Risk and the Banking Business
Risk taking is the business of the bank. The risk includes both weakness of asset value as well as loss of expected income. As such the banks, be it conventional bank or Islamic bank, are in the business of taking risk. As it is said, there is no reward without risk. A successful organization turns risk threat into an opportunity by developing policies and practices which help them to mitigate, though not eliminate, the risk to a considerable extent.
As the objective of the banking business to enhance shareholders value and the return to its depositors, they have a greater appetite for risk but by building firewalls to protect themselves from potential losses.
Evolution of Risk Management in Banking
After the major financial meltdown of 2007-2008, risk avoidance and risk management has become quite important feature of banking industry. However, the thought process on risk management in banking had been initiated much before it when Basel committee was founded in 1974 in Switzerland as an international committee to develop framework on banking supervision matters.
The first Basel Accord was issued in 1988 and focused on credit risk by creating a classification system for bank assets. Although, the Basel accord does not have any legal mandate but banks in most of countries started its implementation in 1992-1993.
The Basel Accords are a series of three sequential banking regulation agreements (Basel I, II, and III) set by the Basel Committee on Bank Supervision (BCBS). The Basel Committee gives counsel on banking and financial regulations regarding different risks that intuitions are exposed to. However, importance is given to market risk, operational risk, and capital risk.
Basel IV standards put forth changes to global capital requirements. They were agreed in 2017 but implementation will take place till January 2023. Basel IV standard build on and amend the standards already under operation.
Owing to the nature of banking business, it is not possible to completely avoid all inherent risk, but efforts are being made to clamp down the bank failures through stringent capital adequacy requirement and robust risk management framework like rating of the obligor and risk weightage of collaterals. As of now more than one hundred countries have implemented the Basel III Accord.
Enterprise-Wide Risk Management
In the normal course of business, banks are exposed to a wide range of risks. However, the individual banking institutions, mechanisms to professionally analyze the credit proposal and even structural changes are being made as the need for risk management to move from a “back office” function often loosely parked within the credit unit, to a “middle office” function with a unified and more clearly defined enterprise-wide responsibility for Risk Management not only the credit risk but also operational risk, liquidity risk, market risk, legal risk, and other risk exposures has been identified (BCBS).
The risks to which the banks are exposed in this modern era need to be discussed briefly to examine the extent of hazards for this sector.
Credit Risk
Credit risk is generally “defined as the potential that the counterparty fails to meet its obligations in accordance with the agreed terms” (Global Islamic Finance Report, 2015).
The definition is applied to Islamic Banking Institutions (IBIs) which manage all the exposures related to financing such as diminishing musharaka, ijara and murabaha as well as working capital financing projects such as istisna, mudaraba and salam (Global Islamic Finance Report, 2015).
IBIs must manage credit risk intrinsic in their financing and investment portfolio. Credit risk can also arise from transactions which have to be cleared and settled.
Market Risk
Market risk is the “potential loss to the bank from positions taken in contracts where an Islamic bank is exposed to ownership and price risks” (Global Islamic Finance Report, 2015).
Market prices face fluctuations in terms of fluctuations in values of assets that are tradable or leasable. When this phenomenon happens and IBIs risk facing losses, this risk is known as market risk. While this was an example of risk of losses in balance sheet items, there are off balance sheet items too such as investments which also face market risk.
“This can happen, for example, when the bank takes up a true murabaha sale involving purchase of assets, which it will later sell on a credit basis” (Global Islamic Finance Report, 2015).
Liquidity Risk
Liquidity risk arises when institutions do not have enough cash from either borrowing or sale of assets. Firms need liquidity to perform day to day activities but when they fail to do so, it is characterized as liquidity risk.
Operational Risk
Operational risk is the risk that arises from losses because of failures in internal processes of an organization or mistakes by people or outdated technology. Additionally, operational risk can also result from events that an organizational has no control over such as war, civil unrest, strikes, or terrorism.
Operational risk is not unique to IBIs. All institutions face operational risk. However, IBIs face operational risk in a complicated manner due to difference in contractual obligations and regulations from that of conventional institutions. It is due to this reason that regulators, practitioners and even academics have given more attention to operational risk in IBIs (Global Islamic Finance Report, 2015).
