Risk Management for Islamic Banks: Recent Developments from Asia and the Middle East

By Imam Wahyudi, Fenny Rosmanita, Muhammad Budi Prasetyo and Niken Iwani Surya Putri

Gain insight into the unique risk management challenges within the Islamic banking system

Risk Management for Islamic Banks: Recent Developments from Asia and the Middle East analyzes risk management strategies in Islamic banking, presented from the perspectives of different banking institutions. Using comprehensive global case studies, the book details the risks involving various banking institutions in Indonesia, Malaysia, UAE, Bahrain, Pakistan, and Saudi Arabia, pointing out the different management strategies that arise as a result of Islamic banking practices. Readers gain insight into risk management as a comprehensive system, and a process of interlinked continuous cycles that integrate into every business activity within Islamic banks.

The unique processes inherent in Islamic banking bring about complex risks not experienced by traditional banks. From Shariah compliance, to equity participation contracts, to complicated sale contracts, Islamic banks face unique market risks. Risk Management for Islamic Banks covers the creation of an appropriate risk management environment, as well as a stage-based implementation strategy that includes risk identification, measurement, mitigation, monitoring, controlling, and reporting. The book begins with a discussion of the philosophy of risk management, then delves deeper into the issue with topics like:

• Risk management as an integrated system
• The history, framework, and process of risk management in Islamic banking
• Financing, operational, investment, and market risk
• Shariah compliance and associated risk

The book also discusses the future potential and challenges of Islamic banking, and outlines the risk management pathway. As an examination of the wisdom, knowledge, and ideal practice of Islamic banking, Risk Management for Islamic Banks contains valuable insights for those active in the Islamic market.

• Language: English
• Publisher: Wiley
• Release date: Sep 1, 2015
• ISBN: 9781118734452

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Library of Congress Cataloging-in-Publication Data

Wahyudi, Imam, 1981–

Risk management for Islamic banks : recent developments from Asia and the Middle East / Imam Wahyudi, Fenny Rosmanita, Muhammad Budi Prasetyo, Niken Iwani Surya Putri.

pages cm. – (The Wiley finance series)

Includes bibliographical references and index.

ISBN 978-1-118-73442-1 (cloth) – ISBN 978-1-118-73443-8 (epdf) – ISBN 978-1-118-73445-2 (epub) 1. Banks and banking–Religious aspects–Islam. 2. Banks and banking–Risk management–Islamic countries. I. Title.

HG3368.A6W34 2016

332.1068′1 – dc23

2015019100

Cover Design: Wiley

Cover Image: © iStock.com/javarman3

In the Name of Allah, the Most Merciful, the Most Beneficent. I dedicate this book to:

My beloved mother—Siti Choirotun hafidhahallahu

My father—Imam Munajat hafidhahullahu

Our teacher—Bambang Hermanto rahimahullahu

Both of my siblings—Yusuf Karomaini, Anita Citra Sari

My family—Dian Amalia, Rini Rohimah, Asiyah, Ibrahim, Yahya, Musa

—Imam Wahyudi

Preface

The Islamic bank is a financial institution that is established and managed under the principles of Islamic syari'ah and is universal in its practices in improving welfare for mankind. Right now, the Islamic bank is growing and developing rapidly. Even so, as time passes, the risk and challenges faced by the Islamic bank will become more complex and extensive; thus, the future of the Islamic bank is highly reliant on its abilities to anticipate changes in the financial world; such as the effects of globalization, the chain reaction of effects that can take place when a crisis occurs, and the rapid development of information technology. The financial sector is also more dynamic, competitive, and complex; and often creates a new risk in the financial system, such as the too-connected-to-fail risk or the displaced commercial risk. In performing various financial functions and services, the Islamic bank will certainly face various risks, both financial as well as nonfinancial. The bank should be able to manage various risks faced well, without reducing or sacrificing performance, service quality, operational ease, or targets set by the bank's owners. If the bank is able to manage risk appropriately, then not only will the bank avoid the more obvious risks, but the Islamic bank can also change that risk into a business opportunity that can generate profit for the bank.

The rapid development of Islamic banks has been followed by other Islamic financial institutions, such as Islamic insurance, Islamic leasing companies, Islamic venture capital, Islamic capital market, Islamic money market, Islamic microfinance institutions, and the like. These institutions often interact with one another, both directly and indirectly. Interconnection occurs through financial institutions between them, both on the asset side (financing or fund placement in other institutions); while indirect interconnection occurs through indirect investment activities (or issuing securities) in the financial market. Other than the interconnection between financial institutions, the product and operating activities of the Islamic bank are also developing into more complex and sophisticated forms, making it necessary to develop risk management and analysis that is also more comprehensive.

