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Shariah Risk

Introduction: Shariah Risk on the Rise
While Islamic Finance spent many years in early-development bliss, recent controversies over compliance (i.e. OIC's recent announcement about Tawarruq'; Mufti Taqi Usmani's rulings on Sukuk; Sh Yusuf DeLorenzo's rulings on the Islamic Swap, the Malaysian High Court ruling against Bay' Bithaman Ajil (BBA) and the subsequent overturning by the Court of Appeals) all point to the rise of Shariah Risk.

Aside from the above types of transactions, some of today's popular products clearly have significant embedded Shariah risks (see e.g., Dr Nazim Ali's article in New Horizon for a listing of some high risk products, see this Zawya article for an overview of the many risks faced by Islamic Banks).

The more common risks each have corresponding groups in a large risk management department: Market Risk, Credit Risk, and Operational Risk (and to a lesser extent the new contender for "Risk of the Year" awards, Liquidity Risk), are all the focus of a tremendous amount of attention and their maximal NPV impact is easily understood. However, with Shariah Risk there is a great deal more uncertainty (i.e. it fits more in line with Legal Risk, Compliance Risk, Political Risk and Reputational Risk).

Shariah Risk is probably the least well-understood (and poorly modelled) form of risk faced by Islamic Banks.

Overview and Breakdown of Shariah Risk

This paper by Sh Yusuf Talal DeLorenzo on Shariah Risk highlights the operational aspects of Shariah Risk, detailing the approval process for new products, the risks of pre-fatwa failure, and even the risks that, if a fatwa is issued, it may or may not be accepted by the ummah, due to many possible factors, among which he lists the board's geographical origins and acceptance within the market, innovative interpretations of shariah, etc.

The level of detail given to describe the various pipeline risks goes a long way to filling out possible further lines of enquiry.

Clearly banks developing new products can be subject to developmental risk, and this may be overly concentrated. Sh Yusuf discusses means of alleviating some of these risks.

Islamic Finance vs Islamic Law: Shariah Risk is the Unfortunate Offspring

Taking a slightly different tack, this paper by Killian Balz outlines the systemic nature of Shariah Risk due to the disenfranchisement of Islamic Law from Islamic Finance.

As we have posted on our discussions before, English Law is usually the governing law for international contracts, and English Law has a chequered past in applying Shariah principles properly.

Balz highlights this chequered past, and the root of the issue, that Islamic Finance effectively relegates Islamic Law to a set of guiding principles rather than to apply it properly in a way that would ensure that transactions truly adhere to it. The end-product is Shariah risk, the risk that a transaction which in many standard cases appears to be halal, will, due to circumstance and court rulings, in the end be haram. Furthermore, there is the risk that the product traded was stamped "halal" using a more innovative approach to Shariah and that this stamp of approval may come into question at a later date. In both cases, the risk is real.

In the end, unlike most of the more common risks, Shariah risk can hit asset values (with possible loss of investment or loss of reinvestment income), can damage reputation, and has far greater implications for one's relationship with Allah (swt).


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