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Shariah Risk: Its Origin, Definition, and Application in Islamic Finance:

Shariah Risk: Its Origin, Definition, and Application in Islamic Finance: “Risk” is widely used to explain an event pertaining to the probability of an outcome to occur. This paper provides the review of risk from its origin, where the concept of risk has been a concern for humanity since days of old, without the usage of its proper terminology. The study relies solely on related literature and highlights the application of risk in Islamic finance. Reviews of previous studies normally have its own terminology in research methodology. This section covers the issues of how risk is defined by researchers in various disciplines and therefore, how it is specifically related to Islamic finance through a generic and unique name, that is, Shariah risk. The major issue highlighted is where the sources are, which led to a deviation from the path that creates harmful effects. There are other sources for the risk that still need to be clarified further, but this study revealed the sources that lead to the changes of circumstances which result in having risks, based on the Quranic evidences in Islamic perspective. Hence, this paper aims to fill the gap of the current literature by showing the need to conduct further research on the derivation of Shariah risk and its potential in determining capital requirements in Islamic financial institutions. Keywords risk, origin, definition, Islamic finance, Shariah generic names as well as other possible sources of risks in Introduction Islamic finance. The subjects have not been touched by many The establishment of Islamic financial institutions has researchers except for a few that have looked at the founda- brought about a new landscape in the financial system. They tions and epistemology of risk in the context of language, offer various financial products and services (hereafter, logic, and social science such as Thompson (1986), Hayes financial services) that comply with Shariah rules and prin- (1992), and Althaus (2005). Despite its current popularity, ciples. This means that in offering financial services, under- the concept of risk was seen as neutral in earlier literature. lying contracts which include processes, utilization of The term “risk” itself has been referred to as the probability financial services, and legal documentation should follow of an event that occurs together with the amount of losses or the rules and principles of Shariah. This is to relate the gains that might entail. Today, however, the notion of risk is potential of Islamic financial contracts to serve Maqasid more likely to be attributed only with negative outcomes Al-Shariah, which is the main thrust of the Islamic financial (Hayes, 1992). system and guidelines for Islamic finance operations (Lone, Therefore, the main concern of this paper is to clarify the 2016; Lone & Ahmad, 2017). origin of risk and its definitions as well as the sources which Failing to comply with the underlying contracts means that ultimately led to a unique name such as Shariah risk. It Islamic financial institutions deserve specific attention because addresses the issues of the following questions: Where did it may erode customers’ confidence in Islamic financial insti- the word “risk” originally derived from? What are the pos- tutions and the whole financial system (El Tiby, 2011; sible sources of risk that finally contributed to the generic Lahsasna, 2014). Although the unique contractual features of the financial services have exposed Islamic financial institu- 1 Universiti Kebangsaan Malaysia, Bangi, Selangor Darul Ehsan, Malaysia tions to the mix of risks, the risk resulting from failure in com- Universiti Islam Sultan Sharif Ali, Brunei Darussalam plying with Shariah principles is considered as a unique aspect Corresponding Author: and significant in Islamic financial institutions. Nurul Syazwani Mohd Noor, Institut Islam Hadhari, Universiti Kebangsaan It is necessary to have a clear explanation on the origin Malaysia, 43600 Bangi, Selangor Darul Ehsan, Malaysia. and definition of risk itself before the appearance of its Email: waniesyaz@gmail.com Creative Commons CC BY: This article is distributed under the terms of the Creative Commons Attribution 4.0 License (http://www.creativecommons.org/licenses/by/4.0/) which permits any use, reproduction and distribution of the work without further permission provided the original work is attributed as specified on the SAGE and Open Access pages (https://us.sagepub.com/en-us/nam/open-access-at-sage). 2 SAGE Open and unique name such as Shariah risk? Subsequently, this centuries. The concept of risk is found to be practiced by our study could potentially extend the existing literature in two forefathers in certain circumstances. The evidences show ways. First, it makes significant contribution to the dearth of that people all over the centuries have practiced the concept studies on risk origin and its various definitions. Second, this of risk in the absence of the specific word “risk” to represent work illustrates the possible sources of risk that can contrib- their actions (Althaus, 2005). The well-known researcher on ute to the importance of Shariah risk derivation which has risk and culture, Mary Douglas (1982, 1985, 1990) has received little or no attention in previous literature. observed the connotation related to the word “risk” has This paper is divided into six sections as follows. Section changed over time. The concept of risk was originally intro- “The Origin of Risks in Islamic Finance” starts with an duced in the 17th century in the context of gambling. It was insight into the origin of risk in Islamic finance followed by found to be neutral where it means that “the probability of an the definitions of risk in section “Definitions of Risk”. event occurring united with the scale of losses or gains that Section “Sources of Risk” provides the sources of risk might be involved.” involving its generic name. Section “Applications of Risk in Moreover, quantitative understandings have brought to Islamic Finance” describes the application of risk in Islamic domination thinking about risk that leads to the development finance. Section “Conclusion and the Way Forward” high- of theories. In pre-1494, a risk is considered as fate coming lights concluding remarks and the way forward. from God. In the late 15th century, Fra Luca Pacioli (an Italian mathematician) contributed to the first trigger of probability theory by proposing the coin tossing puzzle. This The Origin of Risks in Islamic Finance solution did not withstand the analysis by later mathemati- The origin of risks has been discussed in western academic cian, Fermi who solved the puzzle and proved the theory of works such as those of Thompson (1986), Trimpop (1994), probability. Consequently, it led to later theories of law of and Althaus (2005). In historical literature, despite of being large numbers by Bernoulli in 1711, development of normal described as a phenomenon in its own way, risk is also used distribution (de Moivre) in 1738, the idea of prior beliefs as a framework where events and issues can be analyzed. Not (Bayes) in 1763, and the theory of expected loss in 1800s. only that the notions of risk have been applied practically The chronology has shown how the origin of risk began from without having a specific terminology to describe their God to its measurement within 400 years. action. The concept is found to be practiced since the days of On top of that, Markowitz continued to develop diversifi- the earliest civilizations (bc ) until the existence of a specific cation as an effort toward risk management in 1952, fol- terminology to define that concept. Thus, it is also widely lowed by Sharpe and Lintner, with the introduction of CAPM used in Islamic financial system today. (Capital Asset Pricing Model) in 1964 that described the Trimpop (1994) revealed that the concept of risk has been relationship between risk and expected returns used in the a concern for humanity from the earliest days of recorded pricing of risky securities. Then, Stephen Ross introduced history. It most likely took place even before that. Among the development of no-arbitrage theory in 1976 to predict a early recordings, Asipu (the scholars and practitioners of relationship between the returns of a portfolio and the returns diagnosis and treatment in Tigris-Euphrates valley) in of a single asset through a linear combination of many inde- Mesopotamia has dealt with risk prediction and management pendent macroeconomic variables. To construct portfolios as early as 3,200 bc . They employed approaches which with certain characteristics, such as risks, Fama and French included identifying the importance of a problem, designing developed multifactor risk model in 1992. To date, Bank alternative actions and collecting data on likely outcomes. International Settlement (BIS) has adopted value-at-risk For example, these included profit or loss and success or fail- (VaR) as a standard since 1998, after it was developed in ure. As such, the early recording of risk concepts has also 1994 by JP Morgan. Hence, the chronology extended with been practiced in law such as in the Code of Hammurabi and the concept of risk was brought up to date, from measure- in protection plans from natural disasters as a kind of insur- ment to precision in the 50 years later. ance practices in 5th century (bc ) in Chinese, Greek, early In Islamic finance, many studies such as the ones con- Roman, and other ancient civilizations. Apart from several ducted by Khan and Ahmed (2001), Sundararajan and Errico doctrines on laws and informal regulations for human inter- (2002), Elgari (2003), Tariq (2004), Akkizidis and actions, the code also formulated contract of an arrangement Khandelwal (2008), Greuning and Iqbal (2008), Siddiqui when the owner of a ship borrows money and uses the ship (2008), Eid and Kamal (2012), Febianto (2012), and itself as collateral for vehicles and cargo besides an interest Al-Suwailem (2013) have focused on risks that are particu- rate and risk premium for the chance of loss. Until that period larly aimed at being controlled risks and how to manage in time, the concept of risk was yet to be defined until a spe- them in a way of that reduces “bad effect” in decision mak- cific terminology related to risk appeared in the period of ing. Due to that, the issue of how the risk originally exists 15th to 19th centuries. and why it is perceived as a bad effect instead of a good one However, the origin of risk is still quite difficult to be should first be answered. Although the concept of risk from traced back as the word “risk” has only appeared in later western studies originally derived from the fate or will given Mohd Noor et al. 3 Table 1. Summary of Comparison on Risk From Conventional and Islamic Perspectives. Conventional perspectives Islamic perspectives Fate coming from God Originally from God’s fate Limited sound evidence on risk as harmful effect Risk as destruction, evidence from Al-Baqarah, 2:195 Found to be neutral in the context of gambling Very close to khatr (an exposure to damage) Source: Author’s summary. by God, it was found that they have limited sound evidence According to the above Quranic verse and Hadith, in both to categorize the God’s will (risk) as an unfavorable result. cases, God’s will can be roughly classified as an unpleasant Therefore, there is a need to discuss on what the meaning of outcome to humans due to their actions where they are not God’s will is from an Islamic perspective in the context of alert to the probability of an unfavorable outcome to occur. It risk to identify the basic concept of a risky situation, whether should be managed in the best way to reduce terrible dam- it really produces a good or bad outcome. ages. In another Quranic verse, God also gave a guide on In Islam, a set of evidence related to the origin of risk can how to manage risks in general. Furthermore, the Prophet be identified from the command of God in a Quranic verse: Ya’kub said, And spend in the way of God and do not throw [yourselves] with O, my sons! Enter not all by one gate: enter ye by different gates. your [own] hands into destruction [by refraining]. And do good; Not that I can profit you aught against God (with my advice): indeed, God loves the doers of good. (Al-Baqarah, 2:195) None can command except God. On Him do I put my trust: and let all that trust put their trust in Him. (Surah Yusuf, 12:67) From this verse, God explained that He does not allow us This verse explained Prophet Ya’kub’s advice to his sons to throw ourselves into destruction. The meaning of destruc- to make the best plan and seek various alternatives so that tion here is very close to an earlier description of khatr, they will not fall into danger. It depicts a variety of approaches which is an exposure to damage. Noting that, the concept of to manage and reduce risks. Since the sets of evidence of risk risk itself has already been recorded in the Quran through management have been presented, risk is believed to exist God’s command which means a bad outcome. It is proven to earlier than that. It took place earlier but was unofficially answer the issue of whether a risk brings about a good or bad known as “risk.” In Islam, risk management is essential in outcome. In a specific context of risk, if a product or service financial transactions. It falls within the ambit of one of the was exposed to damage and not being managed properly, it highest objectives of Maqasid Al-Shariah, which is the pro- will face destruction. This discussion shows that the verse of tection of wealth (hifz al-mal). The objectives can be Al-Baqarah (2:195) is proven to describe risk as unfavorable achieved by the practices of Islamic financial system with outcome. Therefore, risk in conventional practice slightly Shariah principles and law. differs from Islamic practice in terms of this evidence. Table 1 provides a summary of comparison on risk from conven- tional