Like the sides of a coin, the rate-of-return and risk will always be attached to each other in a business. Islam admits the presence of profit the same way it admits the presence of risk. In a fiqh principle, it is stated, "al ghunmu bil ghurmi and al kharaju bidh dhamani, also known under the modern financial term of risk-return trade-off." The application of reliable risk management is just as important as the application of various business strategies to optimize rate-of-return. A bank's birth is similar to that of a baby with permanent and inconveniencing disabilities; the bank will always exist in a state of permanent mismatch liquidity, and bears the risk from it. Even if the Islamic bank is able to reduce and even eliminate its financial risks, such as default risk, market risk, operational risk, rate-of-return risk, investment risk, and various other nonfinancial risks such as reputation risk, syari'ah-compliance risk, strategic risk, and other business risk, the Islamic bank will still face liquidity risk. This means that the bank's failure in managing various risks, other than liquidity risk, will worsen the bank's already-present flaw. Under extreme conditions, the bank will be paralyzed and unable to perform its role as financial intermediary.

A well-designed risk management approach, accommodating the distinct products and operating activities of an Islamic bank and performed with utmost prudence, is the prerequisite of maintaining the existence of the Islamic bank as a highly competitive institution: prudent, profitable and able to generate loyalty in its customers. Apart from that, a well-managed risk will also ease the regulator in performing its duties in monitoring the Islamic bank's risks and ensuring the banking industry's health, both on a micro as well as macro level. This is in line with the authority of regulators in every country related to the supervision and management of the banking industry and ensures that prudential principles are followed in a bank's business activities. These activities include risk management, bank governance, and the principle of knowing your customer; prevention against money-laundering and terrorism and criminal enterprise financing; and bank checks. The application of comprehensive risk management in the Islamic bank is expected to be able to protect the banking industry and depositors from various possible aberrations that can occur, as well as mismanagement.

The coverage of risk is very wide and is as extensive as the business process run by the bank itself. In principle, risk is attached to every business activity. To understand the framework of risk management comprehensively and holistically, the Islamic bank's business processes will first need to be understood in detail: the innovation process and development of banking products, the creation of contracts and their different maturities, the methods the bank uses to place itself in the customer's perspective as well as its stakeholders, and so on. Various questions on the bank's existence and survival need to be asked and answered to build a reliable risk management system for the bank. Related to that issue, various existing literature tend to choose one of two approaches: The first approach explains the risk management framework from the approach of risk measurement. In the first approach, each risk has a distinct characteristic, philosophy, and trait. For that, we often find one book that specializes in discussing various methodologies, methods, and market risk measurements. Other books specialize in discussing the measurement of credit risk, while yet others cover operating risk and the like. The second approach is the book or literature that discusses how risk management is built in part as a system, as in the application of enterprise risk management (ERM). In this book, it usually explains how a bank or another institution integrates risk management into the entire element of the business unit. Risk management is not treated as a separate business function, but is integrated with vision, mission, planning, and performance measurement. Whether the bank's goals are achieved or not is not only determined by the fulfilment of the bank's return target, but also by the risk measure applied.

The two approaches require a basic understanding of an Islamic bank's business process and also of the characteristic, philosophy, and distinct trait of each risk faced. Up until now, we have yet to encounter a single book or literature that tries to clearly explain the two prerequisites. As such, we endeavor to analyze various business processes present in Islamic banking. We try to identify the existence of risk and its type, as well as understand the characteristics, philosophy, and distinct character of each risk. All these we have tried to write in this book. This book does not begin from a case study of any particular Islamic bank, but discusses the common traits of Islamic banking around the world. The approach that we use is a combination of regulation analysis, literature study and analysis of field practices on several Islamic banking institutions. Various findings and analyses of field practice are used as a basis to draw general conclusions on the character and practice of the Islamic banking industry.

This book consists of five parts. Part I is the introduction and consists of two chapters: Chapter 1 discusses the basic philosophy of the Islamic financial system, including the banks. Specifically, this chapter will discuss the characteristics of Islamic finance and the concept of usury that is prohibited in Islam. Chapter 2 will explain Islamic banks and risk management, various global institutions related with an Islamic bank's activities (e.g., the Islamic Financial Services Board [IFSB], the Basel Committee on Banking Supervision [BCBS], and the Accounting and Auditing Organization for Islamic Financial Institutions [AAOIFI]), as well as best practices of bank governance. The chapter also discusses the philosophy of risk management, especially related to the meaning and concept of risk, the understanding that risk is inseparable from the Islamic bank, the stages of risk management practices, the relevance of risk and rate-of-return, Islamic perspective on risk, risks faced by the Islamic bank, various approaches to recognizing risk and the benefits that can be reaped by the Islamic bank from good risk management.

