Islamic banks face a greater number of risks compared to conventional banks. These additional risks arise for various reasons, including the specific nature of financing contracts and legal requirements to ensure compliance with Shariah principles.
In order to manage and mitigate these greater risks, an Islamic bank needs to allocate more resources than what a conventional bank would need to do for the same purpose.
A recent study of risk management practices of Islamic banks in Pakistan, undertaken by the authors, reveals that the strength of risk management practices has a negative relationship with profitability. The study examined the risk management practices of all five full fledged Islamic banks operating in the country.
However, it is thought that while Islamic banks would need a relatively higher commitment of resources for their risk management function and thereby adversely affect profitability, it is crucial for their sustenance in the long run.
Islamic banks need to arm themselves with management skills and operational systems to cope with this environment in the face of rapid growth. A weak risk culture has been identified as a hindrance to sustainable growth of Islamic banks by EY World Competitiveness Report 2013.
The risks identified by the IFSB Guidelines 2005 were the focus of the study.
These include credit risk, market risk, liquidity risk, operational risk, Shariah compliance risk, equity investment risk, rate of return risk and displaced commercial risk. The risk management practices were further subdivided into Risk Policy and Environment, Risk Measurement and Risk Mitigation.
Risk Environment assessed the board-level approach of providing a risk management framework to their respective banks. The risks that were identified by the banks were under the radar of the Board of Directors (BoD), and they were outlining the overall objectives