Islamic Banking and

Financial Markets
Module 7 (Continued)
Risk Management in Islamic Banking
Dr. Mustafa Disli

1
 Market risk
Rate of Return
General Market Risk

Reflects the impact of broad market movements (e.g., interest Commodities

rates, inflation, and economic cycles) on asset values. Market
• Affects entire asset classes or sectors rather than individual Risk
securities, leading to system-wide fluctuations. Foreign
Exchange
Specific Market Risk
Pertains to price changes in a specific asset due to factors
Equities
directly tied to its issuer (e.g., company performance, industry
developments, or credit rating changes).
• This risk can be mitigated through diversification, unlike
general market risk, which affects broader market conditions.

2
 Market risk

Rate of return risk Commodity risk FX rate risk Equity risk

The Murabaha
potential Arises from price
Murabaha The Murabaha
risk arising TheMudaraba
risk arising
impact on the volatility in
from the change from entering into
returnsIjarah
caused by commodities
Salam Musharaka
in priceIjarah
of one partnership of
unexpected (e.g., oil, metals,
currency against participating in a
changeSalam
in the rate agricultural
Istisna Salam
another. business activity.
of returns products).
Istisna Istisna

Mudaraba
The risk that financial institutions face commercial pressure to
Displaced
provide returns to investmentMusharaka
account holders that exceed actual
commercial risk
earnings on assets. 3
Difference between Rate of Return Risk and
Displaced Commercial Risk?
• Rate of Return Risk
– Involves the uncertainty in returns Islamic banks earn on their financing assets due
to external factors like market fluctuations, economic conditions, and inflation.
– Arises when actual returns on financing activities differ from expected returns,
impacting profitability.
– Unlike displaced commercial risk, this focuses on direct external influences on
financing outcomes rather than customer-driven pressures.
• Displaced Commercial Risk
– Occurs when investment account holders’ (PSIA) return expectations exceed the
actual returns generated by the bank’s assets.
– This difference may lead to pressure on the bank to cover the gap, often by using
its own funds, to meet depositor expectations.
4
 Sources of funds
ISLAMIC BANKS CONVENTIONAL BANKS

Capital (equity) Capital (equity)

Current accounts Current accounts

Saving accounts Interest-based Saving accounts

Unrestricted Profit Sharing Investment Time & certificates of deposits

Accounts (PSIAs)

Profit equalization reserves (PER) Reserves

Investment risk reserve (IRR)

5
 Sources of funds
ISLAMIC BANK CONVENTIONAL BANK
Current accounts Current accounts
Banks in both cases use shareholders’ equity to protect these deposits

Profit sharing investment accounts Time deposits, certificates of

(PSIA) deposits, etc – fixed income
Shareholders’ equity protects these liabilities
liabilities only in case of fiduciary
risks (theory); Profit Equalization Shareholders’ equity and
Reserve (PER) & Investment Risk subordinated loans protect these
Reserve (IRR) liabilities against all risks

Cost of funds: Variable Cost of funds: Fixed

6
Difference between PER & IRR

Profit Equalization Reserve (PER): An amount set aside by the bank from gross income,
before distributing the mudarib (bank’s) share, to maintain a stable return for Investment
Account Holders (IAHs).
– Purpose: Aims to smooth out returns over time, ensuring consistent and competitive returns
for IAHs, even during periods of fluctuating profits.
– Use: Functions as a buffer to stabilize ROI (return on investment) by absorbing periods of
lower returns, thus maintaining investor confidence and satisfaction.
Investment Risk Reserve (IRR): A reserve created from the IAHs' net income, after the
bank’s share has been allocated, to provide a cushion against potential future losses that
may directly affect IAHs.
– Purpose: Primarily a risk management tool, IRR protects IAHs from financial losses by
mitigating investment risks associated with the bank’s assets.
– Use: Unlike PER, which stabilizes returns, IRR is meant to absorb potential investment losses,
enhancing the bank’s financial resilience on behalf of IAHs.
7
Difference between PER & IRR: example

