INTRODUCTION: Learning the Ropes
A man once asked the Prophet Muhammad (S.A.W) whether he should tie his camel and rely upon Allah or leave it loose and rely upon Allah. The noble Prophet of Islam responded, saying “tie it and rely upon Allah.”
From this brief yet profound hadith, we garner that Islam calls upon individuals to engage in their activities in a responsible and diligent manner, taking up the precautionary measures required to prevent the occurrence of unfavorable circumstances or mitigate their impact.
In the context of the financial industry, market players or business entities (e.gs. investors, corporations and public sector agencies) need to protect themselves against financial risks. The first step to doing so is understanding such risks. That being the case, let’s run through some of the prevalent financial risks that market players are exposed to. Upon doing so, we’ll discuss the countermeasures to be considered in order to ‘tie loose ends’ i.e. mitigate the applicable risks!
Credit Risk
Simply put, it is the risk of a debtor defaulting in payment, meaning failing to honor a debt that is due. For example, in a Murabaha contract (mark-up sale), the financier expects the customer who is a debtor to make periodic payments on specified dates. But of course, there is the possibility that the customer would not make payment on time for whatever reason. Hence, in a contract of Murabaha, the financier is exposed to a credit risk.
Market Risk
These are risks associated with factors beyond market players and those have an impact on the economy. They are divided into two types; systemic and specific risk.
Systemic Risk (or Systematic Risk) is a risk that affects all or most markets i.e. the economy as a whole. Examples of these include changes in oil price, currency fluctuations (known as Currency Risk), natural disasters, or civil wars (referred to as Political Risk).
Specific Risk (or Unsystematic Risk), on the other hand, is one that affects specific industries or companies. For example, Pakistan’s intent to completely eliminate interest from its banking system before 2028 would evidently have a great impact on its financial sector!
Operational Risk
Now, in addition to credit risk and market risk, there is what is known as operational or business risk which, in contrast to market risk, relates to factors within market players. They are (business) decisions that hinder a business entity’s profits or cause it to suffer loses. For instance, a drop in value of an investment may occur due to one of many operational reasons:
- Poor analysis or prediction of the market (which is referred to as Strategic Risk)
- Deliberate or unintended failure of market player to comply with relevant policy or regulation (which would bring about a Legal/Compliance Risk).
- Involvement in unethical financial activities or practices that result in lofty sanctions being imposed and the customer base shrinking. This would amount to a Reputational Risk.
Liquidity Risk
This occurs when a company is unable to convert its illiquid assets (into liquid assets i.e. cash) fast enough to pay off its dues or make up for serious loses. This is caused either due to internal issues like poor management of resources or external factors like a market decline.
Shariah Risk
The last of these risks is pertinent particularly to players in the Islamic finance industry! It is the risk of a company’s financial products or activities being non-compliant with the applicable Shariah rulings. What follows is an example of a Shariah risk materializing.
In 2007 Sheikh Mufti Muhammad Taqi Usmani, Chairman of AAOIFI, declared that the overwhelming majority of (non-lease-based) Sukuk issuances were Shariah non-compliant. His rationale for this statement was that most sukuk were asset-based rather than asset-backed, which entails that in case the buyer (or obligor) defaults in payment, the sukuk holders would only have a legal claim against the buyer, but not in the underlying sukuk asset. This bold declaration of Sheikh Taqi Usmani is said to have disrupted the global sukuk market, plummeting its size from over $30 billion to a humble $1.4 billion!! That is just one of many examples of a Shariah risk manifesting.
EFFECTIVE COUNTERMEASURES: Rope Tying Techniques
Having covered a number of key financial risks that market players, particularly those in the Islamic finance industry, ought to be cognizant of in their financial affairs, let’s talk about some of the effective countermeasures that they should adopt to mitigate such risks.
Credit Risk Management
The first risk we discussed about was the risk faced by creditors due to the default of their debtors. Of the many mitigating measures that creditors may adopt to mitigate credit risks, here are three viable ones:
Credit rating systems
These essentially help financiers ascertain the creditworthiness of a borrower i.e. the likelihood of them repaying the debt without defaulting. A debtor’s creditworthiness or credit score is based on factors including whether or not they have any outstanding debts and their payment history in terms of how early or late they pay their bills and other debts. By having effective credit rating systems in place, creditors would be able to mitigate the likelihood of their debts going bad.