and Islamic perspectives. Definitions of Risk There is a Hadith supporting the verse Al-Baqarah (2:195) In the Oxford dictionary, “risk” is defined as “a possibility of where it describes the practice of risk management. An exam- harm or damage against something which is insured.” When ple of the concept of risk management in Islam can be the word is used as a noun, its term means the possibility of loss explained through the famous command from Prophet or damage of money or property. As a verb, it means to put (p.b.u.h.) to a Bedouin. The Prophet (p.b.u.h.) asked the oneself or someone or something in danger, failure, or loss. In Bedouin why he left the camel untied. The Bedouin answered, the fourth edition of Kamus Dewan, “risk” is referred to “the “I trust in God.” Hence, the Prophet (p.b.u.h.) said, “Tie your probability or danger of loss without considering the possible camel, then trust in God.” From the Hadith, it explained that hazards and is also referred to the unpleasant outcome.” These Prophet (p.b.u.h.) commanded the Bedouin not to leave his definitions also depend on the point of view of certain disci- camel untied then trust in God. Instead, the Bedouin was plines. For example, in finance, “risk” is defined as “the prob- commanded to tie his camel then put his trust in God. It ability that an actual return on an investment is lower than the clearly shows that even though everyone should rely on God’s expected return.” In a workplace, risk is the product of the con- will, people should always think clearly and wisely to make sequence and probability of a hazardous event or phenomenon. the best decision for their actions in certain circumstances as In economics, according to Misman and Bhatti (2010), “risk” is long as it does not violate the Shariah rules. The Hadith is known as “the existence of uncertainty about the future out- significant in declaring the Prophet’s order to his people to comes whereas the possibility of more than one outcome and practice the rules with diligence to reduce unpleasant future the ultimate outcome is unknown or unclear.” outcomes (Hidrus & Abd Rahman, 2013; Laldin, 2013). 4 SAGE Open In Islamic finance, the first systematic discussion on risks and loss (al ghunm bil ghurm) or revenue corresponds to was produced by Elgari (2003), who defined the concept of liability for bearing loss (al-kharaj bid-dhaman). Dusuki and mukhatarah (risk) as “the situation that involves the proba- Smolo (2009) categorized this discussion as the risk that is bility of deviation from the path that leads to the expected or compulsory to be borne. For instance, Rosly (2005) high- usual result” and “the likelihood of loss.” This is in line with lighted that the seller should bear the risk of damage or Ibn Manzur (n.d.) in a book of Lisan ul-Arab, who explained depreciation of the merchandise before they are delivered to the concept of risk in accordance with the Arabic language, the buyer. The requirement of bearing risk on the part of the as mukhatir or mukhatarah or khatr. The experts have seller is a precondition for business transactions. As men- revealed the meaning of khatr from the language parlance as tioned earlier, the basic approach to this principle is based on an exposure to damages or very close to being perished. On “al ghunm bil ghurm” where the return gained is adequate to the contrary, a majority of scholars have claimed that khatr the risk borne. The approach is formed based on the Prophet’s has various meanings such as gambling (maysir), uncertainty (p.b.u.h.) Hadith : (gharar) or compensation. Throughout his work, Elgari’s emphasis is on the construction of theory that captures the Indeed, profit is the reward for the readiness to bear the loss. (Al-Nasa’i 2001: Ibn Majah) unique concept of risk from the Islamic perspective. Hence, he used the linguistic approach by introducing the word The word “dhaman,” in the fiqh parlance, refers to vari- khatar as an equivalent to “risk” in English. It wavers ous meanings related to one another. Maliki, Shafi’I, and between existence and nonexistence. He suggested this term Hambali scholars used the word dhaman to refer to a guaran- in the discipline of Islamic finance. Although other risks tee (kafalah) in the sense of fulfilling the duty toward a per- such as credit and investment risks are very much affiliated son by another person. Meanwhile, Elgari (2003) explained to financial and trade transactions, these risks are quite famil- that Hanafi scholars defined dhaman as the obligations to iar because they exist in the contract of financial and trade pay compensation toward the damage. Majority of the fiqh transactions. scholars have agreed to use this parlance in the context of However, the lack of clarity is recognized because Elgari’s bearing risk for adequate returns. By this definition, there analysis is arguably the most theoretically refined among should be a balance between risks and benefits of transac- those that have introduced the term in contemporary Islamic tions. Al-Suwailem (2013) pointed out that an exposure to finance discourse. His treatment of the concept is obvious, excessive risk is undesirable because the size of the possible focusing on the acts undertaken by human beings as the loss is such that, if it eventuates, the consequences are likely sources of expected results and on the known consequences to be socially harmful. of losses for the purpose of managing this risk. In his paper, In addition, this definition should also be used along with he went as far as asserting that “risk as an ingredient of the the prohibition of earning profit without liability (or prohibi- process of arriving at financial decisions” and the purpose of tion of riba such as interest payment and receipt) and of studying risk is to “reduce its harmful effects in making deci- transaction involving hazard (gharar). It is related to the sions.” The acts are not naturally given and must be con- basic activities of acquiring wealth without legislation. There structed through a contractual basis embedded in the is no growth in reality where wealth is created. Among them standardization of contractual relations, useable as reliable is the risk that is prohibited due to an element of extreme source of risks. Elgari’s definition makes it clear that risk is uncertainty (gharar fahish). Also included in this category decomposable into two elements: first, the act itself which are gharar produced as a result of gambling (maysir) and allows human beings to make decisions which do not deviate zero-sum game that is forbidden by Islamic law (Al-Suwailem, from the right path and, second, the situation that leads 2000). Jurists have agreed that gharar fahish can make the human beings to deviate from the path. contract void, especially uqud mu`awadat (Mohd Razif & The second systematic discussion on risks was produced Mohamad, 2011). An example of the most obvious gharar by Althaus (2005) and Aygun (2007). They substantiated the fahish currently practiced is gambling in any particular price derivation of risk from the Arabic word, rizq or risq, which paid for the unknown. The element of uncertainty could means a portion, anything allotted (by God), livelihood, and expose someone to that kind of illegal risk. from which you gain profit. To this conclusion, Elgari (2003) Islam also emphasizes that a risk is not a factor of prohibi- noted that whatever risk caused by human beings is viewed tion to such contracts as long as it is not related to activities of as coming from God and they should be pleased with it. obtaining invalid reward due to gharar. This is explained by Many researchers highlight the third systematic discus- Ibn Taimiyyah in al-Fatawa al-Misriyyah. According to him, sion; among them are Elgari (2003), Dusuki and Smolo God and Prophet (p.b.u.h.) allowed all risks because not every (2009), Ismail and Ahmad (2010), Abdullah, Shahimi, and transaction which involved the probability of loss, gain, or Ismail (2011), and Bougatef (2015). They have defined risks neutral is prohibited. What is prohibited is the risk that causes based on the principles of jurisprudence (qawa’id fiqhiyyah). one to have an invalid property. Even if the activities do not This principle deliberately shows a relationship of direct pro- include risk, they would be prohibited (Ibn Taimiyyah, 1987). portion between risk and return, that is, a link between profit Mohd Noor et al. 5 The above findings have paved the way for a more refined more toward an analytical perception of liability risk, also definition of the same approach, namely, based on terminol- known as asset risk. This is because the contracts always ogy-based and principle-based approaches. In their initial deal with contractual relationships attached with rights and analysis of the definition, both Elgari and Aygun acknowl- liabilities. edge the basis of terminology in deriving the definition of Second, other than sources of risks, if a party chooses to risk. However, in the later stage, Elgari concurs with other approach contracts from the concept of contract risks, the researchers that the meaning of risk should originate from details of the contracts will be the main focus to deal with the principles of jurisprudence because both approaches are the risks that the contracts are surrounded with. In Islamic equally important and we want to reach a consensus on the finance, this type of risk is often related to the various sources that lead to a deviation from the path that causes financial contracts. The applied principle of Shariah has harmful effects. brought about a concept where one potentially engages with such contract risk that is Shariah risk in which if the change of circumstances deviates from the compliance Sources of Risk requirement, the risk does exist. Therefore, the risk is most The origin of the word “risk” is also argued in the literature. likely depended on the details of the contracts. Finally, The 1660s saw that the word “risk” appeared in different lan- Keskitalo (2006) also added that the contracts are no longer guages such as risqué (French), risco (Italian), riesgo hypothesized merely as sources of risks if a party chooses (Spanish), risiko (German), and risiko (Malay). In the begin- contracts from the perspective of business risks and views ning, philosophical creation of risks in its modern sense the contracting activity as another division of the organiza- started by redefining a Latin word “probabilis.” By this time, tions’ activities. However, its concept is defined as tools for the European etymologies for the word “risk” were common the management of business risk besides the contract and parlance among numerous researchers. They also claimed liability of legal risks. the Latin word riscum where Latin-derived terms are risco, Meanwhile, the discussion of sources of risk should be riscare, and rischiare (Althaus, 2005; Beck & Kewell, 2014). followed by the differentiation of risk and uncertainty. This However, there is a healthy disagreement as to the true origin is due to the concept that both terminologies differ. What we of its modern meaning. look into is the risk in economy especially in financial con- Other derivatives appeared such as “risk taker” (1892), tracts, while the existence of uncertainty (gharar) in finan- “risk factor” (1906), and “risk management” (1963). The cial system will cause the contract to be void. These can be phrase “risk management” leads us to find ways to maintain further explained in the following discussions. a good balance between risk and reward and carefully weigh potential profit against potential problems or threats to oper- Risk Versus Uncertainty ational stability. There are a number of sources of risk in Islamic finance. The generic name is apparent after we have The definition relating to the concept of epistemological risk identified the definition of “risk.” must be recognized earlier from the nature of economics lit- Although in Islamic finance risks exist, as mentioned by erature. This is intrinsically important in expressing the epis- Elgari (2003), the sources that lead to a deviation from the temological definition of risk in the point of risk characteristics path that creates the harmful effects have not been clear. to explain something different from uncertainty. The best Today, we tend to discuss the sources of risk in terms of devi- basic way to differentiate risk and uncertainty is through ation from the optimum solution or process, usually described their definitions. Earlier researcher, Knight (1964) drew a in terms of expected loss. The optimum solution is a condi- distinction between risk and uncertainty in the following tion where the “contract” in which any changes to certain manner. He proposed that this distinction was important for circumstances will cause risk to occur. It can be considered an economic theory because uncertainty affords opportuni- as a basic hypothesis for the source of risk. This has been ties for profit that does not exist in certain situations, whereas theoretically defined by Keskitalo (2006) where he provided risks can be calculated. the view of a relationship between contracts and risks in dif- Most of the studies, such as Hertz and Thomas (1983), ferent ways. In selected approach to contracts and risks, he Althaus (2005), Mohd Razif and Mohamad (2011), and discovered three examples of circumstances which involved Hidrus and Abd Rahman (2013), defined that both terms are legal risk, contract risk, and business risk. different from each other. Although the idea of risk and uncer- First, Keskitalo (2006) explained that contracts them- tainty is related to the unknown, they agreed that risk is selves will most likely be seen as a source of risks when closely referred to an attempt to “control” the unknown by the contracts found in such circumstances are understood applying knowledge based on the orderliness of the world. as legal instruments. This view is valid if a party chooses This is due to the fact that risk is something that lacks predict- the contracts and contracting activity of businesses and