Part II discusses the risk management framework in the Islamic bank. This part consists of three chapters: Chapter 3 discusses the history of risk management development in Islamic banks. It begins by discussing why the bank will need to be managed and supervised, why various regulations emerged, and why it is necessary to create an agreement on operating ground rules in the global financial system, then continues with discussions of Basel I, Basel II, and Basel III. The framework and coverage of these three frameworks are discussed to understand the reason for various amendments and revisions. Then, Chapter 3 specifically discusses Islamic bank accounting standards. This discussion is important considering various measurements, methods, and risk models are based on accounting systems and reporting. The end of Chapter 3 discusses the risk management framework in the IFSB as a community of global Islamic financial institutions, and various regulations that are specifically issued by Bank Indonesia as Indonesia's banking regulator. In Chapter 4, this book discusses the risk management process in an Islamic bank. Specifically, the chapter explains the philosophy that risk management is a continuous process, then enters the topic of risk management models in an Islamic bank along with the risk identification process, the development of the risk matrix, the risk mitigation process, and the risk review process. The final part of Chapter 4 will discuss various facilities and infrastructure necessary for the construction of a reliable risk management system. Chapter 5 covers the Islamic bank's financial statements and related analyses. In this chapter, we will explore the details related to the structure of financial statements (on balance sheet, income statement, off balance sheet, etc.), the philosophy of financial statement construction, the available financial statement analysis tools, and how to integrate financial statement analysis into the risk management framework.

Part III will specifically discuss the characteristic, profile, philosophy, coverage and distinct character of all the risks faced by the Islamic bank. Apart from that, there will also be an explanation of the identification process of key risk factors of the business process of each product and the bank's business activities, how the tools and policies of risk mitigation are constructed, and various issues related to those risks in the framework of developing the Islamic banking institution. This part consists of seven chapters. Chapter 6 discusses financing risk in an Islamic bank, including the function of the Islamic bank, the urgency of financing risk management in an Islamic bank, the Islamic bank's financing risk profile, the definition and scope of financing risk, the role of rahn (asset collateral) and kafalah (third party guarantee), and various other factors that determine financing risk. Afterward, the urgent need for an independent rating agency is also discussed, as are the role of financing risk provision, financing limit strategies based on risk profile, concentrated financing portfolio risks, the management of financing portfolios, and how to construct the best practice of financing risk management by optimizing the synergic relationship between interrelated institutions. Chapter 7 discusses the Islamic bank's operational risk; it covers the concept and definition of operational risk, the relation between operational risk and Islamic bank's business, the importance of building consciousness on the presence of risks when operating the business, the definition and scope of operational risk, identification of the various determining factors of operational risk, how to measure operational risk in an Islamic bank, and how to build a reliable operational risk management in an Islamic bank.

Chapter 8 discusses syari'ah-compliance risk. This risk needs to be covered in higher detail, considering many Islamic banks carry the mission of manifesting the principles of Islamic syari'ah in the Islamic bank's business practices. In this chapter, the basic principles of Islamic financial system and economy are discussed; the basic philosophy that syari'ah is the principle and spirit in business, as well as the various prohibitions in mu'amalah. Why the Islamic bank should be syari'ah-compliant in its business is also discussed, as well as the ways that syari'ah-compliance should be an integral part of policies and management processes at all levels of the Islamic bank, the urgency for the national syari'ah council and the existence of a syari'ah supervisory board in an Islamic bank, and the relationship between the syari'ah supervisory board and the syari'ah-compliance audit as part of a framework. The final part of this chapter discusses the syari'ah-compliance risk identification process and how to build risk management and mitigation for syari'ah-compliance in an Islamic bank.

Chapter 9 covers an Islamic bank's strategic risks. This chapter specifically discusses the concept of strategic risk for the Islamic bank, the scope and definition of strategic risk, the determinants of strategic risk, and how to mitigate it, as well as the issues relevant to strategic risk. Chapter 10 discusses investment risk in an Islamic bank. This chapter covers syirkah as a distinct characteristic of Islamic banks, the basic concept of investment risk, the forms of investment risk and its mitigation, as well as covering several issues related to investment risk in an Islamic bank, such as the basis of determining profit-sharing ratios, the policy of profit equalization reserve (PER), investment risk reserve (IRR), and investment risk (IR) support in reducing fraud and moral hazard in a profit-loss-sharing-based contract.

