Exploring and developing risk management in Islamic finance and banking

Dr Jothee Sinnakkannu - School of Business
Dr Jothee Sinnakkannu
School of Business

Islamic finance and banking is fast becoming a competitive alternative to conventional banking around the world, and is not merely confined to Muslim nations. However, despite the fact that Islamic banking has well-grounded its roots into subsidiaries of the conventional banking system, there are many areas yet to be explored and developed in the risk management practices of Islamic finance and banking.

In any financial institutions, there are various kinds of risks, ranging from credit risks to operational risks to systemic market risks. The largest risk financial institution faces, whether Islamic or conventional, is default risk where borrowers fail to settle their loan obligations, said Dr. Jothee Sinnakkannu, Senior Lecturer of Finance in the School of Business in Monash University Sunway campus.

“In conventional banking, we have got a recovery process that can bring a person to bankruptcy as the last resort. However, in Islamic banking system, it’s not easy to recover loans through bankruptcy or foreclosures in the case of mortgage loans,” said Dr. Jothee.

“But in Islamic finance, it’s very challenging to manage risk as due to the need to be Syariah compliant, they can’t use derivatives as risk management tools which conventional banks can use.

Risk management practices in Islamic finance are very challenging as they can’t use financial derivatives to hedge their risks which conventional banks are free to use.

He explained that a loan loss in Islamic finance is considered a loss for the depositor, and not the bank itself under the profit and loss sharing principle.

“In Islamic finance which works on the profit and loss sharing principle, a deposits is are transferred into loan to borrowers while in conventional banking, deposits i are transformed into loans so where the bank stands as the recourse guarantor for the loan deposits. This makes risk management substantially more challenging for Islamic banking,” he said.

Dr Jothee said that despite the growing popularity of Islamic finance around the world, very little empirical research has been done on its risk management practices, compared to the voluminous work done for in the conventional banking systems.

“Here at Monash, we are committed to delve deeper into research in the area of Islamic finance and Islamic banking. One of the most challenging topics of research is how to accept the use of derivatives in a syariah-compliant system,” he said.

“An increasingly crucial question to answer is ‘How do we modify or synthetise existing derivatives in order to comply with syariah’.

“Answering this question would mean creating new instruments or risk management tools which follow the conventional system, but strikes a balance by adhering to syariah principles,” said Dr. Jothee, who is an authority in the area of Islamic banking.

Thus far, research conducted on credit exposure in Islamic financial institutions have mixed conclusions with some saying that the system is less risky, while many others saying they are riskier than conventional financing.

“At Monash, we are committed to conduct empirical research in this area to identify an appropriate measurement to manage  any other unique risks pertaining to the nature of their instruments and operations.”

Dr. Jothee, who is currently supervising two post-graduate students whose areas of research are in Islamic finance, said that the fast pace with which Islamic finance was developing around the world meant that it would soon be very crucial to the global financial system.

His own research has him looking into the Islamic golden dinar as an alternative currency in the world, which may possibly create stability in the global financial system. Apart from that, he is also currently looking into Islamic pawn broking as an excellent alternative for micro finance especially in Malaysia and other developing countries.

“After the global financial crisis in 2008, many European countries have started adopting Islamic finance as an alternative financial system because of its distributive justice, where they naturally by principle don’t take in excessive risks.

“With the momentum of its development almost everywhere in the world, students who study this alternative financial system can be an authority in this area themselves,” said Dr. Jothee.

“The way forward for people to invest in a less risky and more optimistic alternative to banking and finance, is Islamic finance.”

Monash University will soon be releasing a book -- “Contemporary Issues in Islamic Business and Economic Development” -- which is targeted at post-graduate students who are keen to have a comprehensive knowledge in contemporary issues in Islamic business.

The School of Business, which already offers a unit entitled Introduction into Islamic Banking and Finance, is in the midst of developing a new major in Islamic finance, following a high demand and interest from students.