ability of structure, outcomes, or consequences in a decision other organizations from the legal risks perspective. The making or when planning a situation. Hence, risk requires perception of contracts as sources of risk seems to be lean sound knowledge to understand how uncertainty and 6 SAGE Open Table 2. Disciplinary Perspectives on the Epistemological Status of Risk. Disciplines How risk is viewed Knowledge applied to the unknown Mathematics and Logic Risk as a calculable phenomenon Calculations Science and Medicine Risk as an objective reality Principles, postulates, and calculations Social Sciences Anthropology Risk as a cultural phenomenon Culture Sociology Risk as a societal phenomenon Social constructs or frameworks Economics Risk as a decisional phenomenon, a way of Decision-making principles and postulates securing wealth or avoiding loss Law Risk as a fault of conduct and a judicable Rules phenomenon Psychology Risk as a behavioral and cognitive phenomenon Cognition Linguistics Risk as a concept Terminology and meaning History and the Humanities History Risk as a story Narrative The Arts (literature, music, poetry, Risk as an emotional phenomenon Emotion theater, art, etc.) Religion Risk as an act of faith Revelation Philosophy Risk as a problematic phenomenon Wisdom Source. Althaus (2005). complexity can be managed. Hertz and Thomas (1983) tend its excessiveness combined with elements of uncertainty to distinguish risk and uncertainty by stating that risk is suit- (gharar) can cause a contract to be invalid. ably related to the concepts of chance such as the probability of loss or the probability of ruin. That means that a risk is a Risk From Economic Perspectives known–unknown where the probabilities exist and are assign- able involving likelihood and frequency of occurrence. To date, risk has been understood by economists as an exclu- On the contrary, uncertainty (as opposed to risk) has been sion of prohibited conditions that results in a void transac- the subject of extensive literature. It denotes the totally ran- tion. They view risk as a decisional phenomenon, a way of dom unknown, as well as cannot be predicted or controlled. securing wealth or avoiding loss that needs the knowledge of Contradictory to risks, it is such unknown–unknown due to decision-making principles, postulating and calculating risks the probabilities that can be undefined. Hertz and Thomas (Table 2). Generally, every discipline has a different view of (1983) highlighted that the situation of uncertainty arises risk. It depends on the perspective of the epistemology of when a consensus or agreement among the set of experts risk where a different knowledge is applied to that known– cannot be achieved. There is an undefined probability distri- unknown. Hence, the generic name of risk derived from how bution on the set of outcomes. In Islam, a few researchers each discipline views risks. have distinguished uncertainty from risk through the Arabic Risk is inevitable in economic activities where it is seen word, gharar. Rosly (2005), Dusuki and Smolo (2009), as “part and parcel of financial intermediation” (Akkizidis & Mohd Razif and Mohamad (2011), and Hidrus and Abd Khandelwal, 2008). Meanwhile, the generic name of risk Rahman (2013) agreed with the literal meaning of uncer- from the perspective of economic science can also be seen tainty through the word “gharar,” that is, danger, fraud, and from various dimensions. This is because there are various mistake. In terms of Arabic language, gharar is a derivative ways to classify risk until the derivation of its generic names. of the verb gharra which means trickery, to deceive, to The classification of risk depends on the outcome (result), delude, and to mislead. Among fiqh scholars, gharar is iden- loss, or the nature of such risk and it also depends on con- tified as a type of uncertainty (Al-Saati, 2003). Therefore, tracts involved, facility, and hardship faced by an Prophet (p.b.u.h.) prohibited gharar due to its speculative individual. nature that may lead to disputes, unfair gains or “eating other Basically, there are studies that have divided risk into sev- people’s wealth unlawfully.” According to Ibn Taimiyyah, eral categories. Mohd Razif and Mohamad (2011) catego- gharar describes selling things with an unknown fate. Selling rized risks into systematic and nonsystematic risks. such things is maysir and gambling (Al-Suwailem, 2000). Systematic risks are related to the movement of the entire Consequently, gharar can be defined as the sale of probable economy, the growth of the industry, and all considerations goods whose existence and/or characteristics are not certain that can affect the overall price level. For example, changes and due to these reasons, the trade is akin to gambling. in interest rates, recession, and war. The above-mentioned From the above discussion, we have arrived at a simple factors can result in having a systematic risk because they conclusion that risk is necessary for a valid contract and that affect market conditions. In fact, the systematic risk is a risk Mohd Noor et al. 7 that cannot be eliminated or controlled by diversifying risk Applications of Risk in Islamic Finance because the instability of the risk is influenced by macroeco- In capital management of Islamic financial institutions, risk nomic factors, whereas nonsystematic risk can be controlled is a part of financial transactions. Thus, it should be taken or avoided through diversification. This is because the risk into consideration. This is because Islamic financial institu- exists only in a particular company or industry. Several fac- tions need to set the capital adequacy requirement based on tors that lead to unsystematic risk are poor management, identified risks exposure. The capital acts as a buffer to financial position, and earnings. Therefore, these risks can be absorb losses because in a financial system, losses are related traced through the reading and analysis of company data and to risk. Daher, Masih, and Ibrahim (2015) in a study of deter- information. By referring to the company’s annual financial minants of Islamic financial institutions’ capital buffers evi- statements, there is a high possibility of this type of risk to dently revealed that there are influences of displaced exist. commercial risk (DCR), rate of return (ROR) risk, and equity In addition, Khan and Ahmed (2001) have categorized investment risk exposure on Islamic financial institutions’ risks into business risk and financial risks. According to capital buffers. In other words, Islamic financial institutions them, business risks arise from the behavior of a business should identify the risk exposure to adequately balance the such as market risk, credit risk, liquidity risk, and so on, risk and capital. whereas financial risks arise from the probability of losses in According to capital regulation in IFSB, Committee on the financial markets caused by the movement of financial Banking Regulation and Supervisory Practices requires all variables such as foreign exchange rate risk, equity risk, banks to maintain a minimum capital of 8% from risk interest rate risk, and commodity price risk. weighted asset (RWA) of the banks since the capital ade- Al-Saati (2002) and Dusuki and Smolo (2009), however, quacy framework was altered in 1990. This is termed as discussed the division of risks into primary and secondary minimizing risk for banks. In addition, for specific Islamic risks. The primary risk refers to a risk that cannot be avoided financial institutions, Islamic Financial Services Board and it is interrelated to each business, whereas secondary (IFSB) has issued The Capital Adequacy Framework for risks can be eliminated or hedged using derivative financial Islamic Banking institutions (RWA; the Framework) that instruments. Although the primary risk cannot be eliminated specifies the measurement methodologies for the purpose of as a whole, a part of the risk level can be reduced. For exam- calculating RWA for credit risk, market risk, and operational ple, a farmer cannot eliminate the price risk but he can reduce risk, respectively. The financial regulator may specify an the risk by entering the market forward with contracts. He additional buffer requirement for an Islamic banking institu- can sell part or all of the harvest to be obtained later in the tion, with specific regard to risk profile of the institution. present. Risks in Islamic financial institutions are slightly different In Islamic finance, instead of having a generic risk, insti- from their conventional counterparts. Nevertheless, both tutions offering Islamic products and services face additional need to possess adequate capital to absorb exposure to risks. risks, namely, a unique risk. The unique risks reflect the mix Whether they are conventional or Islamic financial institu- of risks exposed by Islamic financial institutions and risk- tions, researchers such as Greuning and Iqbal (2008), Laldin sharing arrangements resulting from the contractual design (2013), and Srivastava and Subramaniam (2013) agreed that of instruments (Sundararajan, 2007). Accordingly, risks they are exposed to various risks in their operations. The faced by Islamic banks may differ either in terms of the risks’ risks generally fall into four categories such as financial, structure or severity compared with conventional banks. For operational, business, and event risks (El Tiby, 2011). It instance, providing home-financing facility under mushara- would be expected that some Islamic financial institutions kah, Islamic banks are exposed to two additional risks com- risks will resemble those encountered by conventional finan- pared with conventional banks providing the same facility, cial institutions, that is, credit, market, liquidity, and opera- namely, equity risk resulting from the asset ownership and tional risks. Even so, Islamic financial institutions face a Shariah risk. unique mix of risks due to the contractual design of instru- Each risk category that has been mentioned above is part ments applied (Sundararajan, 2007). Accordingly, Islamic of the types of risk that can be further discussed. There are financial institution’s risks may differ in terms of the origin many other risk categories that have been identified based on of risks compared with conventional institutions. As men- the understanding of an individual or organization. What this tioned before, by providing home-financing facility under study is concerned with is the forms of risk which cause dif- musharakah, Islamic financial institutions are exposed to ficulties and harmful effects where the risks should be pos- two additional risks from the same facility provided by con- sibly eliminated or, at least, reduced to a minimum. To date, ventional institutions that is equity risk as a result of the asset various approaches have been taken to manage risks such as ownership and Shariah risks. buying an insurance policy, diversifying portfolios, or buy- Consequently, Islamic financial institutions face two ing derivative contracts. Based on that note, Islam also has types of risk while operating their business. First, Islamic its own perspective on the concept of risk management which financial institutions face risks which are similar to the ones will be presented in the next section. 8 SAGE Open faced by conventional financial institutions. Second, they in liquidation. Hence, this is also a part of risk management face unique and specific risks. The second type of risk arises purposes. from contractual design which ought to comply with Shariah After the period of subprime crises and an ongoing rules and principles. The prohibition of interest determines European debt crisis, risk management becomes a crucial the nature of their financial services and contracts that can be activity for all institutions. The activity is not only important offered by Islamic financial institutions and their associated in conventional institutions but also practically allowed in risks (Ahmed & Khan, 2007; Sundararajan & Errico, 2002). Islamic financial institutions. Due to this, we discuss risk Nevertheless, the existence of risk in financial transactions, management as one of the subjects of generic risk associated particularly in Islamic financial institutions, has become a with regulatory capital requirements for Islamic financial source of argument from various perspectives. There is a institutions. There are following discussions on risk manage- common perception on Islamic banking where the industry is ment from Islamic perspective. assumed to be safer than its conventional counterparts because it is not based on interest rates. Another argument is Risk Management From Islamic Perspective that several of the products use a marked-up arrangement so that they carry less risk. However, these points of view are Risk management is permissible in Islam (Abdul Kader understatements and they are not entirely true. This is Malim, 2015). Its concept is acceptable to contemporary because Islamic financing relies more on equity financing Islamic scholars based on the Quranic verse (Al-Baqarah: rather than debt financing, hence inherently riskier (Akkizidis 282) which requires Muslims to record debt or provide wit- & Khandelwal, 2008). nesses, and the supporting Hadith (Sunan al-Tirmidhi: 2517) Sundararajan and Errico (2002) agreed with this argument which requires Bedouin to tie the camel before leaving its where Islamic financial institutions with Islamic banking fate to God (tawakkal). Therefore, the management must be institutions as a major part can be riskier than conventional parallel with Shariah principles because it involves the pro- financial institutions due to the specific nature of contract cess of protecting individuals or their properties from facing risks, namely, the unrestricted number of ways to finance a the probability of loss. It considers the protection of wealth project using either profit and loss sharing or nonprofit and (hifz al-mal) as a value which is emphasized in Islam. From loss sharing