Chapter 11 discusses an Islamic bank's market risk. The beginning of the chapter will touch on the basic differences between the market risk of a conventional bank and those of an Islamic bank. Then, we will discuss the identification process and measurement of market risk in an Islamic bank, the mitigation method that is appropriate to the Islamic bank's character, and the application of risk mitigation methods in an Islamic bank. Chapter 12 discusses liquidity risk in an Islamic bank. This chapter specifically discuss the definition, basic concept, and philosophy of liquidity risk for a bank, as well as the definition and scope of liquidity risk, asset, and liability management in an Islamic bank. Last, liquidity risk management for Islamic banks will also be discussed.

Part IV discusses the potential and challenges of the Islamic bank in the future. This part consists of four chapters. Chapter 13 covers the development of the Islamic financial market, both from the institutional side as well as from the financial products traded. Chapter 14 discusses the development of pricing methods in the Islamic bank. It discusses the urgency for Islamic banks to develop their own pricing systems independent from a usurious reference rate, such as the market interest rate. Various approaches are discussed, such as the microeconomic of banking approach, the real sector's rate-of-return, the productivity-based pricing model, and the like. Specifically, we provide an illustration of pricing construction on a salam product; from this, the pricing method for other Islamic financial products can consequently be developed. Chapter 15 covers the pathways of risk management in an Islamic bank and various related issues, beginning from correcting any possible misapprehension on the Islamic bank, and how the Islamic bank itself is an actual implementation of risk management. The Islamic bank is an alternative and practical solution compared to the weakness of the current conventional financial system. After this, we will discuss sequentially the challenges faced by Islamic banking in Indonesia as well as the blueprint for Islamic banking. Other important issues are the potential for moral hazard and the lack of a global super-body institution, such as an international arbitrage and mediation institution for Islamic banks, an international syari'ah judicial institution, or a global regulator. This chapter also discusses the development potential of Islamic banks and their challenges, the strategic issues of risk management application in an Islamic bank, as well the form of Islamic banking risk management in the future. The pros and cons of syari'ah-based products and syari'ah-compliant products will be discussed, as well as the risks behind the usage of profit-loss-sharing scheme, the implications of mudharabah mutlaqah versus mudharabah muqayyadah, and how the Islamic bank answers the challenge of creating a syari'ah-compliant product. Then, Chapter 16 discusses the future agenda of Islamic bank's risk management development, the potential for synergy between Islamic financial institutions, the requirements and competencies that must be built and prepared for, and the direction of regulation in the future. To build Islamic banking risk management in the future, continuous development of the risk management system and an integrated risk management landscape development. Finally, Part V is the conclusion of this book.

Imam Wahyudi

Fenny Rosmanita

Muhammad Budi Prasetyo

Niken Iwani Surya Putri

Depok, March 2015

Acknowledgments

Alhamdulillahi Rabbil ‘alamiin, all praises belong only to Allah Ta'ala. With His blessings and favors, this book can be finished.

It is true what is advised by Imam Muhammad bin Idris asy-Syafii al-Quraisy rahimahullahu Ta'ala:

O my brother … knowledge is not gained unless through six things that I will tell in detail: intelligence, passion, earnestness, sufficiency (of capital), befriend (study from) a teacher, and it requires a long time (patience).

The same can be said of the construction of this book. Without passion, earnestness, and patience, it would not have been possible for us to finish it. This book is the result of further research on our first book, Manajemen Risiko Bank Islam [Risk Management in Islamic Bank], which uses cases in the Islamic banking industry in Indonesia. The first research was done with the funding and data support related to the real practises of Bank Mu'amalat Indonesian and Muamalat Institute. For that, we express our gratitude—"jazakumullahu khairan" (may Allah reward you all with kindness)—to Bank Muamalat Indonesia dan Muamalat Institute, especially for Mr. Andi Bukhari, Ms. Etien Syafitri and Mr. Yudi Susworo. We also do not forget to express our thanks to our colleagues, Mr. Ardiansyah and Mr. Alfiansyah from the Syari'ah Compliance Division and the Risk Management Division of Bank Muamalat Indonesia. The discussions we've had with them contribute to a maturing understanding over the application of risk management in Islamic banking. We also express our gratitude to our teachers and colleagues, Mr. Irwan Adi Eka Putra, Mr. Adi Zakaria Afif, Mr. Musthafa Edwin Nasution, Mr. Jossy Prananta Moeis, Mr. Ruslan Prijadi, Mr. Zaafry A. Husodo, and Mr. Buddi Wibowo.