Unique Risks Faced by Islamic Banking Institutions
Besides these industry risks, IBIs are exposed some unique risk which further compound its risk profile and needs specialized treatment to mitigate such risks. It is understood that the IBIs are handicapped to manage and mitigate this risk to a significant extent.
An example is that of Mark-up risk. In order to price different contracts, IBIs use a set rate. Mark-up is determined differently too. For example, in murabaha contract, risk premium is added to the rate already set (Ahmed & Khan, 2007). However, the nature of the contract is such that the rate cannot change during the length of contract.
As a result, if the benchmark rate changes, the rate of the contract will remain unchanged and therefore, there is a risk of losses from these fixed income contracts (Ahmed & Khan, 2007). On the other hand, conventional banks are permitted to change their rates at the end of every quarter to benefit from a change in market rate. This risk is also present in Musharakah contracts where profit sharing is done on a fixed rate.
Fiduciary, Reputational, and Legal Risks
Fiduciary risk is faced where there is risk of breach in a contract by the IBI. There are sharia (Islamic Law) requirements present in various contracts and the IBI might not be able to comply with all of them.
Reputational risk can arise due to a number of reasons, for example, not being able to meet obligations but also due to sharia non-compliance by IBIs. Therefore, legal risks for IBIs are significant and, in most cases, legal decisions will go against the IBIs because most Islamic countries have either adopted common law or civil law framework.
As a result of modernization, most Islamic legal systems were dismantled and replaced by European regimes. Therefore, contemporary legal systems are state based rather than Islamic. As such their legal systems do not contain specific laws/statutes that support the unique features of Islamic financial products.
For example, whereas Islamic banks’ main activity is in trading (murabaha) and investing in equities (musharaka and mudaraba), current banking law and regulations in most jurisdictions forbid commercial banks undertaking activities such as buying and selling of commodities, property, and other assets except for their own use in their business needs.
Most of the contract documentation is not standardized which make the process more expensive and difficult to understand easily. “Use of standardized contracts can also make transactions easier to administer and monitor after the contract is signed” (Ahmed & Khan, 2007).
Legal Framework in Pakistan
The lack of Islamic courts, which have not been established in most countries, coupled with the non-availability of personnel qualified both in finance and sharia is also a major hindrance in enforcement of Islamic contracts.
However, the State Bank of Pakistan made this amendment in the Banking Companies Ordinance 1962 as applicable to Banks in Pakistan by inserting this clause,
“purchase or acquisition in the normal course of its banking business of any property, including commodities, patents, designs, trade-marks and copyrights with or without buy-back arrangements by the seller, or for sale in the form of hire purchase or on deferred payment basis with mark-up or for leasing or licensing or for rent-sharing or for any other mode of financing” (Pakistan, 1984).
No doubt it is a major development which has legalized the functioning of Islamic Bank in the country, but the lack of courts to hear the cases of Islamic banks and nonavailability of qualified staff is yet another bottleneck in deciding litigation effectively.
Unfortunately, few judgements of Banking Courts of Pakistan were studied, and it transpired that the judgment have been given on the same basis as conventional banking. Instead of awarding a decree for the sale amount of goods, the bank was only awarded the decree for principal amount plus actual cost of funds which is customary in normal banking cases.
It is ironical that the judge was completely oblivious of the concept of Islamic Banking and used the word as Loan and interest instead of Marahaba financing. This was just to highlight the situation prevailing in Muslim state.
Islamic Finance in Non-Islamic Jurisdictions
The situation is further compounded when the legal cases are brought to jurisdiction with Non-Islamic Law. To cite an example, UK has the largest Islamic Banking market outside the Islamic World. However, the courts decide all matters relating to contract in accordance with English Law, which is law of the land and do not consider the sharia and fiqah interpretations.
Islam forbids Riba (interest) and therefore, Islamic dealings are designed to avoid Riba. Any unlawful gain is known as Riba. Although it is clearly forbidden by the Holy Quran, there is still not a universally accepted definition. Moreover, most jurists are of the opinion that Riba includes interest but the opinion that Riba and interest is the same is incorrect.