contracts. Another factor that renders Islamic the Islamic perspective, risk is allowed and it differs from financial institutions riskier than its companion is might be gharar which is prohibited. due to the nonstandard practices in each type of contract. As God’s command regarding the forbidden ownership of the discussed earlier, Islamic financial institutions have to deal property of others has also been recorded in the Quran. One with the new risk as a result of the uniqueness in asset and of the Hadiths of Prophet Muhammad (p.b.u.h.) stated that liability structure. This is due to the compliance of Shariah the safety and property of others cannot be contested; any requirement (El Tiby, 2011; Khan & Ahmed, 2001). This form of violation of property rights is a property crime. makes Islamic financial institutions slightly different from Prophet (p.b.u.h.) also encouraged the sharing of business conventional financial institutions in terms of risk exposure. risks in line with the intention of sharing profits and losses as Meanwhile, the capital owners in Islamic financial institu- well as providing mutual assistance and cooperation between tions face the unique nature of risk in accordance with the one another. This is evident through a Quranic verse which types of financial instruments used, the people hired to man- says, age the banks, and the degree of transparency (Hassan & Dicle, 2005; Rosly & Zaini, 2008). As Islamic financial insti- And cooperate in righteousness and piety, but do not cooperate tutions offer various types of contracts, the risks exist in their in sin and aggression. And fear God; indeed, God is severe in operations. Due to that, in a capital management approach, penalty. (Al-Maaidah, 5: 2) Islamic financial institutions require adequate capital to adapt to these risky circumstances. What is [wrong] with you? Why do you not help each other? Notwithstanding, the financial regulator highlighted that (As-Saffat, 37:25) regulatory capital requirements seek to ensure the risk expo- sures faced by Islamic financial institutions are backed by an For example, musharakah product is based on a capital adequate amount of capital to absorb losses. This ongoing partnership and joint venture. Each member of the business concern is to ensure the continuing ability of Islamic finan- works on the capital and enjoys the profit and loss of the cial institutions to meet its obligations if they were to fall due business together. For products of mudharabah, the profit to financial instability. Besides, it also preserves the confi- and loss are shared between investors (rabbul mal) and dence of customers, depositors, creditors, and other stake- entrepreneurs (mudharib). Although investors only provide holders to deal with the institutions. In a financially difficult capital and surrender the management of the business to its situation, capital requirements also seek to further safeguard operators, in the event of a risk or business failure due to the the depositors and other senior creditors by promoting an negligence of the operator accidentally, the employer will additional cushion of assets that can be used to meet claims not have to pay compensation to the investors. Mohd Noor et al. 9 There are also some other verses of the Quran that Risk Management in Islamic Financial Institutions explained the importance of risk management. God says in Risk management is recognized as a main activity for all Surah Yusuf verses 46 to 49: institutions specifically after the recent subprime crisis and an ongoing European debt crisis. The financial industries He said: Yusuf, O man of truth, explain to us about seven fat experienced a rude awakening from crises occurred. It started cows eaten by seven [that were] lean, and seven green spikes [of when the oldest London merchant bank—Barings PLC grain] and others [that were] dry—that I may return to the people; perhaps they will know [about you]. [46] reported collapse in 1995, Sumitomo Corporation lost US$2.6 billion on copper derivatives in 1996, Yusuf said: You will plant for seven years consecutively; and Metallgesellschaft AG lost DM1.8 billion on oil futures, and what you harvest leave in its spikes, except a little from which Orange County California lost on interest rate derivatives. you will eat. [47] More recently, the United States’s second and fourth largest banks, Bank of America and Wachovia were wiped out by Then will come after that seven difficult [years] which will the subprime crisis, with multibillion dollar write-downs consume what you saved for them, except a little from which (Tafri et al., 2011). In East Asia, financial institutions were you will store. [48] badly affected during the 1997 financial crisis. Earlier on, the first Islamic bank in Malaysia, Bank Islam Malaysia Berhad Then will come after that a year in which the people will be (BIMB), reported loss in 2005. given rain and in which they will press [olives and grapes]. [49] Many of the losses could have been avoided if an effec- (Surah Yusuf, 12: 46-49) tive risk management strategy had been practiced. It practi- cally helps to protect the banks from financial losses such as In this Surah, it is narrated, how the Prophet Yusuf inter- credit risk from subprime mortgage crisis. Generally, banks preted the dreams of the king of Egypt, where Egypt would and organizations use two approaches for risk management face a 7-year drought after 7 years full of prosperity. Based strategies. The first one involves risk decomposition and the on that interpretation, the Prophet Yusuf a.s. then proposed a other involves risk aggregation. Banks practically use both plan for dealing with those critical years. The plan is that the approaches when managing market and credit risk. Both Egyptians needed to grow food during the 7 years of prosper- approaches are needed to sustain business growth and con- ity and keep most of it. This should be carried out so that they tinued profitability of the banks where both conventional and would be ready when the drought struck for the next 7 years. Islamic financial institutions are required to possess strate- Yusuf was then appointed by the king of Egypt as Minister gies to manage risks. of Agriculture. As the Minister of Agriculture, he imple- In managing risk, the banks need sufficient capital called mented a plan that has been framed. As a result, Egypt sur- capital buffer to counter the losses. The capital buffer plays a vived when drought hit and lasted for 7 years. This is a clear role as an absorber of unexpected losses, that is, risk absorber. evidence of risk management, where the risk of hunger and The amount of equity and the forms of capital held reflect the starvation was reduced by growing food and keeping most of ability of absorbing losses (Abdullah et al., 2011). In this it during the first 7 years—the years of prosperity. This context, the capital acts as a protector of the bank from unfa- proves that risk management is essential and permissible in vorable outcomes. As the banks are subjected to banking Islam as a preparation to face a loss in the event of disasters regulations, their depositors and stability of financial sys- and undesirable circumstances. Yusuf a.s. was a smart person tems are protected by capital requirements. The settings are and could help the administration of Egypt perfectly because mainly designed for banking institutions based on interna- he was intelligent and capable in solving the problems tional standards supervision. An example includes the Basel encountered. Although the concept is different from the man- II capital requirements. agement of financial risk, it shows that the decision has been The Basel II is structured based on three “Pillars.” Pillar 1 right and appropriate to reduce the risk. deals with a new approach for credit risk and a new capital There are three basic guidelines in Islam. First, humans charge for operational risk. The minimum capital require- are not the real owner of properties and resources. This is ments that need to be held for credit risk are calculated in a because God (Allah s.w.t.) is the absolute owner of this world new way which reflects the credit ratings of counterparties, and everything in it. Second, there are instructions and guid- whereas the RWA for operational risk is set as 12.5 times the ance for any action, including the taking-over and develop- calculated operational risk capital. Pillar 2 addresses the ment of resources. Third, the ultimate goal of Islam is to supervisory review process from the standpoint of the super- achieve prosperity in society as individuals are also encour- visor’s responsibility to promote the safety of the banking aged to earn a living with their own effort. Indeed, Islam system. Supervisors are required to do more than just ensur- requires that for whatever is done in the world needs to be ing the minimum capital requirement held. Among their based on Islamic principles. Risk management is also not an critical role is to encourage the banks to develop and use exception in the implementation of businesses according to better risk management techniques. Pillar 3 lays down Islamic laws. 10 SAGE Open market discipline. It requires a minimum number of public where one potentially engages with such contract risk that reporting standards on risk and risk management intended in is Shariah risk if the change of circumstances deviates from enhancing the ability of market participants in the awareness the Shariah compliance requirement. of a bank’s risk profile. In relation to this, the adequacy of its In an application of risk, the unique nature as well as vari- capital thus involves such market discipline in the capital ety of financial and investment activities has its own risk adequacy regime. characteristics which affect both sides of the balance sheet of The document of IFSB issued in 2005 has set number of Islamic financial institutions. To manage such those risks, principles for Islamic financial institutions regarding the risk Islamic financial institutions should take into account the management. Among the objectives are to ensure Islamic risks in their transactions so that the capital can adequately financial institutions comply with the Shariah rules with the absorb the risks involved. prohibition of interest as the main element, applying Shariah- compliant risk mitigation techniques and complementing the Declaration of Conflicting Interests Basel Committee on Banking Supervision’s (BCBS) guide- The author(s) declared no potential conflicts of interest with respect lines on risk management to accommodate the specific needs to the research, authorship, and/or publication of this article. of Islamic financial institutions (El Tiby, 2011). Nonetheless, the issues related to risk management in Funding Islamic financial institutions requires significant attention. The author(s) received no financial support for the research, This is because some risks arise due to the nature of Islamic authorship, and/or publication of this article. financial institutions themselves. In fact, these additional risks are associated with specific Islamic contracts and Notes business model arising from compliance with Shariah. In Φѧѧ ѧϟ΍ϥΎϤѧѧѧѧѧѧѧ ѧπϟΎΑΝ΍έ assessing risk management system in these institutions, 2. See Ramli et al. (2016). there is a need to understand some of these risks by exam- ining the various items of asset and liability sides in their References balance sheet (Ahmed, 1997). Therefore, managing risks in Islamic financial institution demands thorough investi- Abdul Kader Malim, N. (2015, October-December). Islamic bank- gation on where some of these risks are originally derived. ing and risk management: Issues and challenges. Journal of Islamic Banking and Finance, 64-71. Abdullah, M., Shahimi, S., & Ismail, A. G. (2011). 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Islamic financial institution Kaherah: Dar al-Ma’arif. and products in the global financial system: Key issues in risk Ibn Taimiyyah, A. (1987). Al-Fatawa al-Misriyah [The Egyptian management and challenges ahead (International Monetary Fund Rulings]. Beirut: Dar al-Jil. working paper). Washington, DC: International Monetary Fund. Islamic Financial Services Board. (2005). Guiding principles of risk Tafri, F. H., Abdul Rahman, R., & Omar, N. (2011). Empirical evi- management for institutions (other than insurance institutions) dence on the risk management tools practised in Islamic and offering only Islamic financial services. Available from www. conventional banks. Qualitative Research in Financial Markets, ifsb.org 3(2), 86-104. http://doi.org/10.1108/17554171111155339 12 SAGE Open Tariq, A. A. (2004). Managing financial risks of Sukuk Structures Abdul Ghafar Ismail obtained his PhD in Economics from (Doctoral thesis). Loughborough University, UK. Retrieved University of Southampton. He has been a lecturer since 1987 and from http://kantakji.com/media/7829/f216.pdf has been teaching several economics courses such as money and Thompson, P. B. (1986). The philosophical foundations banking, financial economics, Islamic economics system, interna- of risk. Southern Journal of Philosophy, 24, 273-286. tional finance, Islamic banking, and risk management in Islamic doi:10.1111/j.2041-6962.1986.tb01566.x banking. Currently, he is a professor of Islamic Financial Economics Trimpop, R. M. (1994). The psychology of risk taking behavior. and research fellow in Universiti Islam Sultan Sharif Ali, Brunei Amsterdam, The Netherlands: North-Holland. Darussalam and Islamic Economic Studies and Thoughts Centre (www.iestc.net). Muhammad Hakimi Mohd. Shafiai received his PhD in Islamic Author Biography Economics from the Graduate School of Asian and African Area Nurul Syazwani Mohd Noor obtained her bachelor degree (Hons.) Studies, Kyoto University, Japan. Currently, he is a senior lecturer in Actuarial Sciences and master in Management (Islamic banking) at Universiti Kebangsaan Malaysia. He has written a book (Islamic from the Universiti Sultan Zainal Abidin, Malaysia. Currently, she Finance for Agricultural Development, 2013) and has published is doing PhD in Islamic Civilisation at Institut Islam Hadhari, several scholarly articles related to Islamic economics. He is also Universiti Kebangsaan Malaysia. She is conducting research in involved in research on Islamic finance, Islamic microfinance, Islamic finance specifically on Shariah risk modelling. Islamic agricultural finance, agricultural economics, and waqf. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png SAGE Open SAGE

