Risk and Regulation of Islamic Banking

Risk and Regulation of Islamic Banking

Foundations of Islamic Finance series

Edited by Mervyn K. Lewis, Mohamed Ariff and Shamsher Mohamad

From a single product offering in 1963, the Islamic financial services industry has grown to an estimated $1.6 trillion in assets. Products must comply with profit and risk-sharing criteria and regulations preventing banks from venturing into activities with high risk and excessive uncertainty. This timely volume analyses these matters and considers the range of new products, discussing both conceptual and practical dimensions. It connects Islamic finance to the mainstream theoretical literature on financial intermediation while also exploring its differences. The expert contributors also examine why an ethical foundation is important and why the system requires well-thought-out regulations to ensure outcomes that protect the community’s well-being.

Chapter 16: Risk management and derivatives in Islamic finance

Obiyathulla Ismath Bacha

Subjects: asian studies, asian economics, economics and finance, asian economics, financial economics and regulation, islamic economics and finance, money and banking


This chapter examines risk management issues in Islamic Banking and Finance (IBF). It describes the current state of affairs, the available risk management tools and prescribes possible solutions where there are no risk management tools currently. It focuses on four key areas within IBF. These are: (1) net worth/profit rate risk of Islamic banks; (2) risks associated with sukuk portfolios; (3) equity risks of Islamic mutual funds; and (4) exchange rate risks of Shari’ah-compliant business entities. Highlighting the potentially large duration gaps of Islamic banks, the design and use of Islamic profit rate swaps and variable profit rates are discussed. The chapter then proposes the use of sukuk portfolio swaps as a means to manage the risks, especially the concentration risk inherent in sukuk portfolios. As Islamic mutual funds now have no Shari’ah-compliant means of hedging their equity risk exposures, the chapter proposes an arrangement by which portfolio insurance could be made available to such mutual funds. In the area of exchange rate risks, the use and efficacy of wa’ad-based forward and option contracts are evaluated.

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