Risk Management for Islamic Banks. Imam Wahyudi

contracted. This failure in payment/default can be caused by two things: the inability to pay, or the unwillingness to pay the defaulted loan. In various risk management literature, this risk is also called default risk, financing risk, rating downgrade risk, and contract completion risk.

      Market Risk

      Market risk is the risk that occurs from adverse market movement, for example, in the stock price and sukuk price, commodity price, and foreign exchange value of the various assets held in a portfolio by the Islamic bank; this can of course, cause actual loss. This risk only occurs when the bank holds the asset, but not to be owned or held until its maturity period is up, but to resell at some time in the future. Generally, the coverage of market risk included exchange rate risk, commodity price risk, and equity price risk as well as benchmark rate risk.

      Liquidity Risk

      Liquidity risk is the risk that emerges from the Islamic bank's potential inability to fulfill obligations that have reached their maturity date. This risk occurs as a consequence of the temporal mismatch among the sources of the bank's funds, the third-party funds, and the financing contract to the bank's various debtors, especially if the financing done by the bank often defaults or experiences returns that are less than what is initially expected. Often the main trigger of bankruptcy experienced by banks, both large and small, isn't from the losses they experienced, but due to the inability of the banks to fulfill their liquidity shortage.

      Operational Risk

      Operational risk is the risk of loss that is generated by inadequate internal control systems, the failure of internal processes, human error, system failure, and/or the possibility of some external events that can disturb the bank's operations. An Islamic bank can also fail to follow the rules and principles of Islamic syari'ah, and this falls under the category of compliance risk. Business risk is often included in the category of operational risk. Counterparty risk embedded in financing risk where the involvement of every party – the Islamic bank itself, buyers, renters, business partners, suppliers, and the like – can also cause operational risk.

      Legal Risk

      Legal risks occur from the possibility of a lawsuit and/or a weakness in the judicial aspects of some of the bank's operations. Some experts place legal risk in operational risk because lawsuits usually accompany failure or weakness in a written contract. Some of the ways this risk can manifest, among others, are through a filed lawsuit and the absence of laws and regulations particular to the contract, or any weakness in the contract, like the failure to fulfill the validity requirements of a contract, or imperfect binding of the collateral.

      Reputational Risk

      Reputational risk occurs when the trust of the stakeholders in Islamic banks is reduced, which is caused by a negative perception toward Islamic banking. This risk occurs, among others, because of media coverage and/or rumors about Islamic banking that are negative in nature, along with Islamic banks' ineffective communication strategy. Negative publication toward one Islamic bank has the potential to smear the reputations of other Islamic banks, even if they aren't involved in the stated incident or action, just by dint of association.

      Strategic Risk

      Strategic risk happens due to an Islamic bank's inaccuracy in making and/or executing a strategic decision, as well as the Islamic bank's failure to anticipate changes in the business environment, both internal and external. This risk emerges, among others, because the Islamic bank applied a strategy that does not align enough with the vision and mission of the Islamic bank, the Islamic bank did not complete a comprehensive strategic environment analysis, and/or there is a strategic plan mismatch between strategic levels. Other than that, strategic risk can also occur because of the Islamic bank's failure to anticipate the changing business environment, such as technological changes, changes in macroeconomic conditions, dynamics of market competition, and policy changes of related authorities.

      Compliance Risk

      This risk occurs when the Islamic bank does not obey and/or does not comply with the rules and regulations that are in effect and with the principle of Islamic syari'ah that is manifested in the form of the syari'ah board's fatwa. In addition to fulfilling all the regulations and rules that are in effect, like a conventional bank, an Islamic bank should fulfill the principles of Islamic syari'ah in their business activity. The Islamic bank should purely operate based on Islamic syari'ah.

      Rate of Return Risk

      Rate of return risk occurs due to changes in the rate of return paid by the Islamic bank toward its customers, which affect customer behavior. When placing their funds in an Islamic bank, the customer has expectations on the rate of return that he or she wishes to attain. The dispersion from expectation can be caused by internal factors, like a depreciation of the bank's assets, a decrease in the bank's profit–loss share from debtors, or an increase in defaulting debtors, as well as external factors, like the increase in the rate of return offered by other Islamic banks, the increase in interest rate in conventional banks, and an increase in inflation in the market that the rational, strictly transactional investors will start to expect to get a higher rate of return. These changes in expectations of the rate of return can trigger the transfer of funds to other banks.

      Investment Risk

      This risk occurs as a result of the Islamic bank bearing the risk of the debtor's business experiencing losses when the business is financed with a profit–loss sharing contract, like mudharabah or musyarakah. The investment risk is larger if the profit-sharing base used is operating profit or net profit of the debtor's business. If the debtor's business goes bankrupt, the Islamic bank can lose the principal financing channeled to the debtor.

      Fiduciary Risk

      Fiduciary risk is a risk that arises from the Islamic bank's failure in fulfilling both an implicit and explicit standard that can be applied towards their fiduciary responsibility. Investment failure can cause the Islamic bank to experience bankruptcy (insolvency) in which it cannot pay back its third-party funds. AAOIFI categorizes a risk as a fiduciary risk if an Islamic bank provides a rate of return that is lower than the market rate and if the depositors interpret this low rate of return as being due to the Islamic bank making mistakes in managing their funds and to violations in the Islamic bank's investment contract.

      Stages in Risk Management

      In facing risks, Islamic banks need to acquire various risk management methods as ammunition. This should be done from the very beginning, at the point of deciding on the risk management goals and strategy, as well as identifying, measuring, and mitigating risks; running supervision; and reporting the implementation of risk management that has been done. Risk management practices need to occur continuously, the same way that risks constantly change and grow in amount and variety.

Risk management practices continuously experience changes from time to time. Classic risk management focuses in determining the risk limit while ensuring that the business run is still profitable. The cutting-edge practice of risk management ensures that the organization has achieved the expected risk-adjusted performance. The evolution that has happened in risk-management practices is not only in the context of concept and framework, but also covers methods, measurement, and risk mitigation. The evolution of risk management is illustrated in Figure 2.1.

Figure 2.1 The Evolution of Islamic Risk Management

      The current principles and methods of risk management have been used by many financial institutions and are claimed to be quite sensitive to risk. This progress is undoubtedly connected to the development of new methods in risk management, a more complete and informative database, and more advanced and well-developed information systems. But on the other hand, the types and forms of risk have also changed, along with the development of risk management practices. With those drastic changes, the probability of having a large risk exposure and having that risk actually manifest as a major problem can be reduced and avoided. The high degree of interconnection