Shariah Risk: Its Origin, Definition, and Application in Islamic Finance:

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Abstract

“Risk” is widely used to explain an event pertaining to the probability of an outcome to occur. This paper provides the review of risk from its origin, where the concept of risk has been a concern for humanity since days of old, without the usage of its proper terminology. The study relies solely on related literature and highlights the application of risk in Islamic finance. Reviews of previous studies normally have its own terminology in research methodology. This section covers the issues of how risk is defined by researchers in various disciplines and therefore, how it is specifically related to Islamic finance through a generic and unique name, that is, Shariah risk. The major issue highlighted is where the sources are, which led to a deviation from the path that creates harmful effects. There are other sources for the risk that still need to be clarified further, but this study revealed the sources that lead to the changes of circumstances which result in having risks, based on the Quranic evidences in Islamic perspective. Hence, this paper aims to fill the gap of the current literature by showing the need to conduct further research on the derivation of Shariah risk and its potential in determining capital requirements in Islamic financial institutions. Keywords risk, origin, definition, Islamic finance, Shariah generic names as well as other possible sources of risks in Introduction Islamic finance. The subjects have not been touched by many The establishment of Islamic financial institutions has researchers except for a few that have looked at the founda- brought about a new landscape in the financial system. They tions and epistemology of risk in the context of language, offer various financial products and services (hereafter, logic, and social science such as Thompson (1986), Hayes financial services) that comply with Shariah rules and prin- (1992), and Althaus (2005). Despite its current popularity, ciples. This means that in offering financial services, under- the concept of risk was seen as neutral in earlier literature. lying contracts which include processes, utilization of The term “risk” itself has been referred to as the probability financial services, and legal documentation should follow of an event that occurs together with the amount of losses or the rules and principles of Shariah. This is to relate the gains that might entail. Today, however, the notion of risk is potential of Islamic financial contracts to serve Maqasid more likely to be attributed only with negative outcomes Al-Shariah, which is the main thrust of the Islamic financial (Hayes, 1992). system and guidelines for Islamic finance operations (Lone, Therefore, the main concern of this paper is to clarify the 2016; Lone & Ahmad, 2017). origin of risk and its definitions as well as the sources which Failing to comply with the underlying contracts means that ultimately led to a unique name such as Shariah risk. It Islamic financial institutions deserve specific attention because addresses the issues of the following questions: Where did it may erode customers’ confidence in Islamic financial insti- the word “risk” originally derived from? What are the pos- tutions and the whole financial system (El Tiby, 2011; sible sources of risk that finally contributed to the generic Lahsasna, 2014). Although the unique contractual features of the financial services have exposed Islamic financial institu- 1 Universiti Kebangsaan Malaysia, Bangi, Selangor Darul Ehsan, Malaysia tions to the mix of risks, the risk resulting from failure in com- Universiti Islam Sultan Sharif Ali, Brunei Darussalam plying with Shariah principles is considered as a unique aspect Corresponding Author: and significant in Islamic financial institutions. Nurul Syazwani Mohd Noor, Institut Islam Hadhari, Universiti Kebangsaan It is necessary to have a clear explanation on the origin Malaysia, 43600 Bangi, Selangor Darul Ehsan, Malaysia. and definition of risk itself before the appearance of its Email: waniesyaz@gmail.com Creative Commons CC BY: This article is distributed under the terms of the Creative Commons Attribution 4.0 License (http://www.creativecommons.org/licenses/by/4.0/) which permits any use, reproduction and distribution of the work without further permission provided the original work is attributed as specified on the SAGE and Open Access pages (https://us.sagepub.com/en-us/nam/open-access-at-sage). 2 SAGE Open and unique name such as Shariah risk? Subsequently, this centuries. The concept of risk is found to be practiced by our study could potentially extend the existing literature in two forefathers in certain circumstances. The evidences show ways. First, it makes significant contribution to the dearth of that people all over the centuries have practiced the concept studies on risk origin and its various definitions. Second, this of risk in the absence of the specific word “risk” to represent work illustrates the possible sources of risk that can contrib- their actions (Althaus, 2005). The well-known researcher on ute to the importance of Shariah risk derivation which has risk and culture, Mary Douglas (1982, 1985, 1990) has received little or no attention in previous literature. observed the connotation related to the word “risk” has This paper is divided into six sections as follows. Section changed over time. The concept of risk was originally intro- “The Origin of Risks in Islamic Finance” starts with an duced in the 17th century in the context of gambling. It was insight into the origin of risk in Islamic finance followed by found to be neutral where it means that “the probability of an the definitions of risk in section “Definitions of Risk”. event occurring united with the scale of losses or gains that Section “Sources of Risk” provides the sources of risk might be involved.” involving its generic name. Section “Applications of Risk in Moreover, quantitative understandings have brought to Islamic Finance” describes the application of risk in Islamic domination thinking about risk that leads to the development finance. Section “Conclusion and the Way Forward” high- of theories. In pre-1494, a risk is considered as fate coming lights concluding remarks and the way forward. from God. In the late 15th century, Fra Luca Pacioli (an Italian mathematician) contributed to the first trigger of probability theory by proposing the coin tossing puzzle. This The Origin of Risks in Islamic Finance solution did not withstand the analysis by later mathemati- The origin of risks has been discussed in western academic cian, Fermi who solved the puzzle and proved the theory of works such as those of Thompson (1986), Trimpop (1994), probability. Consequently, it led to later theories of law of and Althaus (2005). In historical literature, despite of being large numbers by Bernoulli in 1711, development of normal described as a phenomenon in its own way, risk is also used distribution (de Moivre) in 1738, the idea of prior beliefs as a framework where events and issues can be analyzed. Not (Bayes) in 1763, and the theory of expected loss in 1800s. only that the notions of risk have been applied practically The chronology has shown how the origin of risk began from without having a specific terminology to describe their God to its measurement within 400 years. action. The concept is found to be practiced since the days of On top of that, Markowitz continued to develop diversifi- the earliest civilizations (bc ) until the existence of a specific cation as an effort toward risk management in 1952, fol- terminology to define that concept. Thus, it is also widely lowed by Sharpe and Lintner, with the introduction of CAPM used in Islamic financial system today. (Capital Asset Pricing Model) in 1964 that described the Trimpop (1994) revealed that the concept of risk has been relationship between risk and expected returns used in the a concern for humanity from the earliest days of recorded pricing of risky securities. Then, Stephen Ross introduced history. It most likely took place even before that. Among the development of no-arbitrage theory in 1976 to predict a early recordings, Asipu (the scholars and practitioners of relationship between the returns of a portfolio and the returns diagnosis and treatment in Tigris-Euphrates valley) in of a single asset through a linear combination of many inde- Mesopotamia has dealt with risk prediction and management pendent macroeconomic variables. To construct portfolios as early as 3,200 bc . They employed approaches which with certain characteristics, such as risks, Fama and French included identifying the importance of a problem, designing developed multifactor risk model in 1992. To date, Bank alternative actions and collecting data on likely outcomes. International Settlement (BIS) has adopted value-at-risk For example, these included profit or loss and success or fail- (VaR) as a standard since 1998, after it was developed in ure. As such, the early recording of risk concepts has also 1994 by JP Morgan. Hence, the chronology extended with been practiced in law such as in the Code of Hammurabi and the concept of risk was brought up to date, from measure- in protection plans from natural disasters as a kind of insur- ment to precision in the 50 years later. ance practices in 5th century (bc ) in Chinese, Greek, early In Islamic finance, many studies such as the ones con- Roman, and other ancient civilizations. Apart from several ducted by Khan and Ahmed (2001), Sundararajan and Errico doctrines on laws and informal regulations for human inter- (2002), Elgari (2003), Tariq (2004), Akkizidis and actions, the code also formulated contract of an arrangement Khandelwal (2008), Greuning and Iqbal (2008), Siddiqui when the owner of a ship borrows money and uses the ship (2008), Eid and Kamal (2012), Febianto (2012), and itself as collateral for vehicles and cargo besides an interest Al-Suwailem (2013) have focused on risks that are particu- rate and risk premium for the chance of loss. Until that period larly aimed at being controlled risks and how to manage in time, the concept of risk was yet to be defined until a spe- them in a way of that reduces “bad effect” in decision mak- cific terminology related to risk appeared in the period of ing. Due to that, the issue of how the risk originally exists 15th to 19th centuries. and why it is perceived as a bad effect instead of a good one However, the origin of risk is still quite difficult to be should first be answered. Although the concept of risk from traced back as the word “risk” has only appeared in later western studies originally derived from the fate or will given Mohd Noor et al. 3 Table 1. Summary of Comparison on Risk From Conventional and Islamic Perspectives. Conventional perspectives Islamic perspectives Fate coming from God Originally from God’s fate Limited sound evidence on risk as harmful effect Risk as destruction, evidence from Al-Baqarah, 2:195 Found to be neutral in the context of gambling Very close to khatr (an exposure to damage) Source: Author’s summary. by God, it was found that they have limited sound evidence According to the above Quranic verse and Hadith, in both to categorize the God’s will (risk) as an unfavorable result. cases, God’s will can be roughly classified as an unpleasant Therefore, there is a need to discuss on what the meaning of outcome to humans due to their actions where they are not God’s will is from an Islamic perspective in the context of alert to the probability of an unfavorable outcome to occur. It risk to identify the basic concept of a risky situation, whether should be managed in the best way to reduce terrible dam- it really produces a good or bad outcome. ages. In another Quranic verse, God also gave a guide on In Islam, a set of evidence related to the origin of risk can how to manage risks in general. Furthermore, the Prophet be identified from the command of God in a Quranic verse: Ya’kub said, And spend in the way of God and do not throw [yourselves] with O, my sons! Enter not all by one gate: enter ye by different gates. your [own] hands into destruction [by refraining]. And do good; Not that I can profit you aught against God (with my advice): indeed, God loves the doers of good. (Al-Baqarah, 2:195) None can command except God. On Him do I put my trust: and let all that trust put their trust in Him. (Surah Yusuf, 12:67) From this verse, God explained that He does not allow us This verse explained Prophet Ya’kub’s advice to his sons to throw ourselves into destruction. The meaning of destruc- to make the best plan and seek various alternatives so that tion here is very close to an earlier description of khatr, they will not fall into danger. It depicts a variety of approaches which is an exposure to damage. Noting that, the concept of to manage and reduce risks. Since the sets of evidence of risk risk itself has already been recorded in the Quran through management have been presented, risk is believed to exist God’s command which means a bad outcome. It is proven to earlier than that. It took place earlier but was unofficially answer the issue of whether a risk brings about a good or bad known as “risk.” In Islam, risk management is essential in outcome. In a specific context of risk, if a product or service financial transactions. It falls within the ambit of one of the was exposed to damage and not being managed properly, it highest objectives of Maqasid Al-Shariah, which is the pro- will face destruction. This discussion