In addressing the question whether Islamic Finance is a success or a failure, Usman explains that some have hailed the success of the industry based on its growth and international expansion, while others consider it a failure based on the divergence of its practice from the theory as illustrated by the emulation of conventional finance at the expense of the core principles of Islamic Finance.

The article triggers an extension to the initial question: Is the growth of Islamic Finance (flagship of its success) sustainable despite the industry’s tendency to emulate conventional finance at the expense of its core principles of risk-sharing (flagship of the failure argument)?

Dr. Elgari -a prominent Sharia scholar and holder of a PhD in Economics from the University of California- states that the increasing predominance of debt-like financial products, which are similar to conventional products as opposed to the Islamic Finance risk-sharing products, causes a higher risk profile for Islamic Banks.

The suggestion that there is a linkage between the riskiness of Islamic banks and their drifting towards conventional banking products can be contemplated in the context of another linkage: Ernst and Young asserts that, as businesses grow, “investors and other stakeholders will want assurance that their risks facing the business are understood and under control”. In simpler terms: Growth and Risk management go hand in hand, Risk management and the choice of products and the business model go hand in hand.

These complex yet common-sense relationships resound well in the words of Ibrahim Wardé –a Tufts University professor who teaches Islamic Banking and Finance amongst other courses- “a binary approach cannot capture the diversity and nuances of Islamic finance … and would be misleading”. This leads us to examine what others say on Growth and Risk Management at Islamic Banks:

 In an IMF working paper, Inwon Song and Carel Oosthuizen state that, given their widespread expansion and in order to preserve their own soundness and prevent undesirable effects on the financial system, Islamic banks require the adoption of a prudential and supervisory risk management framework consistent with the global framework.

 Professor Simon Archer of the University of Reading’s ICMA Centre, whose expertise includes financial reporting, capital adequacy, risk management and corporate governance of both conventional and Islamic financial institutions, states that the rapid expansion brings the need for the adaptation of effective risk management policies and procedures in line with the international Basel standards.

 Tariqullah Khan, Professor of Islamic Finance at HKU and previously Division Chief at the research center of the Islamic Development Bank, stated that “the survival of Islamic banks depends on how well bankers, regulators, and Sharia scholars understand the inherent risks” and manage them.

 (The first line of the CFA’s Institute “Practical Guide to Risk Management”, by Coleman, states that: “Managing risk is at the core of managing any financial organization".)

While Islamic finance represents only a small fraction of the global financial system, its interface with it and its substantial weight in some countries (Islamic Banking assets represent approximately 20% of the total banking system in the UAE) suggest that: the success of Islamic banking:

 should be equally of interest to those keen on its compliance with the substance of Sharia and to those just keen on preserving a healthy global financial system

 is dependent on the composition of the balance sheet of Islamic banks – that is their choice of products and product profiles-

 is determined by how well risk is identified, measured, monitored and reported.

OPINION

In a “Risk Analysis for Islamic Banks” published by the World Bank, Hennie van Greening and Zamir Iqbal add that “the task of the risk manager is to manage the different types of risk at acceptable levels”. They describe risks and challenges specific to Islamic Banking; lack of hedging instruments, scarcity of high quality liquid assets, reduced ability to discount assets, return risk and displaced commercial risk, inability to get compensation for delayed payments, to mention only a few.

It is worth mentioning, in the context of the form-versus-substance debate, that there are commercial and financial risks embedded in Islamic finance contracts -such as widely used leasing contracts- whose terms cannot be side-stepped when adapting these products to mirror their conventional finance equivalents. It is not clear whether these “residual” risks are acknowledged and measured across banks and jurisdictions.

It would be unwise to generalize whether Islamic bankers assess risks efficiently or whether supervisory authorities appreciate and monitor adequately the reporting of these risks across jurisdictions; still, certain core observations can be drawn from the literature cited:

 Islamic finance is growing at an unprecedented rate and is expanding in terms of assets, geographies and number of clients.

 The success and prudential management of Islamic banks affect local and global financial systems.

 There is a direct relationship between the form-versus-substance debate, or the simulation of conventional banking products, and adequate risk management of Islamic Banks.

 Risk management and balance sheet management at Islamic banks may be more complex and may be intimidating but is not necessarily more complicated than at conventional banks; the same applies to its supervision.

A methodical identification of risks embedded in Islamic banking transactions gains in clarity when conducted based on the intrinsic profiles of the products and in isolation of the conventional products they emulate; its quality is also non-dependent on the challenges brought by disparate accounting models, jurisprudence and other constraints.

A methodical measurement of risks incurred is not only essential but a requirement in a regulatory environment where the amount of risk incurred determines the amount of capital a bank is required to hold for the safety of its depositors.

Risk identification, risk measurement and a comprehensive reporting of risks would most likely reinforce the credibility of Islamic Finance, contribute to the sustainable growth and success of an industry which has produced notable achievements, and may dilute the form-versus-substance debate.

Farid Karkaby teaches Islamic Finance at the Paris-Sorbonne University in Abu Dhabi and is a doctoral research associate at the Henley Business School; he is a Risk and Balance-sheet Management practitioner and advisor to Islamic Banks. He can be reached on [email protected] (and happy to provide this commentary with links to the references quoted in the blog).