8
Case study

9
Case study 1. Liquid assets
– Cash & equivalents: Direct cash holdings.
– Commodity Murabaha (Tawarruq): Short-term
liquidity management tool.
• Process: Purchase commodity on credit →
Sell for cash.
• Example: Commonly conducted via the
London Metal Exchange (LME).
2. Financing assets
– Receivables through financing modes:
– Mudaraba, Murabaha, Ijara, Istisna’a, and
Salam.
– Excludes Musharaka (similar risk profile to
Mudaraba).
3. Investment & other assets
– Long-term investments categorized as:
• Available-for-Sale: Fair-value reserves.
• Held-to-Maturity: Bonds or fixed securities.
4. Fixed Assets
– Infrastructure: Computers, furniture, land,
premises.
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 Case study
1. Current accounts
– Nature: Safekeeping deposits (Qard Hassan); No
returns; principal is guaranteed; Purpose: Meets
clients' transactional needs.
2. Profit-Sharing Investment Accounts (PSIA)
– Structure: Based on Mudaraba agreement (bank-
client partnership); Types: Saving Investment
Accounts: No fixed maturity; open access; Fixed
Investment Accounts (F-PSIA): Fixed terms (e.g.,
3, 6, 12 months); Open-Maturity F-PSIA: Terms >1
year; Implication: Differentiation in account types
impacts risk analysis.
3. Other liabilities
– Unpaid depositors’ share of profits: Includes
previous PER allocations.
– Deferred Profit: Classified by AAOIFI as neither
liability nor equity.
4. Total equity
– Components: Share capital, reserves, retained
11
earnings.
Case study 1. Operating income
– Financing income: From sale-based and Profit
& Loss Sharing (PLS) financing.
– Investment income: Generated from
investment assets (e.g., properties, associates).
– Service income: Includes fees, commissions,
and foreign exchange income from services
(e.g., fund management, advisory).
– Other income: Gains/losses on asset
revaluation and other miscellaneous income.
2. Operating expenditures
– G&A expenses: General & administrative
expenses (rent, utilities, professional fees,
insurance)
– Provisions for Impairment: Key item related to
credit risk from financing and investment
activities.
3. Deductions
– PER (Profit Equalization Reserve) & IRR
(Investment Risk Reserve): Deductions before
distributions to PSIA holders. 12
Case study

AAOIFI standards on profit & loss allocation

• Profits are allocated proportionally between the bank and Investment Account Holders (IAHs) based on the
contribution amount from each party.
• Alternatively, profits may be shared according to agreed-upon percentages between the bank and IAHs.
• Selective profit sharing: Some Islamic banks distribute profits only from specific activities (e.g., financing and
investment). Other Income Sources (e.g., commissions or trading income) may be retained entirely by the bank.
• Loss allocation: Losses are first deducted from undistributed profits. If losses exceed this, the remainder 13is taken
from investment accountholders.
Market risk Value at Risk (VaR)

• Value at Risk (VaR) is a statistical measure that estimates the potential

maximum loss of an asset or portfolio over a specified holding period and
at a given confidence level (e.g., 95% or 99%).
• Commonly used in risk management, VaR helps financial institutions
quantify potential losses and assess the level of risk associated with specific
positions.
• Factors affecting VaR:
– Changes in positions: Increasing or decreasing positions affects the overall risk.
Larger or more volatile positions amplify potential losses, raising the VaR.
– Market volatility: Higher volatility in markets leads to larger fluctuations in asset
values, increasing the likelihood of substantial losses, thus raising the VaR.
Conversely, lower volatility reduces VaR.
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Value at Risk (VaR)

Value at Risk (VaR) is a statistical measure that estimates the potential

loss in value of an asset or portfolio over a defined period for a given
confidence interval.
Key characteristics:
– Single metric: VaR condenses complex risk assessments into a single
figure, simplifying risk communication.
– Time frame: Estimates loss over a specified time horizon (e.g., daily,
weekly, monthly).
– Probability: Indicates the likelihood of loss exceeding a certain
threshold, helping investors understand potential financial exposure.
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 Value at Risk (VaR)
Scenario:
– Suppose a portfolio has a 10-day VaR of $1
million with a 99% confidence level.
Interpretation:
– This means there is a 1% probability that the
portfolio could experience a loss of $1 million
or more over the next 10 days.
– In other words, under normal market
conditions, the portfolio is expected to
remain within this threshold 99% of the time.