May we always receive the blessing and pleasure of Allah Ta'ala over every process of our search for knowledge, its practice, and the teaching of that knowledge, both in class as well as in the community. Finally, we do not forget to thank our assistants, Rizky Nugrahani and Nur Dhani, who had helped us in the construction of this book, as well as our comrade-in-arms in the Syari'ah Economics and Business Centre—Faculty of Economics and Business, University of Indonesia, Yusuf Wibisono, Banu M. Haidir, Rahmatina A. Kasri, Miranti Kartika Dewi, Muhammad S. Nur Zaman, Tika Arundina, and Wisam Rohilina.

Imam Wahyudi

Fenny Rosmanita

Muhammad Budi Prasetyo

Niken Iwani Surya Putri

About the Authors

Imam Wahyudi is a lecturer at the Faculty of Economics and Business, University of Indonesia (FEB-UI). As an assistant professor, he is currently teaching Islamic finance, risk management, mathematics of finance, and corporate finance. He is also a senior researcher at the Centre of Islamic Economics and Business, with research interest on Islamic finance and institutions, risk management in Islamic banking and capital markets, market microstructure, and corporate finance. After earning his master's of management degree at FEB-UI, he has published numerous papers and publications in national and international journals, and was involved in various projects with Bank Indonesia, Ministry of Finance, and the Indonesia Financial Services Authority.

Fenny Rosmanita is a lecturer at FEB-UI. She is currently teaching statistics for economic and business, mathematics for economics and business, Islamic economics, macroeconomics, Islamic banking funding, Islamic banking, and business operations. She is also a researcher in the Centre of Islamic Economics and Business Centre at FEB-UI, with research interest on the area of Islamic finance and accounting, as well as zakah and awqaf management. In addition, she is a researcher at the Centre of Islamic Economics and Business Centre at FEB-UI, with research interests in the areas of Islamic finance, Islamic philanthropy, and Islamic management. She obtained her bachelor's degree in economics from the Department of Economics at FEB-UI and her master's of management on Islamic business and finance from the University of Paramadina, Jakarta.

Muhammad Budi Prasetyo is a lecturer and a junior researcher in the Department of Management at FEB-UI. His research areas are finance and banking, especially Islamic banking. He attained his bachelor's degree from the Department of Management at FEB-UI in 2007, and gained his master of science in management with specialization in finance and banking from the graduate program in management science (2011).

Niken Iwani Surya Putri is a lecturer at FEB-UI. She is currently teaching risk management, corporate finance, entrepreneurship and management studies. She is also a junior researcher at the Centre of Islamic Economics and Business. Her research interests are in the area of Islamic microfinance, Islamic nonprofit institutions, consumer behavior, and entrepreneurship. She obtained her master's degree in economics and business at Erasmus University in Rotterdam.

List of Acronyms

Part One

Introduction

Chapter 1

Principles of the Islamic Financial System

Islamic finance is an integrated social, economic, and financial system based on a set of principles that brings a positive motive for economic activity, balanced between material and spiritual needs and between personal and societal interest. Among those principles are balance between work and reward, equal treatment of humans, responsibility over self and society, fairness in scale and measurements, the principle of coexistence, prioritization of the interest of other people and society over one's self-interest, and freedom of conscience.

The initial purpose of the modern financial industry's intermediation is to assist the economy and from it the distribution of resource within society. But then, this purpose encounters obstacles in the form of bourgeois appetites, democratic politeness, and individual work ethic. These three forces cause humans, as economic agents, to never be satisfied with the resources that they already own, and propel the mechanism of financial manipulation to create high-powered money, ending in excessive risk-taking behavior. The combination of these three powers supports the idea of individual freedom and achievement, but abandons the idea of the economic agent's part in social responsibility. Islam recognizes the three powers as nafs, a catalyst for economic activity and the progress of civilization that can only aid in achieving prosperity when coupled with institutional reform and a mechanism to check the morality of the actions of humans in its execution. Islamic financial institutions arise as entities that are trusted to have a strategic function for institutional reform in the direction of prosperity as well as priority in the real sector, complemented with an ethical oversight mechanism through syari'ah principles that grounds operations and transaction activity.