shows that the verse of tection of wealth (hifz al-mal). The objectives can be Al-Baqarah (2:195) is proven to describe risk as unfavorable achieved by the practices of Islamic financial system with outcome. Therefore, risk in conventional practice slightly Shariah principles and law. differs from Islamic practice in terms of this evidence. Table 1 provides a summary of comparison on risk from conven- tional and Islamic perspectives. Definitions of Risk There is a Hadith supporting the verse Al-Baqarah (2:195) In the Oxford dictionary, “risk” is defined as “a possibility of where it describes the practice of risk management. An exam- harm or damage against something which is insured.” When ple of the concept of risk management in Islam can be the word is used as a noun, its term means the possibility of loss explained through the famous command from Prophet or damage of money or property. As a verb, it means to put (p.b.u.h.) to a Bedouin. The Prophet (p.b.u.h.) asked the oneself or someone or something in danger, failure, or loss. In Bedouin why he left the camel untied. The Bedouin answered, the fourth edition of Kamus Dewan, “risk” is referred to “the “I trust in God.” Hence, the Prophet (p.b.u.h.) said, “Tie your probability or danger of loss without considering the possible camel, then trust in God.” From the Hadith, it explained that hazards and is also referred to the unpleasant outcome.” These Prophet (p.b.u.h.) commanded the Bedouin not to leave his definitions also depend on the point of view of certain disci- camel untied then trust in God. Instead, the Bedouin was plines. For example, in finance, “risk” is defined as “the prob- commanded to tie his camel then put his trust in God. It ability that an actual return on an investment is lower than the clearly shows that even though everyone should rely on God’s expected return.” In a workplace, risk is the product of the con- will, people should always think clearly and wisely to make sequence and probability of a hazardous event or phenomenon. the best decision for their actions in certain circumstances as In economics, according to Misman and Bhatti (2010), “risk” is long as it does not violate the Shariah rules. The Hadith is known as “the existence of uncertainty about the future out- significant in declaring the Prophet’s order to his people to comes whereas the possibility of more than one outcome and practice the rules with diligence to reduce unpleasant future the ultimate outcome is unknown or unclear.” outcomes (Hidrus & Abd Rahman, 2013; Laldin, 2013). 4 SAGE Open In Islamic finance, the first systematic discussion on risks and loss (al ghunm bil ghurm) or revenue corresponds to was produced by Elgari (2003), who defined the concept of liability for bearing loss (al-kharaj bid-dhaman). Dusuki and mukhatarah (risk) as “the situation that involves the proba- Smolo (2009) categorized this discussion as the risk that is bility of deviation from the path that leads to the expected or compulsory to be borne. For instance, Rosly (2005) high- usual result” and “the likelihood of loss.” This is in line with lighted that the seller should bear the risk of damage or Ibn Manzur (n.d.) in a book of Lisan ul-Arab, who explained depreciation of the merchandise before they are delivered to the concept of risk in accordance with the Arabic language, the buyer. The requirement of bearing risk on the part of the as mukhatir or mukhatarah or khatr. The experts have seller is a precondition for business transactions. As men- revealed the meaning of khatr from the language parlance as tioned earlier, the basic approach to this principle is based on an exposure to damages or very close to being perished. On “al ghunm bil ghurm” where the return gained is adequate to the contrary, a majority of scholars have claimed that khatr the risk borne. The approach is formed based on the Prophet’s has various meanings such as gambling (maysir), uncertainty (p.b.u.h.) Hadith : (gharar) or compensation. Throughout his work, Elgari’s emphasis is on the construction of theory that captures the Indeed, profit is the reward for the readiness to bear the loss. (Al-Nasa’i 2001: Ibn Majah) unique concept of risk from the Islamic perspective. Hence, he used the linguistic approach by introducing the word The word “dhaman,” in the fiqh parlance, refers to vari- khatar as an equivalent to “risk” in English. It wavers ous meanings related to one another. Maliki, Shafi’I, and between existence and nonexistence. He suggested this term Hambali scholars used the word dhaman to refer to a guaran- in the discipline of Islamic finance. Although other risks tee (kafalah) in the sense of fulfilling the duty toward a per- such as credit and investment risks are very much affiliated son by another person. Meanwhile, Elgari (2003) explained to financial and trade transactions, these risks are quite famil- that Hanafi scholars defined dhaman as the obligations to iar because they exist in the contract of financial and trade pay compensation toward the damage. Majority of the fiqh transactions. scholars have agreed to use this parlance in the context of However, the lack of clarity is recognized because Elgari’s bearing risk for adequate returns. By this definition, there analysis is arguably the most theoretically refined among should be a balance between risks and benefits of transac- those that have introduced the term in contemporary Islamic tions. Al-Suwailem (2013) pointed out that an exposure to finance discourse. His treatment of the concept is obvious, excessive risk is undesirable because the size of the possible focusing on the acts undertaken by human beings as the loss is such that, if it eventuates, the consequences are likely sources of expected results and on the known consequences to be socially harmful. of losses for the purpose of managing this risk. In his paper, In addition, this definition should also be used along with he went as far as asserting that “risk as an ingredient of the the prohibition of earning profit without liability (or prohibi- process of arriving at financial decisions” and the purpose of tion of riba such as interest payment and receipt) and of studying risk is to “reduce its harmful effects in making deci- transaction involving hazard (gharar). It is related to the sions.” The acts are not naturally given and must be con- basic activities of acquiring wealth without legislation. There structed through a contractual basis embedded in the is no growth in reality where wealth is created. Among them standardization of contractual relations, useable as reliable is the risk that is prohibited due to an element of extreme source of risks. Elgari’s definition makes it clear that risk is uncertainty (gharar fahish). Also included in this category decomposable into two elements: first, the act itself which are gharar produced as a result of gambling (maysir) and allows human beings to make decisions which do not deviate zero-sum game that is forbidden by Islamic law (Al-Suwailem, from the right path and, second, the situation that leads 2000). Jurists have agreed that gharar fahish can make the human beings to deviate from the path. contract void, especially uqud mu`awadat (Mohd Razif & The second systematic discussion on risks was produced Mohamad, 2011). An example of the most obvious gharar by Althaus (2005) and Aygun (2007). They substantiated the fahish currently practiced is gambling in any particular price derivation of risk from the Arabic word, rizq or risq, which paid for the unknown. The element of uncertainty could means a portion, anything allotted (by God), livelihood, and expose someone to that kind of illegal risk. from which you gain profit. To this conclusion, Elgari (2003) Islam also emphasizes that a risk is not a factor of prohibi- noted that whatever risk caused by human beings is viewed tion to such contracts as long as it is not related to activities of as coming from God and they should be pleased with it. obtaining invalid reward due to gharar. This is explained by Many researchers highlight the third systematic discus- Ibn Taimiyyah in al-Fatawa al-Misriyyah. According to him, sion; among them are Elgari (2003), Dusuki and Smolo God and Prophet (p.b.u.h.) allowed all risks because not every (2009), Ismail and Ahmad (2010), Abdullah, Shahimi, and transaction which involved the probability of loss, gain, or Ismail (2011), and Bougatef (2015). They have defined risks neutral is prohibited. What is prohibited is the risk that causes based on the principles of jurisprudence (qawa’id fiqhiyyah). one to have an invalid property. Even if the activities do not This principle deliberately shows a relationship of direct pro- include risk, they would be prohibited (Ibn Taimiyyah, 1987). portion between risk and return, that is, a link between profit Mohd Noor et al. 5 The above findings have paved the way for a more refined more toward an analytical perception of liability risk, also definition of the same approach, namely, based on terminol- known as asset risk. This is because the contracts always ogy-based and principle-based approaches. In their initial deal with contractual relationships attached with rights and analysis of the definition, both Elgari and Aygun acknowl- liabilities. edge the basis of terminology in deriving the definition of Second, other than sources of risks, if a party chooses to risk. However, in the later stage, Elgari concurs with other approach contracts from the concept of contract risks, the researchers that the meaning of risk should originate from details of the contracts will be the main focus to deal with the principles of jurisprudence because both approaches are the risks that the contracts are surrounded with. In Islamic equally important and we want to reach a consensus on the finance, this type of risk is often related to the various sources that lead to a deviation from the path that causes financial contracts. The applied principle of Shariah has harmful effects. brought about a concept where one potentially engages with such contract risk that is Shariah risk in which if the change of circumstances deviates from the compliance Sources of Risk requirement, the risk does exist. Therefore, the risk is most The origin of the word “risk” is also argued in the literature. likely depended on the details of the contracts. Finally, The 1660s saw that the word “risk” appeared in different lan- Keskitalo (2006) also added that the contracts are no longer guages such as risqué (French), risco (Italian), riesgo hypothesized merely as sources of risks if a party chooses (Spanish), risiko (German), and risiko (Malay). In the begin- contracts from the perspective of business risks and views ning, philosophical creation of risks in its modern sense the contracting activity as another division of the organiza- started by redefining a Latin word “probabilis.” By this time, tions’ activities. However, its concept is defined as tools for the European etymologies for the word “risk” were common the management of business risk besides the contract and parlance among numerous researchers. They also claimed liability of legal risks. the Latin word riscum where Latin-derived terms are risco, Meanwhile, the discussion of sources of risk should be riscare, and rischiare (Althaus, 2005; Beck & Kewell, 2014). followed by the differentiation of risk and uncertainty. This However, there is a healthy disagreement as to the true origin is due to the concept that both terminologies differ. What we of its modern meaning. look into is the risk in economy especially in financial con- Other derivatives appeared such as “risk taker” (1892), tracts, while the existence of uncertainty (gharar) in finan- “risk factor” (1906), and “risk management” (1963). The cial system will cause the contract to be void. These can be phrase “risk management” leads us to find ways to maintain further explained in the following discussions. a good balance between risk and reward and carefully weigh potential profit against potential problems or threats to oper- Risk Versus Uncertainty ational stability. There are a number of sources of risk in Islamic finance. The generic name is apparent after we have The definition relating to the concept of epistemological risk identified the definition of “risk.” must be recognized earlier from the nature of economics lit- Although in Islamic finance risks exist, as mentioned by erature. This is intrinsically important in expressing the epis- Elgari (2003), the sources that lead to a deviation from the temological definition of risk in the point of risk characteristics path that creates the harmful effects have not been clear. to explain something different from uncertainty. The best Today, we tend to discuss the sources of risk in terms of devi- basic way to differentiate risk and uncertainty is through ation from the optimum solution or process, usually described their definitions. Earlier researcher, Knight (1964) drew a in terms of expected loss. The optimum solution is a condi- distinction between risk and uncertainty in the following tion where the “contract” in which any changes to certain manner. He proposed that this distinction was important for circumstances will cause risk to occur. It can be considered an economic theory because uncertainty affords opportuni- as a basic hypothesis for the source of risk. This has been ties for profit that does not exist in certain situations, whereas theoretically defined by Keskitalo (2006) where he provided risks can be calculated. the view of a relationship between contracts and risks in dif- Most of the studies, such as Hertz and Thomas (1983), ferent ways. In selected approach to contracts and risks, he Althaus (2005), Mohd Razif and Mohamad (2011), and discovered three examples of circumstances which involved Hidrus and Abd Rahman (2013), defined that both terms are legal risk, contract risk, and business risk. different from each other. Although the idea of risk and uncer- First, Keskitalo (2006) explained that contracts them- tainty is related to the unknown, they agreed that risk is selves