Risk Management for Islamic Banks. Imam Wahyudi

regards to the how syari'ah-compliant as well as the integrity of the process. The National Syari'ah Board performs its duty assisted by the Syari'ah Supervisory Board. The main responsibility of the Syari'ah Supervisory Board is to study fatwa, to oversee banking activity, to ensure that the operation of Islamic banking is in accordance to syari'ah rules, to issue fatwa related to banking operations and financial transactions, and to ensure that the fatwa is binding for all of the Islamic banks that are its members. The other responsibility of the Syari'ah Supervisory Board is to assist the bank in determining which accounting policy to adopt, how to determine the profit-sharing ratio between the bank and the customer, how to determine the calculation and payment of zakat, and how to determine the income that is distributed and the cost (windows) that is charged.

      Single versus Dual Banking System

      The dual banking system is a set of systems, rules, and applications for the Islamic financial industry that run in parallel with those of conventional banking. There are several reasons why several countries apply a dual banking system through the use of Islamic banking windows. The first reason is about gradual implementation: It takes time to build a customer base, educate the public, change the regulatory environment, develop the capability of the human resources, and build adequate infrastructure. The second reason is related to efficiency. Acquiring the various prerequisites needed to develop Islamic banking requires not only time, but also cost. Using the shortest amount of time possible and the lowest cost, an Islamic banking window is far more profitable than establishing a full-fledged Islamic bank. By enacting an Islamic banking window, an established bank can ensure that the use of infrastructure and human resource allocation in its efforts are as optimal as possible and prevent avoidable duplication of resources. The third reason is effective development. The Islamic banking industry can instantly increase the number of players as well as fund-gathering capabilities, provide product variations, and increase the performance of Islamic banks along with the increase of competition in the industry. With the wide and well-established network of a parent conventional bank, the Islamic window can hitchhike the marketing network of the parent company and mimic the products of the parent bank that are already popular in the general public and can be adjusted to become syari'ah compliant. The fourth reason is the benefit of a well-established technology and system from the parent conventional bank, in the form of standard operating procedures, information systems, control and monitoring systems, as well as information related to the database of existing customers. The fifth reason is the possibility to capture the non-Muslim segment of the market as well as the floating customers.

      Even if it is more practical to use an Islamic banking window, some countries prefer that Islamic banks do not develop from the Islamic windows of a conventional bank, but directly in the form of a full-fledged Islamic bank. This policy of course necessitates the consideration of several things. First, the new Islamic bank must ensure the syari'ah implementation of an its operations in all aspects, including the prevention of the intermixture of funds with the usury-based conventional bank and the prevention of conflicts of interest in management goals and organizational barriers. Second, for the regulator, it is easier to compare the performance between the two institutions, to regulate and ensure that the syari'ah requirements are fulfilled. Third, it preserves the essential idea and image of Islamic banking and to attract international investors, especially from the Middle East. Fourth, in the perspectives of an economic system, a full-fledged Islamic bank creates many new jobs as it proceeds to find people with the relevant, specific knowledge and competence to fill the ranks of its employees and management.

      Risk as an Integral Part of Islamic Bank

      Risk can be defined as the consequence of a choice that contains uncertainty, with the potential to generate an unwanted result or other negative consequence experienced by the decision maker. From that definition, risk has several dimensions: opportunity cost, potential loss, uncertainty, and receiving a result that is not as expected. Risk is also not related to the size of the cost that has to be borne by an individual or institution. In risk management terms, those expenses are expected loss or cost. The real sorts of risk are expenses that occur suddenly through unexpected ways, directly eroding the wealth that was previously accumulated. Both terms, expected and unexpected losses, are two important concepts that are often used in applying risk management, especially in relation with measuring every sort of risk. Most people are able to identify, estimate, calculate, and mitigate expected loss, but fail at anticipating unexpected loss. Events causing unexpected loss happen rarely, but once they happen, the magnitude of the negative effect is large and can cause a large loss. Rare events causing unexpected loss are usually considered unthinkable before they happen.

      In many literatures, risk is often defined more precisely. For example, risk is the volatility of net cash flow of business (or department in the bank, loan portfolio, single debtor, or even the bank as a whole). With that definition, risk is often measured by standard deviation. If we apply this to the context of the cash flow of the bank, the higher the standard deviation of the bank's cash flow, then the wider the spread of the cash flow values from the bank's average cash flow. As a consequence, the bank will often face conditions where the cash flow is outside the average; it can be larger or smaller. Thus, the higher the standard deviation of the bank's cash flow, then the higher the degree of uncertainty of the bank's possible cash flow.

      Risk: Imperfect Information, Uncertainty and Gharar

      Risk begins from imperfect information in various decision-making aspects as well as their results: “Risk comes from not knowing what you are doing.” This information imperfection will bring about uncertainty. There is always a degree of uncertainty in living in the world, as no one knows for certain what will happen tomorrow. There are no guarantees that our efforts (ikhtiar) will always bring us profit. Before any event happens, what exists is mere uncertainty. With this understanding, then, these words are very true: “Risk is Allah Ta'ala's fate, and only Allah Ta'ala knows what will happen tomorrow.” Each person need to realize that risk and the uncertainty feeding it are part of Allah Ta'ala's secret. Perfect information is not achievable for any mortal and belongs only to Allah Ta'ala.

      In Islam, the closest term to this condition of imperfect information is gharar. The condition of imperfect information can emerge naturally without any actual intention from the parties in the transaction. This is the definition of gharar. If there is an intentional element causing the uncertainty from one or more of the parties manipulating information or hiding it, then this is called fraud (tadlis). Islam prohibits the presence of gharar and tadlis in a transaction.

      Natural risk refers to gharar that is minor, easily ignorable, and still attached to the contract, even after one try to alleviate it, and further efforts to alleviate it will only bring a greater cost than the possible cost of leaving the gharar in the contract. But if the gharar itself is major and can be alleviated, and yet is left in a contract on purpose, then this falls into synthetic risk. Synthetic risk happens when various principles and terms of making a contract according to syari'ah are not fulfilled. As such, this definition of risk is closer to syari'ah compliance risk.

      Risks Faced by an Islamic Bank

      The Islamic bank is a financial institution receiving profit from its successes in bridging different liquidity and risk profiles within the public and between parties with surplus funds and deficit in funds, while converting risk into return. The risk that is faced by the Islamic bank is varied and complex, as are the innovations in the financial and banking products that they offer to the public.

      Credit Risk

      Terminologically, it is more appropriate to use the term credit risk in a conventional bank. The term credit risk is generally used for interest-bearing loans. The more accurate terminology in Islamic banks is financing risk, because it covers the risk in various other forms of financing contracts, like interest-free loan (qardh), sale-based contract (salam, murabahah, istishna'), and lease-based contract (ijarah). Traditionally, what is meant by credit risk is the risk that emerges because of the failure of the customer or other parties to fulfill their liabilities to the Islamic bank according to what is