Islamic Financial Contracts: The li-tabarru' Contract versus li-tijari Contract

Based on the purpose or reason of a contract's formation between two people or more, financial contracts can be divided into three. First is the contract for the purpose of generating profit, called li-tijari. Every party in the contract is aware that they or their cosigners enter into the contract for the purpose of acquiring personal gain for themselves through the contract. Usually there is a bargaining and negotiating process, either bilaterally or multilaterally, on the specifications of the contract, such as the terms for price, quality, and quantity of the object; the ratio; the timeframe of settlement; the time of delivery; the time of payment; and the like. With this awareness, all sides have willingly accepted the risk inherent in the contract and have no regrets if the realization of the contract is different from their expectation. In mu'amalah, there are many examples of this sort of contract, like sale (bay'), rent or lease (ijarah), partnering in business (syirkah), the cultivation of agriculture (musaqat), and so forth. Islam allows anyone to enter a transaction with the intention of gaining profit as in the various contracts mentioned, as long as the contracts are made properly and are also executed properly. The profits gained from these contracts are incomes that are lawful and good, for they are gained by the efforts of one's own hand.

Second is the contract that is made with the purpose of giving reward, aid, or assistance to other people; this is called the li-tabarru' contract. This type of contract is usually entered by those who are in need, have lived through a catastrophe, or are under problems that cause them to need the assistance of others. In this contract, negotiation or bargaining is rarely found except in payment terms and due date, where both are related to the ease preferred by the party in need. Because of this, Islam loathes anyone who exploits the opportunities that arise from other people's needs for personal gain or profit, material or immaterial, through any assistance rendered. Among the examples are loan or debt (qardh), entrustment (wadhiah), representation (wakalah), borrowing or lending (dayn), transfer of debts between debtors (hawalah), etc. In qaidah fiqhiyah, it is said, every loan receivable that generates benefit/gain, then it is usury (Asy-Syairazi, Al-Muhadzdzab: 1/304). Included in this group of contracts is a contract of guarantee over debts or loans, like third-party guarantees (kafalah) and asset-backed guarantees (rahn).

It is hoped that by knowing the division of financial contracts and by executing them consistently, one can avoid various forms of usurious transaction. For example, when one is interested in helping others who need capital for business, but is still at the same time interested in turning a profit, then the li-tijari contract can be used, like murabahah or ijarah. In both of these contracts, the capital owner can receive profit in the form of sales margin or rental fee, and the entrepreneur receive working capital in the form of fixed assets without having to expend money at the beginning. Other than that, by understanding the purpose for financial contracts, the parties involved can realize their position within the contract and their rights and responsibilities.

Principles of Islamic Finance

Risk sharing as a principle of justice is embodied in Islamic economy. Every economic agent involved in financial transactions, consciously or unconsciously, directly or indirectly, should complement each other and the system. All parties, without exception, can access money and other resources in the economy. The result is a multiplier effect that appears to drive the economy and improve the welfare of the community, not just the individual. All of these are summarized into three Islamic finance principles: universal complementarity, justice and equity in al-hisba, and abolition of riba.

Universal Complementarity

Both conventional and Islamic financial institutions function with the purpose of creating a system to enhance the efficiency of resource allocation and distribution in society by providing financial services to bridge the gap between the parties with excess funds on hand and those needing funds, thus setting in motion continuous economic growth. The basic difference between the two is that an Islamic financial institution must be free from all forms of usury, gambling (maysir), uncertain or doubtful elements (gharar), swindling (tadlis), injustice and coercion (ikhraha). Islamic financial institutions divide risk and profit fairly between different economic actors, both when there is a surplus of funds as well as when there is a deficit of them. This division of risk is a manifestation of the principle of economic fairness and implemented among the participants in the profit–loss sharing scheme. Every economic agent involved in a financial transaction, aware or not, directly or indirectly, should complement each other's absence of skill or function. Thus, everyone, without exception, can access the money in circulation and the available resource. Of course the multiplier effect that can be generated will mobilize the economy and improve the society's prosperity, not just the individual ones. When every element in the society is considered as an economic agent (producers and consumers, government, households, and industry) with complementary functions needed to achieve societal prosperity, the loss of individual business opportunity is a loss to society.

Justice and Equity in Al-Hisba

Among Islamic financial contract schemes, the profit-sharing instrument is considered to be most representative of Islamic finance's character. This scheme is dependent on the proportion (nisbah) agreed upon, based on the comparison between the opportunity cost of capital and the expectations of profit or loss of business. In Islamic finance, pricing is not determined by conventional standards (e.g., the capital asset pricing model [CAPM], market interest rate, etc.), but from the comparison of the function of satisfaction of capital to individual satisfaction and, on an aggregate level, a comparison to the economic surplus of every economic agent.