Although Riba includes interest but includes much more. Islam has permitted sale but not Riba. The Holy Quran says:
“They said that sale is like riba whereas Allah has allowed sale and has banned riba” (Holy Quran IIL275).
Murabaha Cases in English Courts
As an example, two cases can be quoted that appeared before Court in the United Kingdom. In both cases, murabaha is the contract type used.
The procedure is that instead of lending money to the customer to buy the goods, an IBI buys the goods themselves and then sell the same to the customer at a price higher than market, but it is already agreed to by the customer. IBI obtains a security before giving the goods to the customer.
This procedure is also known as “cost-plus-profit” contract. Unsurprisingly, the difference in price is the same amount as the client would have paid in the conventional, riba-based loan transaction.
In both cases the documents were governed by English law. They differed, though, in the way in which the drafters attempted to subject the transactions to the sharia.
In the case, Symphony Gems the attempt was contained in a mere recital, to the effect that:
“The Purchaser wishes to deal with the Seller for the purpose of purchasing Supplies […] under this Agreement in accordance with the Islamic Shari’ah.”
Presumably because of the negligible effect usually given to recitals, Tomlinson J felt able to brush the reference to the sharia aside, saying:
“it is a contract governed by English law. I must simply construe it according to its terms as an English law contract.”
In case, Beximco, however, the reference to the sharia was contained in the governing law clause and was therefore the subject of considerable discussion. It read:
“Subject to the principles of the Glorious Shari’a, this Agreement shall be governed by and construed in accordance with the laws of England.”
Morison J found at first instance that Article 1.1 Rome Convention (Convention on the Law Applicable to Contractual Obligations, Rome 1980), enacted into English law by section 2(1) Contracts (Applicable Law) Act, 1990, could not be construed so as to permit the sharia to be the applicable law of a contract, as it is not the law of a “country” (paras 27 and 35).
Reference was also made to Article 3.1 (“the law chosen by the parties,” rather flimsy support in this author’s view) and Article 3.3 (much stronger support, containing references to “foreign law” and “country”). This finding was not contested on appeal (paras 43 and 48).
(Foster N.H. Amicus Curiae Issue 68 November/December 2006.)
This is well established in a judgement in the case of Shamil Bank of Bahrain v Beximco Pharmaceuticals Ltd [2004] 1 Lloyd’s Rep 1 (28 January 2004) by the English court and we quote:
“The judge held that English law was the governing law because there could not be two separate systems of law governing the contracts. The words used were intended to reflect the Islamic religious principles according to which S held itself out as doing business, rather than a system of law. The parties had not chosen Shari’a law as the governing law because it was not the law of a country and there was no provision for the application of a non-national system of law such as Shari’a law. Further, it was highly improbable that the parties had intended that an English secular court should determine any dispute as to the nature or application of such controversial religious principles.”
B submitted that:
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Whilst it was accepted that the sole governing law was English law, this should not preclude the possibility of the application of Shari’a principles, and
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It was not improbable that the parties should intend the English court to determine and apply Shari’a, assisted where necessary by expert evidence; the judge’s reasoning was influenced by the erroneous view that the principles of Shari’a constituted a body of controversial religious principles, as opposed to legal principles.
([2004] EWCA Civ 19, [2004] 1 W.L.R. 1784, [2004] 4 All E.R. 1072, [2004] 2 All E.R. (Comm) 312, [2004] 2 Lloyd’s Rep. 1, [2004] 1 C.L.C. 216, (2004) 101(8) L.S.G. 29 Times, February 3, 2004, 2004 WL 62027).
In this case the English Court did not accept the Sharia as a governing law even though the transactions in question were based on Mudaraba and Ijarah contracts.
Due to globalization and extension of Islamic financing beyond the boundaries of Islamic World to even non-Islamic states, the implementation of documentation such as Islamic Contracts in foreign jurisdiction is still quite a major challenge. As it can be observed from the above judgement of English court outrightly rejected the applicability of any separate system of law to govern the contracts.
The serious consequence of non-acceptance of sharia rules renders the entire contract documentation invalid for contestation. In a legal jurisdiction where Islamic finance documentation and Sharia principles cannot be held for contestation of the case, the addition of a governing law clause with a reference to Sharia principles seem to be irrelevant and has no effect.
