Risk Management for Islamic Banks. Imam Wahyudi

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