Abolition of Riba

Other than the two principles, there is at least another that must hold in the implementation of Islamic finance; the principle of removal of usury (riba). It must be understood that the marginal rates of substitution will be different among economic agents. This difference should be reflected in the lack of a unified interest rate as a reference for opportunity cost. In the allocation of return, it should be based on the division of investment roles along with the risk distributed among them. With that, every business opportunity will have a unique rate of return. In the end, this practice will consistently move in the direction of the removal of usury, which is the removal of a predetermined rate of interest between economic agents. In other words, economic agents will share risks and returns based on the actual performance of an investment. Aside from the way that usury is a form of injustice and is as such unlawful in Islam, the removal of usury is an implementation of the principle of fairness in measurement or scales. Every economic agent receives a different return according to their own measure, dependent on the investment role and risk that they've taken.

Interest-Based Return versus Profit–Loss Sharing

In Islamic finance, money is only considered as a medium of exchange and does not have intrinsic value on its own; because of that, if the money is idle (left in the bank or lent to other people) and not used in business, then money should not increase. On the other hand, Islamic finance considers that the human endeavor, initiative, innovation, creativity, and risk inherent in productive business are more important than the money used to fund the project itself. Money is considered capital only if it is invested in business and the investors accept the possibility of loss or failure in business; thus, investment also opens the possibility of growing. If the money is given to a business in the form of a loan, instead of equity, then because it is debt instead of capital, the money has no right to any return generated by the business (like interest). This is because money only has a time value when it is invested as capital, not when it is idling as potential capital. Besides, Islam does not consider loan (or debt) as an income-generating transaction.

Money, Time Value of Money, and the Discounted Model in Islam

Islam forbids the practice of usury in all its forms, such as a discounted debt (borrowing $1,000 for a period of 3 months, but the money received at the beginning is only $950, and the borrower is required to return exactly $1,000 at the due date), an interest-bearing debt (borrowing $1,000 for three months with an interest rate of 12% per annum, thus accepting $1,000 in cash at the beginning and being required to return $1,030 at the end of the three month period), or a return for the due date extension (borrowing $1,000 for three months, without interest, and receiving $1,000, but failing to pay at the due date; the lender extends the due date and asks for an additional payment or late payment penalty of 0.01% per day of delay). This prohibition of usury emphasizes that it is not allowed to apply an indexing method or a discounted model in the case of a debt or loan contract.

On a debt-based sales contract, it is allowed in Islamic finance to set a price that is different from the current market price; a mu'ajjal contract uses a price that is higher than the current market rate (at premium), and a salam contract uses a price that is lower than the current market rate (at discount). Indirectly, Islamic finance accepts the possibility of price different between immediate cash payment and those where the delivery of goods and the delivery of the payment do not coincide in timing; this is an example of the existence of time value of money for the deferral of cash acceptance or goods acceptance. When the price is determined at the beginning of the contract, the profit margin can be immediately recognized, and as long as there is no defaulting payment, then that is also the amount of profit that will be realized. Considering the way price and margin are formed, this mu'ajjal contract is similar with discounted debt. The difference in discounted debt is that in a pure debt (li-tabarru' contract), there are no goods or services that needs to be delivered to the borrower (except for money), because according to the syari'ah the lender has no claim over the difference of what is paid and what is accepted without bearing a part of the risk (other than the risk of default). While in a mu'ajjal contract, the seller transfers the goods to the buyer, where previously the seller must hold the goods and thus bear the market and product risks, and for that cause, according to the syari'ah, the seller has the right to claim the difference between the sale price and the cost of goods sold as profit margin.

Risk-Free Assets in Islamic Finance

Risk-free assets imply that the asset will still give a positive return to its holder, no matter the business condition that has befallen on the firm that issued it, regardless of whether it has succeeded or failed. Other than that, an asset is said to be risk-free if the return that it generates is constant and invariant through time. This term is better known from the CAPM, where the risk-free asset is associated with the opportunity cost borne by the investor when the investor takes additional risk in a project. The investor requests additional return as a compensation for venturing beyond the status quo in placing his or her funds on financial instruments (assets) with a positive yield, and yet risk-free. Here, it is assumed that (1) money can generate real income from itself; (2) alternative projects always generate positive yield; and (3) there is no risk associated with alternative projects; and these three assumptions are frankly not true. Apart from opportunity cost, the concept of the risk-free asset also represents the decline of purchasing power caused by inflation. When there is a positive inflation, if the nominal amount of money does not increase, then within the year, the real value of the money will decline by the same amount as the inflation rate. This is why when investors decide to invest, there is a potential loss if the yield of the project is smaller that the ongoing rate of inflation.

