Risk and Islamic Finance: A Misconception Corrected

Risk and Islamic Finance: A Misconception Corrected

Zubair Hasan (The Global University of Islamic Finance, Malaysia)
DOI: 10.4018/978-1-7998-0218-1.ch024

Abstract

The discussions on risk – its bearing, sharing, or transfer – have recently assumed prominence in Islamic finance literature in the wake of devastations the 2007-2008 financial crises unleashed across nations. Islamic scholars were quick to claim that there was no impact of the crisis on Islamic banks because they worked on a risk-sharing principle. In contrast, mainstream institutions suffered because they worked on a different plank – the transference of risk to other parties. This Chapter argues that neither the current practice of Islamic banking supports risk sharing as its sole principle nor do its future prospects depend on it. The proposition only seeks to put Islamic finance on a non-existent trajectory. It clarifies confusion regarding the proposition and some of its corollaries. Contextually, it deals with measurement of risk, its relationship with return to capital, and its distributional equitability. The focus of the Chapter is rather restricted. It does not deal with various types of risks the banks face in their financing activities or with issues in risk management.
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Introduction

This Chapter deals with a dominant claim in Islamic banking and finance that risk sharing is the sole principle in its organization in contrast to its mainstream counterpart that relies on shifting of risks to counter parties. In this context, the research has the following as its main areas of concern.

  • To explain the notion of risk and its relationship with the return to capital in productive effort in the light of literature on the subject

  • To examine the efficacy of the age long ‘no risk, no gain’ adage in Islamic finance in the light of expert opinion and the maxims of the Islamic law.

  • To investigate if mainstream finance subsists solely on transference of risks?

  • To examine if the mainstream banks came to grief during the 2007 financial turmoil essentially because of risk shifting.

  • To investigate if Islamic banks remained unaffected during the turmoil as they operated on a risk sharing basis?

  • To lay down some policy conclusions in the light of the above explorations.

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The Background

The current debate on ‘risk sharing versus risk transfer’ emerged as an off shoot of the discussions on debt versus equity in the mainstream literature after the 2007-2008 crises. In normal circumstance, going businesses prefer debt to equity as a source of finance for a variety of reason including lower cost, leverage gains and control retention. However, thing are different contextual to financial crises.

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