will most likely be seen as a source of risks when closely referred to an attempt to “control” the unknown by the contracts found in such circumstances are understood applying knowledge based on the orderliness of the world. as legal instruments. This view is valid if a party chooses This is due to the fact that risk is something that lacks predict- the contracts and contracting activity of businesses and ability of structure, outcomes, or consequences in a decision other organizations from the legal risks perspective. The making or when planning a situation. Hence, risk requires perception of contracts as sources of risk seems to be lean sound knowledge to understand how uncertainty and 6 SAGE Open Table 2. Disciplinary Perspectives on the Epistemological Status of Risk. Disciplines How risk is viewed Knowledge applied to the unknown Mathematics and Logic Risk as a calculable phenomenon Calculations Science and Medicine Risk as an objective reality Principles, postulates, and calculations Social Sciences Anthropology Risk as a cultural phenomenon Culture Sociology Risk as a societal phenomenon Social constructs or frameworks Economics Risk as a decisional phenomenon, a way of Decision-making principles and postulates securing wealth or avoiding loss Law Risk as a fault of conduct and a judicable Rules phenomenon Psychology Risk as a behavioral and cognitive phenomenon Cognition Linguistics Risk as a concept Terminology and meaning History and the Humanities History Risk as a story Narrative The Arts (literature, music, poetry, Risk as an emotional phenomenon Emotion theater, art, etc.) Religion Risk as an act of faith Revelation Philosophy Risk as a problematic phenomenon Wisdom Source. Althaus (2005). complexity can be managed. Hertz and Thomas (1983) tend its excessiveness combined with elements of uncertainty to distinguish risk and uncertainty by stating that risk is suit- (gharar) can cause a contract to be invalid. ably related to the concepts of chance such as the probability of loss or the probability of ruin. That means that a risk is a Risk From Economic Perspectives known–unknown where the probabilities exist and are assign- able involving likelihood and frequency of occurrence. To date, risk has been understood by economists as an exclu- On the contrary, uncertainty (as opposed to risk) has been sion of prohibited conditions that results in a void transac- the subject of extensive literature. It denotes the totally ran- tion. They view risk as a decisional phenomenon, a way of dom unknown, as well as cannot be predicted or controlled. securing wealth or avoiding loss that needs the knowledge of Contradictory to risks, it is such unknown–unknown due to decision-making principles, postulating and calculating risks the probabilities that can be undefined. Hertz and Thomas (Table 2). Generally, every discipline has a different view of (1983) highlighted that the situation of uncertainty arises risk. It depends on the perspective of the epistemology of when a consensus or agreement among the set of experts risk where a different knowledge is applied to that known– cannot be achieved. There is an undefined probability distri- unknown. Hence, the generic name of risk derived from how bution on the set of outcomes. In Islam, a few researchers each discipline views risks. have distinguished uncertainty from risk through the Arabic Risk is inevitable in economic activities where it is seen word, gharar. Rosly (2005), Dusuki and Smolo (2009), as “part and parcel of financial intermediation” (Akkizidis & Mohd Razif and Mohamad (2011), and Hidrus and Abd Khandelwal, 2008). Meanwhile, the generic name of risk Rahman (2013) agreed with the literal meaning of uncer- from the perspective of economic science can also be seen tainty through the word “gharar,” that is, danger, fraud, and from various dimensions. This is because there are various mistake. In terms of Arabic language, gharar is a derivative ways to classify risk until the derivation of its generic names. of the verb gharra which means trickery, to deceive, to The classification of risk depends on the outcome (result), delude, and to mislead. Among fiqh scholars, gharar is iden- loss, or the nature of such risk and it also depends on con- tified as a type of uncertainty (Al-Saati, 2003). Therefore, tracts involved, facility, and hardship faced by an Prophet (p.b.u.h.) prohibited gharar due to its speculative individual. nature that may lead to disputes, unfair gains or “eating other Basically, there are studies that have divided risk into sev- people’s wealth unlawfully.” According to Ibn Taimiyyah, eral categories. Mohd Razif and Mohamad (2011) catego- gharar describes selling things with an unknown fate. Selling rized risks into systematic and nonsystematic risks. such things is maysir and gambling (Al-Suwailem, 2000). Systematic risks are related to the movement of the entire Consequently, gharar can be defined as the sale of probable economy, the growth of the industry, and all considerations goods whose existence and/or characteristics are not certain that can affect the overall price level. For example, changes and due to these reasons, the trade is akin to gambling. in interest rates, recession, and war. The above-mentioned From the above discussion, we have arrived at a simple factors can result in having a systematic risk because they conclusion that risk is necessary for a valid contract and that affect market conditions. In fact, the systematic risk is a risk Mohd Noor et al. 7 that cannot be eliminated or controlled by diversifying risk Applications of Risk in Islamic Finance because the instability of the risk is influenced by macroeco- In capital management of Islamic financial institutions, risk nomic factors, whereas nonsystematic risk can be controlled is a part of financial transactions. Thus, it should be taken or avoided through diversification. This is because the risk into consideration. This is because Islamic financial institu- exists only in a particular company or industry. Several fac- tions need to set the capital adequacy requirement based on tors that lead to unsystematic risk are poor management, identified risks exposure. The capital acts as a buffer to financial position, and earnings. Therefore, these risks can be absorb losses because in a financial system, losses are related traced through the reading and analysis of company data and to risk. Daher, Masih, and Ibrahim (2015) in a study of deter- information. By referring to the company’s annual financial minants of Islamic financial institutions’ capital buffers evi- statements, there is a high possibility of this type of risk to dently revealed that there are influences of displaced exist. commercial risk (DCR), rate of return (ROR) risk, and equity In addition, Khan and Ahmed (2001) have categorized investment risk exposure on Islamic financial institutions’ risks into business risk and financial risks. According to capital buffers. In other words, Islamic financial institutions them, business risks arise from the behavior of a business should identify the risk exposure to adequately balance the such as market risk, credit risk, liquidity risk, and so on, risk and capital. whereas financial risks arise from the probability of losses in According to capital regulation in IFSB, Committee on the financial markets caused by the movement of financial Banking Regulation and Supervisory Practices requires all variables such as foreign exchange rate risk, equity risk, banks to maintain a minimum capital of 8% from risk interest rate risk, and commodity price risk. weighted asset (RWA) of the banks since the capital ade- Al-Saati (2002) and Dusuki and Smolo (2009), however, quacy framework was altered in 1990. This is termed as discussed the division of risks into primary and secondary minimizing risk for banks. In addition, for specific Islamic risks. The primary risk refers to a risk that cannot be avoided financial institutions, Islamic Financial Services Board and it is interrelated to each business, whereas secondary (IFSB) has issued The Capital Adequacy Framework for risks can be eliminated or hedged using derivative financial Islamic Banking institutions (RWA; the Framework) that instruments. Although the primary risk cannot be eliminated specifies the measurement methodologies for the purpose of as a whole, a part of the risk level can be reduced. For exam- calculating RWA for credit risk, market risk, and operational ple, a farmer cannot eliminate the price risk but he can reduce risk, respectively. The financial regulator may specify an the risk by entering the market forward with contracts. He additional buffer requirement for an Islamic banking institu- can sell part or all of the harvest to be obtained later in the tion, with specific regard to risk profile of the institution. present. Risks in Islamic financial institutions are slightly different In Islamic finance, instead of having a generic risk, insti- from their conventional counterparts. Nevertheless, both tutions offering Islamic products and services face additional need to possess adequate capital to absorb exposure to risks. risks, namely, a unique risk. The unique risks reflect the mix Whether they are conventional or Islamic financial institu- of risks exposed by Islamic financial institutions and risk- tions, researchers such as Greuning and Iqbal (2008), Laldin sharing arrangements resulting from the contractual design (2013), and Srivastava and Subramaniam (2013) agreed that of instruments (Sundararajan, 2007). Accordingly, risks they are exposed to various risks in their operations. The faced by Islamic banks may differ either in terms of the risks’ risks generally fall into four categories such as financial, structure or severity compared with conventional banks. For operational, business, and event risks (El Tiby, 2011). It instance, providing home-financing facility under mushara- would be expected that some Islamic financial institutions kah, Islamic banks are exposed to two additional risks com- risks will resemble those encountered by conventional finan- pared with conventional banks providing the same facility, cial institutions, that is, credit, market, liquidity, and opera- namely, equity risk resulting from the asset ownership and tional risks. Even so, Islamic financial institutions face a Shariah risk. unique mix of risks due to the contractual design of instru- Each risk category that has been mentioned above is part ments applied (Sundararajan, 2007). Accordingly, Islamic of the types of risk that can be further discussed. There are financial institution’s risks may differ in terms of the origin many other risk categories that have been identified based on of risks compared with conventional institutions. As men- the understanding of an individual or organization. What this tioned before, by providing home-financing facility under study is concerned with is the forms of risk which cause dif- musharakah, Islamic financial institutions are exposed to ficulties and harmful effects where the risks should be pos- two additional risks from the same facility provided by con- sibly eliminated or, at least, reduced to a minimum. To date, ventional institutions that is equity risk as a result of the asset various approaches have been taken to manage risks such as ownership and Shariah risks. buying an insurance policy, diversifying portfolios, or buy- Consequently, Islamic financial institutions face two ing derivative contracts. Based on that note, Islam also has types of risk while operating their business. First, Islamic its own perspective on the concept of risk management which financial institutions face risks which are similar to the ones will be presented in the next section. 8 SAGE Open faced by conventional financial institutions. Second, they in liquidation. Hence, this is also a part of risk management face unique and specific risks. The second type of risk arises purposes. from contractual design which ought to comply with Shariah After the period of subprime crises and an ongoing rules and principles. The prohibition of interest determines European debt crisis, risk management becomes a crucial the nature of their financial services and contracts that can be activity for all institutions. The activity is not only important offered by Islamic financial institutions and their associated in conventional institutions but also practically allowed in risks (Ahmed & Khan, 2007; Sundararajan & Errico, 2002). Islamic financial institutions. Due to this, we discuss risk Nevertheless, the existence of risk in financial transactions, management as one of the subjects of generic risk associated particularly in Islamic financial institutions, has become a with regulatory capital requirements for Islamic financial source of argument from various perspectives. There is a institutions. There are following discussions on risk manage- common perception on Islamic banking where the industry is ment from Islamic perspective. assumed to be safer than its conventional counterparts because it is not based on interest rates. Another argument is Risk Management From Islamic Perspective that several of the products use a marked-up arrangement so that they carry less risk. However, these points of view are Risk management is permissible in Islam (Abdul Kader understatements and they are not entirely true. This is Malim, 2015). Its concept is acceptable to contemporary because Islamic financing relies more on equity financing Islamic scholars based on the Quranic verse (Al-Baqarah: rather than debt financing, hence inherently riskier (Akkizidis 282) which requires Muslims to record debt or provide wit- & Khandelwal, 2008). nesses, and the supporting Hadith (Sunan al-Tirmidhi: 2517) Sundararajan and Errico (2002) agreed with this argument which requires Bedouin to tie the camel before leaving its where Islamic financial institutions with Islamic banking fate to God (tawakkal). Therefore, the management must be institutions as a major part can be riskier than conventional parallel with Shariah principles because it