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Value at Risk – Historical method

Lowest 10% daily returns

Lowest 5% daily returns

The historical method simply re-organizes actual historical, putting them

in order from worst to best. It then assumes that history will repeat itself,
from a risk perspective.
Because these are the worst 10% daily returns, we can say with 90% confidence
that the worst daily loss will not exceed 12.658%.
We expect with 90% confidence that our gain will exceed -12.658%.
Because these are the worst 5% daily returns, we can say with 95% confidence
that the worst daily loss will not exceed 15.052%.
We expect with 95% confidence that our gain will exceed -15.052%.
Linear interpolation
Y

2.9
2 3
Obs#
-12.644%
-12.658%

-12.791%

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Value at Risk – Historical method

If we invest $86 million today (1mio stocks at $86), we are

90% confident that our worst daily loss will not exceed
$10.886 million.

If we invest $86 million today (1mio stocks at $86), we are

95% confident that our worst daily loss will not exceed
$12.944 million.
1-day VaR 10-day VaR

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Expected Shortfall
Limitations of VaR:
• Non-additivity: Value at Risk (VaR) is not an
additive measure, making it challenging to assess
combined risks across different portfolios or risk
factors.
• Tail risk overlooked: VaR only indicates the
minimum loss at a specific confidence level,
without capturing potential extreme losses
beyond this threshold, leading to a possible false
sense of security.
• “Fat tails” Concern: If the distribution has a “fat
tail,” extreme losses become more likely,
suggesting that the actual risk may be higher than
indicated by VaR alone.
Expected Shortfall

ES as a solution:
• Captures tail losses: Expected Shortfall (ES), also known as
Conditional VaR, goes beyond VaR by measuring the average loss
when the loss exceeds the VaR threshold, offering a clearer picture of
tail risk.
– Calculation beyond VaR threshold.
• Improved risk management: ES provides a more robust measure for
managing risks in portfolios prone to extreme events or “black swan”
scenarios.

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 Expected shortfall
Step 1: Gather data and determine VaR
– Suppose we have 100 daily returns for a portfolio, sorted from
worst to best.
– At a 95% confidence level, VaR corresponds to the worst 5% of
losses (i.e., the bottom 5 values in our sorted list of returns).
Step 2: Identify the VaR level
– Let’s say the returns for the bottom 5 days (the worst 5%) are: -
$2.5 million, -$2.2 million, -$1.8 million, -$1.7 million, and -$1.5
million.
– The VaR at a 95% confidence level is the smallest value in this
bottom 5% tail, which is -$1.5 million. So, there is a 5%
probability of a loss equal to or worse than $1.5 million.
Step 3: Calculate Expected Shortfall
– Expected Shortfall at the 95% confidence level is the average loss
in this worst 5% tail.
– We calculate the average of these 5 worst losses:
GAP Analysis

• Purpose: GAP Analysis is a tool used to measure potential changes in

net interest income over specific time intervals based on interest rate
movements.
• Steps in GAP analysis
1. Select time buckets: Define time intervals (e.g., 1 month, 3 months, 6
months) to analyze interest sensitivity.
2. Sort assets and liabilities: Group assets and liabilities into these time
buckets based on:
– Maturity Date (for fixed-rate instruments)
– Repricing Date (for variable-rate instruments)

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GAP Analysis

3. Identify rate-sensitive assets and liabilities (RSAs and RSLs):

– Rate-Sensitive Assets (RSAs): Assets that can be repriced within the selected time interval.
– Rate-Sensitive Liabilities (RSLs): Liabilities that can be repriced within the selected time interval.

• Calculating the GAP:

– Formula: GAP = RSAs – RSLs
• Impact of interest rate changes
– If GAP is positive:
– Increase in interest rates: Increases net interest income (interest income rises more than interest expenses).
– Decrease in interest rates: Decreases net interest income (interest income falls more than interest
expenses).
– If GAP is negative:
– Increase in interest rates: Decreases net interest income (interest expenses rise more than interest income).
– Decrease in nterest rates: Increases net interest income (interest expenses fall more than interest income).

