Risk at Islamic financial institutions

Risk management is at the heart of banks’ financial intermediation process and has assumed utmost importance at a time when complexity and volatility in financial markets have become both differentiating factors building competitive advantages and sources of risk entanglement. Basel II and widespread write-downs have highlighted the importance of sufficient capital adequacy and, more importantly, set a framework for improving the overall risk management architecture in banks. Islamic financial institutions (IFIs) are no exception. Similar to conventional financial institutions, they face many challenges in adequately defining, identifying, measuring, selecting, pricing and mitigating risks across business lines and asset classes. A number of specific financial risks at IFIs deserve closer examination. IFIs also face a series of non-financial risks, including sharia compliance, reputation, perception, and human resource risks, which are outside the scope of the following discussion, but equally important. Risk entanglement within IFIs’ asset classes In IFIs’ portfolios, it is