involves the pro- financial institutions due to the specific nature of contract cess of protecting individuals or their properties from facing risks, namely, the unrestricted number of ways to finance a the probability of loss. It considers the protection of wealth project using either profit and loss sharing or nonprofit and (hifz al-mal) as a value which is emphasized in Islam. From loss sharing contracts. Another factor that renders Islamic the Islamic perspective, risk is allowed and it differs from financial institutions riskier than its companion is might be gharar which is prohibited. due to the nonstandard practices in each type of contract. As God’s command regarding the forbidden ownership of the discussed earlier, Islamic financial institutions have to deal property of others has also been recorded in the Quran. One with the new risk as a result of the uniqueness in asset and of the Hadiths of Prophet Muhammad (p.b.u.h.) stated that liability structure. This is due to the compliance of Shariah the safety and property of others cannot be contested; any requirement (El Tiby, 2011; Khan & Ahmed, 2001). This form of violation of property rights is a property crime. makes Islamic financial institutions slightly different from Prophet (p.b.u.h.) also encouraged the sharing of business conventional financial institutions in terms of risk exposure. risks in line with the intention of sharing profits and losses as Meanwhile, the capital owners in Islamic financial institu- well as providing mutual assistance and cooperation between tions face the unique nature of risk in accordance with the one another. This is evident through a Quranic verse which types of financial instruments used, the people hired to man- says, age the banks, and the degree of transparency (Hassan & Dicle, 2005; Rosly & Zaini, 2008). As Islamic financial insti- And cooperate in righteousness and piety, but do not cooperate tutions offer various types of contracts, the risks exist in their in sin and aggression. And fear God; indeed, God is severe in operations. Due to that, in a capital management approach, penalty. (Al-Maaidah, 5: 2) Islamic financial institutions require adequate capital to adapt to these risky circumstances. What is [wrong] with you? Why do you not help each other? Notwithstanding, the financial regulator highlighted that (As-Saffat, 37:25) regulatory capital requirements seek to ensure the risk expo- sures faced by Islamic financial institutions are backed by an For example, musharakah product is based on a capital adequate amount of capital to absorb losses. This ongoing partnership and joint venture. Each member of the business concern is to ensure the continuing ability of Islamic finan- works on the capital and enjoys the profit and loss of the cial institutions to meet its obligations if they were to fall due business together. For products of mudharabah, the profit to financial instability. Besides, it also preserves the confi- and loss are shared between investors (rabbul mal) and dence of customers, depositors, creditors, and other stake- entrepreneurs (mudharib). Although investors only provide holders to deal with the institutions. In a financially difficult capital and surrender the management of the business to its situation, capital requirements also seek to further safeguard operators, in the event of a risk or business failure due to the the depositors and other senior creditors by promoting an negligence of the operator accidentally, the employer will additional cushion of assets that can be used to meet claims not have to pay compensation to the investors. Mohd Noor et al. 9 There are also some other verses of the Quran that Risk Management in Islamic Financial Institutions explained the importance of risk management. God says in Risk management is recognized as a main activity for all Surah Yusuf verses 46 to 49: institutions specifically after the recent subprime crisis and an ongoing European debt crisis. The financial industries He said: Yusuf, O man of truth, explain to us about seven fat experienced a rude awakening from crises occurred. It started cows eaten by seven [that were] lean, and seven green spikes [of when the oldest London merchant bank—Barings PLC grain] and others [that were] dry—that I may return to the people; perhaps they will know [about you]. [46] reported collapse in 1995, Sumitomo Corporation lost US$2.6 billion on copper derivatives in 1996, Yusuf said: You will plant for seven years consecutively; and Metallgesellschaft AG lost DM1.8 billion on oil futures, and what you harvest leave in its spikes, except a little from which Orange County California lost on interest rate derivatives. you will eat. [47] More recently, the United States’s second and fourth largest banks, Bank of America and Wachovia were wiped out by Then will come after that seven difficult [years] which will the subprime crisis, with multibillion dollar write-downs consume what you saved for them, except a little from which (Tafri et al., 2011). In East Asia, financial institutions were you will store. [48] badly affected during the 1997 financial crisis. Earlier on, the first Islamic bank in Malaysia, Bank Islam Malaysia Berhad Then will come after that a year in which the people will be (BIMB), reported loss in 2005. given rain and in which they will press [olives and grapes]. [49] Many of the losses could have been avoided if an effec- (Surah Yusuf, 12: 46-49) tive risk management strategy had been practiced. It practi- cally helps to protect the banks from financial losses such as In this Surah, it is narrated, how the Prophet Yusuf inter- credit risk from subprime mortgage crisis. Generally, banks preted the dreams of the king of Egypt, where Egypt would and organizations use two approaches for risk management face a 7-year drought after 7 years full of prosperity. Based strategies. The first one involves risk decomposition and the on that interpretation, the Prophet Yusuf a.s. then proposed a other involves risk aggregation. Banks practically use both plan for dealing with those critical years. The plan is that the approaches when managing market and credit risk. Both Egyptians needed to grow food during the 7 years of prosper- approaches are needed to sustain business growth and con- ity and keep most of it. This should be carried out so that they tinued profitability of the banks where both conventional and would be ready when the drought struck for the next 7 years. Islamic financial institutions are required to possess strate- Yusuf was then appointed by the king of Egypt as Minister gies to manage risks. of Agriculture. As the Minister of Agriculture, he imple- In managing risk, the banks need sufficient capital called mented a plan that has been framed. As a result, Egypt sur- capital buffer to counter the losses. The capital buffer plays a vived when drought hit and lasted for 7 years. This is a clear role as an absorber of unexpected losses, that is, risk absorber. evidence of risk management, where the risk of hunger and The amount of equity and the forms of capital held reflect the starvation was reduced by growing food and keeping most of ability of absorbing losses (Abdullah et al., 2011). In this it during the first 7 years—the years of prosperity. This context, the capital acts as a protector of the bank from unfa- proves that risk management is essential and permissible in vorable outcomes. As the banks are subjected to banking Islam as a preparation to face a loss in the event of disasters regulations, their depositors and stability of financial sys- and undesirable circumstances. Yusuf a.s. was a smart person tems are protected by capital requirements. The settings are and could help the administration of Egypt perfectly because mainly designed for banking institutions based on interna- he was intelligent and capable in solving the problems tional standards supervision. An example includes the Basel encountered. Although the concept is different from the man- II capital requirements. agement of financial risk, it shows that the decision has been The Basel II is structured based on three “Pillars.” Pillar 1 right and appropriate to reduce the risk. deals with a new approach for credit risk and a new capital There are three basic guidelines in Islam. First, humans charge for operational risk. The minimum capital require- are not the real owner of properties and resources. This is ments that need to be held for credit risk are calculated in a because God (Allah s.w.t.) is the absolute owner of this world new way which reflects the credit ratings of counterparties, and everything in it. Second, there are instructions and guid- whereas the RWA for operational risk is set as 12.5 times the ance for any action, including the taking-over and develop- calculated operational risk capital. Pillar 2 addresses the ment of resources. Third, the ultimate goal of Islam is to supervisory review process from the standpoint of the super- achieve prosperity in society as individuals are also encour- visor’s responsibility to promote the safety of the banking aged to earn a living with their own effort. Indeed, Islam system. Supervisors are required to do more than just ensur- requires that for whatever is done in the world needs to be ing the minimum capital requirement held. Among their based on Islamic principles. Risk management is also not an critical role is to encourage the banks to develop and use exception in the implementation of businesses according to better risk management techniques. Pillar 3 lays down Islamic laws. 10 SAGE Open market discipline. It requires a minimum number of public where one potentially engages with such contract risk that reporting standards on risk and risk management intended in is Shariah risk if the change of circumstances deviates from enhancing the ability of market participants in the awareness the Shariah compliance requirement. of a bank’s risk profile. In relation to this, the adequacy of its In an application of risk, the unique nature as well as vari- capital thus involves such market discipline in the capital ety of financial and investment activities has its own risk adequacy regime. characteristics which affect both sides of the balance sheet of The document of IFSB issued in 2005 has set number of Islamic financial institutions. To manage such those risks, principles for Islamic financial institutions regarding the risk Islamic financial institutions should take into account the management. Among the objectives are to ensure Islamic risks in their transactions so that the capital can adequately financial institutions comply with the Shariah rules with the absorb the risks involved. prohibition of interest as the main element, applying Shariah- compliant risk mitigation techniques and complementing the Declaration of Conflicting Interests Basel Committee on Banking Supervision’s (BCBS) guide- The author(s) declared no potential conflicts of interest with respect lines on risk management to accommodate the specific needs to the research, authorship, and/or publication of this article. of Islamic financial institutions (El Tiby, 2011). Nonetheless, the issues related to risk management in Funding Islamic financial institutions requires significant attention. 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Islamic financial institution Kaherah: Dar al-Ma’arif. and products in the global financial system: Key issues in risk Ibn Taimiyyah, A. (1987). Al-Fatawa al-Misriyah [The Egyptian management and challenges ahead (International Monetary Fund Rulings]. Beirut: Dar al-Jil. working paper). Washington, DC: International Monetary Fund. Islamic Financial Services Board. (2005). Guiding principles of risk Tafri, F. H., Abdul Rahman, R., & Omar, N. (2011). Empirical evi- management for institutions (other than insurance institutions) dence on the risk management tools practised in Islamic and offering only Islamic financial services. Available from www. conventional banks. Qualitative Research in Financial Markets, ifsb.org 3(2), 86-104. http://doi.org/10.1108/17554171111155339 12 SAGE Open Tariq, A. A. (2004). Managing financial risks of Sukuk Structures Abdul Ghafar Ismail obtained his PhD in Economics from (Doctoral thesis). Loughborough University, UK. Retrieved University of Southampton. He has been a lecturer since 1987 and from http://kantakji.com/media/7829/f216.pdf has been teaching several economics courses such as money and Thompson, P. B. (1986). The philosophical foundations banking, financial economics, Islamic economics system, interna- of risk. Southern Journal of Philosophy, 24, 273-286. tional finance, Islamic banking, and risk management in Islamic doi:10.1111/j.2041-6962.1986.tb01566.x banking. Currently, he is a professor of Islamic Financial Economics Trimpop, R. M. (1994). The psychology of risk taking behavior. and research fellow in Universiti Islam Sultan Sharif Ali, Brunei Amsterdam, The Netherlands: North-Holland. Darussalam and Islamic Economic Studies and Thoughts Centre (www.iestc.net). Muhammad Hakimi Mohd. Shafiai received his PhD in Islamic Author Biography Economics from the Graduate School of Asian and African Area Nurul Syazwani Mohd Noor obtained her bachelor degree (Hons.) Studies, Kyoto University, Japan. Currently, he is a senior lecturer in Actuarial Sciences and master in Management (Islamic banking) at Universiti Kebangsaan Malaysia. He has written a book (Islamic from the Universiti Sultan Zainal Abidin, Malaysia. Currently, she Finance for Agricultural Development, 2013) and has published is doing PhD in Islamic Civilisation at Institut Islam Hadhari, several scholarly articles related to Islamic economics. He is also Universiti Kebangsaan Malaysia. She is conducting research in involved in research on Islamic finance, Islamic microfinance, Islamic finance specifically on Shariah risk modelling. Islamic agricultural finance, agricultural economics, and waqf.

Journal

SAGE OpenSAGE

Published: Apr 11, 2018

Keywords: risk; origin; definition; Islamic finance; Shariah

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