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GAP Analysis

‒ GAP= RSAs –RSLs

‒ Say
• RSA for assets with maturity 3 months is 10 million
• RSL for liabilities with maturity 3 months is 4 million
‒ If the bench mark interest rate goes up by 0.5%, then
• Increase in interest income from RSA=0.005x10,000,000= 50,000
• Increase in interest expenses to RSL= 0.005x4,000,000= 20,000
• Net interest income increase =>50,000-20,000=30,000
‒ If the bench mark interest rate goes down by 0.5%, then
• Decrease in interest income from RSA=-0.005x10,000,000= -50,000
• Decrease in interest expenses to RSL= -0.005x4,000,000=-20,000
• Net interest income decrease => -50,000+20,000=-30,000
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Operational risk

Conventional banks

Operational Risk is the risk of direct or indirect loss resulting from inadequate
or failed internal processes, people and systems or from external events

Islamic banks

Operational Risk is the risk (including Shariah compliance risk) of direct or

indirect loss resulting from inadequate or failed internal processes, people
and systems or from external events

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Scope of operational risk

Risk caused by incompetence, negligence (both unintentional) or fraud (intentional)

People risk by people.
Risk associated with the use of software and telecommunications systems: outdated
Technology risk technology and system incompatibility (i.e., not tailored specifically to the needs of
Islamic banks).
Risk that an agent handling funds on behalf of a principal will not live up to his/her
Fiduciary risk full fiduciary responsibility (i.e., the possibility that an agent will not act in the
client’s best interest)
Legal risk is the risk that the bank will face lawsuits, adverse judgments,
Legal risk unenforceable contracts, and penalties and sanctions pronounced by a regulatory
body.
Shariah compliance The risk that the terms agreed in a contract do not effectively comply with Islamic
risk jurisprudence and thus are not valid under Islamic law

The risk that the irresponsible actions or behavior of management will damage the
Reputational risk trust of the bank’s clients.
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Scope of operational risk

Risk caused by incompetence, negligence (unintentional) or fraud

People risk (intentional) by people.

Management

Effective management of people

risk involves implementing
comprehensive training programs,
establishing clear policies and
procedures, promoting a culture of
accountability, and conducting
regular audits to identify and
mitigate potential risks associated
with human behavior.

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Scope of operational risk

Risk caused by incompetence, negligence (both unintentional) or fraud (intentional)

People risk by people.
Risk associated with the use of software and telecommunications systems: outdated
Technology risk technology and system incompatibility (i.e., not tailored specifically to the needs of
Islamic banks).
Scope of operational risk

Risk caused by incompetence, negligence (both unintentional) or fraud (intentional)

People risk by people.
Risk associated with the use of software and telecommunications systems: outdated
Technology risk technology and system incompatibility (i.e., not tailored specifically to the needs of
Islamic banks).
Risk that an agent handling funds on behalf of a principal will not live up to his/her
Fiduciary risk full fiduciary responsibility (i.e., the possibility that an agent will not act in the
client’s best interest)
Scope of operational risk

Risk caused by incompetence, negligence (both unintentional) or fraud (intentional)

People risk by people.
Risk associated with the use of software and telecommunications systems: outdated
Technology risk technology and system incompatibility (i.e., not tailored specifically to the needs of
Islamic banks).
Risk that an agent handling funds on behalf of a principal will not live up to his/her
Fiduciary risk full fiduciary responsibility (i.e., the possibility that an agent will not act in the
client’s best interest)
Legal risk is the risk that the bank will face lawsuits, adverse judgments,
Legal risk unenforceable contracts, and penalties and sanctions pronounced by a regulatory
body.
‒ Inadequacy of legal systems to deal with Islamic banking
• Absence of Islamic banking law
• Absence of regulatory framework for IBs
‒ Conflict between Shariah and laws
‒ With non-Islamic legal regimes; lack of courts to enforce Islamic contracts increases legal
risk
Scope of operational risk

Shariah non-compliance can arise due to different reasons

‒ Exogenous — some Shariah compliance issues arise due to legal and regulatory requirements
‒ Endogenous — compliance issues stemming from internal factors (policies, procedures, Shariah
framework, Due diligence follow up)
‒ Economic incentives vs. Shariah compliance
‒ Diversity of fatwas (Fatwa shopping)
Implications of Shariah risk:
‒ Some clients may move to other banks
‒ Reputation and credibility of the industry can be at stake

