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Thursday, 5 May 2011

Islamic Risk Management: Types, Trends & Issues


From a bird's eye view, one could differentiate between three basic types of Islamic risk management products and mechanisms: First, those that are formally being standardized, such as the ISDA/IIFM Ta'Hawwut (Hedging) Master Agreement; second, risk management methods directly based on the well-recognized Islamic financing modes and rules; and third, the possibility to use formally Shariah-compliant mechanisms to replicate conventional risk management products and risk profiles.
  
As for the first type, there is a global trend towards the unification or de factostandardization of risk management products, which can be currently observed in the market. One example of this was the creation of Islamic profit rate swaps, which was an Islamic replication of conventional interest-rate swaps through an Islamic Swap Master Agreement that mirrored the ISDA Master Agreement for IRS in a fully Shariah-compliant way. In September 2006, the ISDA and the IIFM signed a memorandum of understanding as a basis for developing a master agreement for over-the-counter Shariah-compliant derivatives. This ISDA/IIFM Ta'Hawwut (Hedging) Master Agreement is being created to take account of Shariah requirements with the assistance of the IIFM Shariah Advisory Panel.

In general, hedging product markets of any kind will only thrive once the general and legal framework for capital market transactions, including contract and property laws, facilitates this. For instance, the legal framework for financial collateral transactions is crucial for such instruments, and local law provisions need to recognize foreign law governed contracts as well as the enforceability of contracts according to their terms. Moreover, the enforceability of close-out netting and of collateral transactions is an important issue.

The second type of risk management products and mechanisms is based on the use of the well-respected Islamic contracts and financial instruments. Within this group, there are strategies which are undoubtedly fully compliant with Shariah, while others may be criticized as being mere replications of conventional vanilla derivative products. For example, standard Murabahah and Salam contracts can be efficiently used to construct Islamic inflation hedges without replicating any conventional derivatives. On the other hand, the replication of e.g. forwards (by Wa'd, or through a combination of Murabahah and Salam transactions), call options (by using Arbun) and, consequently, even put options (by using put-call parity) may certainly seem questionable to many scholars. The same is true for futures contracts, which are possible to replicate in a formally Shariah-compliant manner in various ways.

This problem is even more severe in the case of products like Wa'd-based total return swaps, which have gained popularity in global Islamic finance during the past two years. While various scholars regarded such transactions as being Shariah-compliant (even if those products enabled Islamic investors to benefit from clearly non-Islamic returns), their use may lead to highly undesirable reputations risks, especially with regards to Islamic retail customers. Furthermore, one can bring forward various arguments against such a "Shariah conversion technology", e.g. by making recourse to the concept of "sadd al-dhara`i", which blocks ostensibly legitimate means when they are employed for illegitimate end. Beyond that, there is certainly a difference between using the Libor as a benchmark for pricing and using non-Shariah-compliant assets as a determinant for returns (which can be done in Islamic TRS). By means of these total return swaps, the investor actually participates in the non-Shariah-compliant investments, however indirectly, and the money paid will most certainly be used to finance those other investments. The attempt to draw a legal analogy ("qiyas") between the use of Libor as a benchmark for pricing and the use of the performance of non-Shariah-compliant assets as a determinant for returns could therefore be regarded as inaccurate and misleading. From such a perspective, there is no need even to resort to "sadd al-dhara`i", since the transaction can be prohibited outright.

There are other Islamic hedging products, which are also being criticized by some scholars, but which are close to being already de factostandards, such as currency swaps based on Murabahah or Qard. Moreover, variants of Islamic standard contracts may become more popular in the future, such as diversified deferred price products, value-based Salam, credit-based Mudarabah, Mudarabah (or Musharakah) with deferred sale, as well as methods like appointing debt collectors, creating quasi-debt discount facilities, using cooperative hedging mechanisms or bilateral mutual adjustments. On the "options" side, implicit contract options (especially Khiyar al-Shart and Khiyar al-Tayeen, as well as Istijrar contracts) are likely to gain importance for product developers, and here again there will be an intense discussion on what is allowed and what is not.

At this point, it should be emphasized that it is a trend currently in Islamic product development to try to replicate conventional financial products, but that this may not be the most promising route to follow. Even apart from ethical and religious principles and considerations, it should be kept in mind that Islamic instruments, which try to imitate conventional ones but under the additional constraints of Shariah precepts, will mostly be less efficient than the "original". In fact, it can hardly be expected that an imitation under additional constraints will be as effective and as cost-efficient, and it is well-known that many Islamic replications may come with increased transaction costs.

Furthermore, such a trend makes the Islamic finance industry a mere follower of the dominating conventional financial industry. While this is clearly understandable, considering the direct competition Islamic institutions face and the conspicuous difference in size of markets and of being more attractive to global and non-Islamic investors, it would certainly be more appealing for those target customer groups to add Islamic products to their portfolios, particularly when these products are highly innovative and weakly correlated to other conventional financial instruments. This can surely be accomplished by a product development strategy that starts from the existing and accepted Islamic financing modes.

At last, even when an Islamic institution does not target non-Islamic potential customers, replicating conventional products may not be the best way to go. In fact, conventional financial instruments have been developed to solve "conventional" problems and needs, and it may well be that the needs of the Islamic industry differ from those faced by its conventional counterpart. Islamic banks must manage risks specific to themselves, which cannot be encountered in the same way and extent in non-Islamic institutions. This holds true both at the product-specific / individual level and on the portfolio / balance-sheet level for Islamic banks.

In general, Islamic finance offers a wide range of possibilities to manage risks other than just replicating conventional complex derivatives and hedging products. The focus, thus, should be on choosing and structuring the most adequate risk management strategies, which are truly compliant with Shariah. This is especially true for the management of counterparty / credit risks and liquidity risks, which cannot easily be hedged away, as the current financial market crisis reminds us, andwhich can be a threat to the real existence of a financial institution.

(by Michael Mahlknecht, a risk management consultant)

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Alfalah Consulting:  http://alfalahconsulting.com

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