Risk Management in Islamic Banks

If ever there was a suitable time for Islamic banks to develop risk management capabilities, now is that time. Regulatory changes on the horizon brought about by Basel Accord II will soon make it incumbent on Islamic banks and their competing conventional counterparts to have developed suitable risk management capabilities. There are two crucial steps that must precede the development of a robust risk management capability: 1] proper identification of risks and 2] accurate measurement of risks. However, the view that Islamic financial institutions (IFIs) are in some way insulated from certain types or risk, namely financial return risk, which is similar to interest rate risk for conventional banks, has prevented even the first step from being successfully taken by many Islamic banks. The main objective of this chapter is to explain why Islamic banks are exposed to a risk similar to interest rate risk, even if they do not directly pay or receive interest. A second objective is to discuss ways in which risk can be mitigated in IFIs.