Shariah compliance The risk that the terms agreed in a contract do not effectively comply with Islamic
risk jurisprudence and thus are not valid under Islamic law
Scope of operational risk

Many criticisms of Islamic finance (IF)

‒ ‘Deception’ and ‘charade’ (Saleem)
‒ Rent-seeking Shariah arbitrageurs using ‘ruses to circumvent prohibitions’ (ElGamal)
‒ ‘Legal hypocrisy’ (Holden)
‒ ‘Jurisprudential schizophrenia’ (Hamoudi)
IF is conventional finance, done more inefficiently
‒ Ibn Taymiyyah: Tawarruq is worse than interest (haram and costlier than interest)

The risk that the irresponsible actions or behavior of management will damage the
Reputational risk trust of the bank’s clients
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Sources of operational risk

External Internal

• Internal Fraud
• External Fraud
• Circumvention of
• Cyber crime
regulations
• Pandemic
• Technology risk
• Changes in regulations

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Measuring operational risk

• Lack of a universal measurement standard: There is no single,

universally accepted method for measuring operational risk. This
complexity arises from the diverse nature of operational risk, which
includes human error, system failures, and external events.
• Matrix approach to categorizing loss events:
• A popular method is the "matrix approach“, where losses are categorized by:
• Event type (e.g., fraud, system failure, process management error)
• Business line (e.g., retail banking, corporate finance, asset management)
• This categorization helps banks identify the events that have the most
significant impact and pinpoint which business areas are most vulnerable to
specific risks.

36
37
Measuring operational risk
• Defining and categorizing loss events:
– Banks start by identifying and defining both potential loss events and actual loss events.
– This involves categorizing events based on type (e.g., human error, fraud, system malfunction) and
business impact, enabling a clearer view of risk patterns.
• Data collection and analysis:
– Loss event databases: Banks develop comprehensive databases to track and monitor operational loss
events, supporting data-driven decision-making and compliance with regulatory standards.
– Constructing risk indicators: Metrics known as Key Risk Indicators (KRIs) are developed to measure the
likelihood and impact of operational risks. KRIs allow early detection of potential risks and help assess
trends over time.
• Modeling and quantitative analysis:
– Using statistical models, banks can estimate the frequency and severity of operational loss events. For
example, Loss Distribution Approach (LDA) uses historical data to predict losses and set capital
requirements.
– Scenario analysis: Evaluating hypothetical scenarios, such as cyberattacks or natural disasters, allows banks
to understand extreme risk events and their impact on operational resilience.
38
 Operational risk map Potential losses can be
categorized broadly as arising
from “high frequency, low
Impact

impact” (HFLI) events, such as

minor accounting errors or bank
teller mistakes, and “low
High

frequency, high impact” (LFHI)

events, such as terrorist attacks or
major fraud. Data on losses
arising from HFLI events are
generally available from a bank’s
Low

internal auditing systems.

Low High Frequency 39

Operational risk – Capital charge
Loss experience

Basic Standardized Advanced

Exposure
One simple calculation All risk event types for each Internal Models ex.
for all risk event types Basel-defined business line Operational Loss
and all business lines distribution and scenario
Scenarios based models

Insurance Fixed percentage Based upon gross income, Firms determine their own
(currently 15%) of gross but divided along Basel II- capital charge based upon
income defined business lines and internal model
Industry
loss Gross income = 1mio respective beta charges

15% = 150K
KRI

40
Basic indicator approach – capital charge

‒ Under the basic indicator approach, the amount of capital required

to protect against operational risk losses is set equal to 15% of annual
gross income over the previous three years.
• Gross income = net interest income + noninterest income
‒ Example
• A bank’s net income over the past 3 year was 150 million, 200 million, and
300 million.
• What is the amount of capital required to protect against operational risk
losses?
‒ Solution

41
 Standardized approach – Capital charge
‒ To determine the total capital Standardized
required under the standardized
approach: All risk event types for each
Basel-defined business line
• A bank’s activities are classified into
eight distinct business lines.
• The average gross income for each Based upon gross income,
but divided along Basel II-
business line is then multiplied by the defined business lines and
respective beta charges
line’s beta factor.
• After that, the capital results from all
eight business lines are summed up.