Not long after the decision in Beximco, the English High Court of Justice (Chancery Division) held that the Sharia may be applied to the subject matter and resolution of a dispute in arbitration, where the parties have so chosen in the contract itself.
In Musawi v RE International (UK) Ltd & Ors, [2007], although only English law could govern the interpretation of the agreement itself, resolution of the actual dispute between the parties was to be in accordance with the Sharia.
“The court held that although only English law could govern the interpretation of the agreement itself, resolution of the actual dispute between the parties was to be in accordance with the Sharia.”
(EWHC 2981 (Ch) (14 December 2007)).Another noteworthy point is that a non-Muslim location will not enforce all the provisions of Islamic finance contracts and in particular the provisions referring Sharia. They will also not provide judicial resolves which is in harmony with the concept of in fiqh al-mu’amala.
As such an Alternate Dispute Resolution System should be adopted and matters be referred in such cases. In Islamic finance Dispute Resolution is quite distinct from conventional finance as it requires that the intermediary should understand Sharia and fiqh principles and possess a thorough knowledge of the Sharia and doctrines of the various madhahib governing a particular Islamic finance transaction.
Further the parties to an Islamic finance transaction may, where the law of land is in conflict with the sharia, also face difficulty in urging a court to enforce the terms of the transaction, or to interpret them in accordance with the Sharia.
“In the context of Islamic finance dispute resolution, it has been suggested that the conventional term, ADR, be replaced with a more appropriate term, Islamic Dispute Resolution (IDR), encompassing a form of Islamic dispute resolution that incorporates both substantive and procedural approaches to dispute resolution inherent in Islamic legal tradition.”
This innovative concept is discussed at length in Andrew White, “Dispute Resolution and Specialized ADR for Islamic Finance,” Chapter 12, Islamic Finance: Law and Practice – Islamic finance the new regulatory challenge, Andrew & Chen, Wiley, 2013.
As a matter of general practice, the solicitors routinely add, even in Islamic finance documents, a standard ADR clause, copying the clauses used in conventional transactions. These clauses usually provide for arbitration and/or mediation in accordance with applicable statutory law, if any, and further incorporate by reference a particular ADR institution’s rules or other procedural framework.
It should be avoided, and utmost care should be taken by the legal advisors at the time of drafting and executing Islamic contract and agreements including other financing documentation.
There is no doubt about it that Sharia is the one foundation pillar and deeply ingrained in the principles of Islamic finance, but quite unfortunately it becomes a stumbling stone after the product development. Infect it turns out as a threat as a major risk exposure.
It is therefore imperative that the transaction structure and documentation covering it are carefully drafted to comply not only with a particular body of law (the Sharia), but with yet a different or additional (secular) law will govern the transaction instead.
To overcome this situation the Islamic finance industry must find a route which is less risky for all participants than conventional finance. We must also admit that the extraordinary emphasis on Sharia compliance, without working on viable solutions within its four walls is deterrent causing undue suspicion and misunderstandings both to Muslims and non-Muslims.
We need to educate the people and create more awareness among the peoples on the basic principles of Islam and of Islamic finance. At the same time, we must endeavor to build ample, well-educated, well-trained workforce competent to comprehend and conduct this sensitive business.
It is the lack of understanding and experiences those results in faulty structuring of finance transactions, the usage of inappropriate terminology, charging of rates or upfront fees that are not Sharia compliant, or documentation that is inconsistent with the very Islamic concepts.
With deeper knowledge and greater understanding of Islamic finance and the Shari’ah and fiqh principles upon which it is based, comes better and more innovative structuring, clearer and tighter documentation, more reliable dispute resolution, and a stronger framework of enabling laws and regulations needed for better legal risk mitigation and avoidance.
Needless to say, that legal issues of Islamic Bank in Non-Islamic jurisdictions are indeed quite challenging and difficult to contest owing to flawed documentation referring to applicable law as law of the country as well as sharia laws which create ambiguity, and the courts accord preference to law of land.
Even in the case of arbitration clauses the ambiguous clauses as applicable to conventional banking are negligently inserted by the lawyers, which, thereby, complicate the issue. Documentation should be clear and unambiguous not only about the jurisdiction but also applicable laws.
