Unique Risks in Islamic Banking
Islamic banking can be defined as the providing of and use of financial services and products that conform to Islamic religious practices.20 Islamic financial services are characterized by a prohibition against the payment and receipt of interest at a fixed or predetermined rate. Instead, profit-and-loss-sharing (PLS) arrangements or purchase and resale of goods and services form the basis of contracts. In PLS modes, the rate of return on financial assets is not known or fixed before undertaking the transaction. In purchase – resale transactions, a markup is determined on the basis of a benchmark rate of return, typically a return determined in international markets such as LIBOR (London interbank offered rate). Islamic banks are also prohibited from engaging in certain activities such as (a) financing production or trade in alcoholic beverages or pork and (b) financing gambling operations. A range of Islamic contracts is available, depending on the rights of investors in project management and the timing of cash flows. Special risks in Islamic banking arise because of the specific features of Islamic contracts and the weak environment for effective risk management, thereby reflecting the absence of risk-management tools that are Sharia compatible. Box 5.2 contains further details.