Frameworks
The 5 key principles of Islamic The 3 main Islamic finance Islamic finance is regulated by
finance that guide risk management: contracts used for risk 2 key frameworks: AAOIFI
Riba (prohibition of interest), Gharar management: Mudarabah (Accounting and Auditing
(prohibition of excessive uncertainty), (profit-sharing), Musharakah Organization for Islamic
Maisir (prohibition of speculation), (partnership), and Takaful Financial Institutions) and
Zakat (obligatory charitable giving), (Islamic insurance). IFSB (Islamic Financial
and Halal (permissible investments). Services Board).

In summary, the key takeaways from this presentation on risk management in Islamic finance are the 5 core
principles that guide the industry, the 3 main financial contracts used for risk mitigation, and the 2 primary
regulatory bodies overseeing the sector. These elements work together to create a unique and ethical approach to
finance that aligns with Islamic values and teachings.

Islamic finance offers an alternative to conventional banking and investment models, providing products and
services that avoid interest, excessive uncertainty, and speculation. By focusing on profit-sharing, partnerships,
and mutual insurance, Islamic finance aims to promote financial stability, equitable distribution of risk and
reward, and socially responsible investing. As the industry continues to grow globally, understanding these
principles and frameworks is crucial for both practitioners and consumers of Islamic financial services.