Diversification
Another mitigating measure would be for creditors to better manage their cash flows through diversification strategies. These include financing different types of borrowers, venturing into different markets and exploring a variety of products. By diversifying, financiers would be able to set-off the negative effects caused by defaulting debtors, declining markets and non-performing products with those that have a positive effect.
Securities and guarantees
Financiers may also use securities as a tool mitigating credit risk. This is through demanding third-party guarantee or taking mortgage from borrowers. For example, if an Islamic bank intends to enter into a Murabaha contract (mark-up sale) with a customer, the bank may stipulate that if the customer defaults in payment, then the bank is entitled to regain possession of the mortgaged asset, sell it and reclaim from it the relevant costs.
In summary, good credit rating systems, diversification and securities/guarantees are three highly effective tools to mitigate credit risks!
Market Risk Management
It was highlighted earlier that certain risks occur beyond the control or independent of the decisions made by market players.
Diversification
To counter these market risks, business entities may once again resort to diversification! By diversifying, whether in the form of investing in various sectors or at least sectors outside of one’s own, business entities would stand a fighting chance against inevitable market forces. As such, it is important that one conducts advanced technical market analyses and strategizes accordingly.
Part of their strategizing would be to ensure that their portfolios comprise of investments that have a ‘negative correlation’ with one another. Looking back at Covid-19, it was seen that sectors like the automobile and airline industries, generally, recorded a great loss during the pandemic whilst the pharmaceutical industry, for obvious reasons, witnessed huge gains during the same period. Such phenomenon is a manifestation that when the economy is hit as a whole, the impact of such hit would differ from one sector to another.
Hence, by effectively diversifying, market players would be able to set off the impact of a sector witnessing a decline with another witnessing growth, and ultimately shield themselves from both kinds of market risks.
Forward contracts
In addition to diversification, another tool that business entities may consider using to mitigate industry-specific risks is a forward contract. It is commonly used in the agriculture sector where entities intending to buy agricultural goods pay the price for the said goods upfront for it to be delivered at a future date. In the context of Islamic finance, this arrangement is known as a bay Salam (or advance payment contract), and it serves two main purposes; firstly, to assist farmers in raising/acquiring the seed capital they need to begin farming activities and, secondly, to protect buyers from price volatility.
Operational and Liquidity Risk Management
It’s interesting to note that diversification has thus far appeared on the list of mitigating tools for more than one financial risk. Spoiler alert, it appears on the list yet again for operational risk and liquidity risk! Why is that so? Well, that’s because it serves as a clear indication that a business entity is strategizing well; that instead of putting all their eggs in one basket, they are allocating their limited resources with maximum expertise and efficiency.
Shariah (and Legal) Risk Management
As much as diversification is key it is important that market players do not neglect the compliance aspects of their business operations. It is incumbent that they are well-informed on and in compliance with the applicable laws, particularly as it relates to cross-border transactions involving more than one jurisdiction or legal system, which could be quite tricky to maneuver.
And speaking of compliance, how can we not talk about Shariah?? As we would know, within the Islamic finance industry, there are numerous bodies offering advisory services, some specialized in specific areas while others broader in their scope. Notwithstanding their vigorous efforts, it is important for market players to assess the weight of the advisory services and Shariah certifications that they intend to rely on.
This is critical because Shariah rulings are not standardized across the industry, meaning different states apply different sets of Islamic finance principles. So even in instances when internationally recognized and respected bodies like the OIC’s Fiqh Academy, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), and the Islamic Financial Services Board (IFSB) that serve as the guiding voices within the Islamic finance industry, set standards and issue guidelines, it is incumbent upon market players to reach out to Ahl Azikr; experts with the credentials (i.e. training and certification) required to offer reliable Islamic finance advisory services while also having a deep understanding of the social circumstances (i.e. customs, social needs and demands) and other realities within the locality in question. These experts would ensure that their legal documentations are void of elements that contradict or violate the relevant Shariah requirements.
CONCLUSION: A Tied Camel and A Happy Owner!
In conclusion, it is incumbent upon market players to take active steps like enhancing the technicalities within their business operations and seeking the advice of relevant experts, where necessary, in order to mitigate financial risks. Doing so, would ensure that they are better prepared and positioned to tackle such risks or in some cases prevent them from happening in the first place.
To tying our camels! To taking calculated risks and beyond!
