Know 2 Types of Specific Risks in Islamic Finance

This article will discuss two types of specific risks in the Islamic finance industry. As we know, Islamic finance is different from conventional finance as it has specific rulings and characteristics. In general, we learn various types of risks in finance, such as business risk, credit risk, market risk, liquidity risk, legal risk, operational risk, and many others. Nevertheless, there are specific risks that we can likely find only in the Islamic finance sector, such as Islamic banks or other Islamic financial institutions, namely Shariah non-compliance risk and ownership risk.

1. Shariah Non-compliance Risk

The concept of risk is very broad, whereby its forms are depending on the discipline. Islamic finance experts consider Shariah non-compliance risk as a part of operational risk. Shariah non-compliance risk is a risk that arises from Islamic financial institutions’ failure to comply with Shariah principles while carrying out their finance business activities and operations. Some scholars emphasize the financial losses that Islamic financial institutions (IFIs) may experience due to non-compliance with Shariah standards. Furthermore, Shariah non-compliance risk can result in legal risk as any activity fails to comply with Islamic contractual obligations.

How does Shariah non-compliance risk occur? Let’s take an example from Islamic banks that offer a murabaha based contract and use the AAOIFI standard for its operation. The AAOIFI standard has specified some conditions for valid murabahah contracts. One of them is Islamic banks should legally own the murabahah asset when they sell it to the customers. Suppose an Islamic bank sells the murabahah asset to a customer before the bank purchases it from the developer or dealer (in other words, the Islamic bank does not own the asset yet). In that case, it means a Shariah non-compliance risk has occurred. It is because the Islamic bank did not meet one of the Shariah requirements.

2. Ownership Risk

Ownership risk is an important element in Islamic finance regarding the principle of justice in financial dealing. The most distinct character in Islamic teachings is to bear the risk of all acts as a natural consequence of life. In the Islamic finance context, one who owns property must accept its risks and consequences; such as maintenance costs, losses, and damage risk. Those are what we call ownership risks. It arises along with the ownership of any assets or properties.

The specific risks in Islamic Financial Institutions arise due to the nature of their business model and Islamic finance contracts. The risks that arise from Shariah compliance rulings and principles need to be included in their risk management assessments.

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