There are three possibilities of implementation of the concept of risk-free asset: qardh (loan or debt), debt-based sale contract (salam or mu'ajjal), and partnerships or syirkah (mudharabah, musyarakah). In the first case, the application of the concept of the risk-free asset will cause the payment of debt to be larger than what is received by the borrower. For whatever reasons, whether due to opportunity cost or compensation over the effects of inflation, this nominal addition to the future value is not allowed in Islam, and falls under usury. In the second case, the concept of the risk-free asset is used to determine the size of the margin in a mu'ajjal sale or the discounted price in a salam price, and this is allowed in Islamic finance. In the third case, the application of the concept of risk-free asset is only allowed as a benchmark and cannot be set as a predetermined rate of return. This concept can only be used to simulate the ratio for the preferred rate of return and estimate the yield with that ratio. But, after the ratio is set, the realization of the return will rely on the realization of the profit or loss of the business. Thus, different from the second case, on syirkah, the application of the concept of the risk-free asset is abstract and not real.

Chapter 2

The Islamic Bank and Risk Management

The Islamic bank is a financial intermediation institution, bridging a deficit sector in funds with one that experiences a surplus of funds. Conceptually, a bank is a win-win solution not only for the surplus sector and the deficit sector, but also for the bank facilitating the needs of the two. This concept is in line with the concept of transaction within Islam; that all mu'amalah transaction began from the intent of mutual assistance (at-ta'awun), and to spread good deeds among men. The party with the surplus funds benefited from the security provided by the bank (wadhiah-based product) or from the returns of the invested funds (profit-sharing–based product). The party with the fund deficit benefited from the needed financing assistance.

In Islamic finance, Islamic banks are not only expected to be able to fulfill their function as a financial intermediary optimally, but also to fulfill a wider function. The Islamic bank should be able to mobilize the economy by channeling funds that would otherwise lie idle from the surplus sector to business and economic actors in order to support production, distribution, and consumption functions within the society. With this approach, economic benefit will be experienced by all members of society, not only among the richest layers but also by those in need of working capital; this increases the multiplier effect as the gears of the economy move. The function of ‘adalah (fairness) can only be manifested as closely to the ideal as possible if Islamic banks not only act as a dumb pipe that funds enter and exit passively, but also involve themselves actively in real economic activities.

Other than the economic-profit dimension, Islamic banks should also encourage various business activities and operations toward a social dimension; this is beyond just executing a social responsibility function. An Islamic bank is encouraged to accept and distribute social funds, like zakat, infaq, and alms (shadaqah), to parties who need them. Islamic banks may have ended up only channeling these funds to fund the consumption function of the poor and needy, in which afterward the funds will be depleted there, without the ability to generate a new cash flow for the poor or to increase their income capacity. Even then, that is enough for the bank to be said to have fulfilled its social function.

Differences between an Islamic Bank and a Conventional Bank

The concept of Islamic banks exists in the middle of the frenetic pace of conventional banking practice, in which these two business entities have different principles. In fulfilling the intermediation function, conventional banks use as a basis the interest rate, both from the asset side and the liability side. Because syari'ah prohibits the application of interest, various modes of financial transaction not involving interest were developed. This prohibition of interest is comprehensive in nature, covering funding, financing, products, and services. This interest system is replaced with a profit–loss sharing system. This profit-sharing system is applied in investment contracts (i.e., mudharabah and musyarakah).

On the funding side, conventional banks reward depositors with a certain level of interest, and thus the return of the funds kept is already predetermined at the beginning of the contract. This is different from Islamic banks, which reward depositors based on a ratio (nisbah) predetermined at the beginning of the contract between the bank and depositor. As the return is divided according to the profit received by the bank during the investment period, the precise amount cannot be predicted beforehand. For products of credit or loan, conventional banks use interest-bearing instruments to channel third-party funds. In channeling third-party funds in the form of financing, Islamic banks can use a profit-sharing system, asset leasing, or sale-based contracts. In a profit–loss sharing system, other than sharing profit based on an agreed-upon ratio (nisbah), there is also a sharing of risk. This