42
 Standardized approach
The Basel Committee specifies eight business lines within the SA whereby regulatory capital
is calculated by means of multiplying a beta factor (β) with the average gross income for the
last three years for each business line. The loss data used in this example is extracted from the
retail division and thus falls under the “retail banking” business line for which the Basel Committee
proposes (β = 12%).

43
Standardized approach – capital charge

‒ To use the standardized approach, a bank has to satisfy several

requirements. The bank must:
• Have an operational risk management function tasked with identification,
assessment, monitoring, and control of operational risk.
• Consistently keep records of operational risk losses incurred in each business
line.
• Install an operational risk management system that is well documented.
• Regularly subject its operational risk management processes to independent
reviews by both internal and external auditors.

44
Advanced measurement approach – capital
charge
‒ The Basel Committee on Bank Supervision has identified seven categories of
operational risk:
1. Internal fraud
2. External fraud
3. Clients, products and business practices
4. Employment practices and work safety
5. Damage to physical assets
6. Business disruption and system failures
7. Execution, delivery, and process management
‒ Combining the seven categories of risk with the eight business lines gives a total of 7 x
8 = 56 potential sources of operational risk for a bank.
‒ Bank must estimate one-year 99.9% VaRs for each combination and then aggregate
them to determine a single one year 99.9% operational risk VaR measure.
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Market risk – Unhedged FX position
Assets Liabilities
EQUITY

DEPOSITS

46
Market risk – Unhedged FX position
Assets Liabilities
Initial situation:
EQUITY
€ 1 = QAR 4
(QAR 20 mio)

FX DEPOSITS
(EUR 10 mio =
QAR 40 mio)

DEPOSITS
(QAR 40 mio)

QAR 100 million QAR 100 million

47
Market risk – Unhedged FX position
Assets Liabilities
EQUITY Depreciation of QAR:
(QAR 10 mio) € 1 = QAR 5
 EUR 10 mio = QAR 50 mio
FX DEPOSITS
(EUR 10 mio =
QAR 50 mio)

DEPOSITS
(QAR 40 mio)

QAR 100 million QAR 100 million

48
Market risk – Hedged FX position
Assets Liabilities
Initial situation:
EQUITY
€ 1 = QAR 4
(QAR 20 mio)

FX LOANS FX DEPOSITS
(EUR 10 mio = (EUR 10 mio =
QAR 40 mio) QAR 40 mio)

DEPOSITS
(QAR 40 mio)

QAR 100 million QAR 100 million

49
Market risk – Hedged FX position
Assets Liabilities
Depreciation of QAR:
EQUITY
€ 1 = QAR 5
(QAR 20 mio)
 EUR 10 mio = QAR 50 mio
FX LOANS FX DEPOSITS
(EUR 10 mio = (EUR 10 mio =
QAR 50 mio) QAR 50 mio) But this causes another
issue!

DEPOSITS
(QAR 40 mio)

QAR 110 million QAR 110 million

50
Wa’ad

• Islamic forward contracts, or Wa’ad, are binding unilateral promises

made by one party to buy or sell a specific asset at a predetermined
price in the future.
• Key features:
– Unilateral binding: Unlike conventional forward contracts, which are bilateral
and binding on both parties, Wa’ad is binding only on one party. This
structure avoids uncertainty and aligns with Islamic finance principles.
– Hedging tool : Wa’ad is primarily used to hedge currency risks, making it an
essential instrument in the risk management strategies of Islamic banks.

51
Wa’ad

• Purpose of Wa’ad: Commonly utilized by Islamic banks to lock in

future currency exchange rates for international trade transactions,
effectively managing currency exposure.
• Application: The bank enters into a Wa’ad agreement to secure a
future exchange rate for incoming or outgoing currencies, ensuring
predictability in cash flows.
• Example context: A Qatari Islamic bank expects to receive €1 million
from a European client in three months and wants to hedge against
currency depreciation.

52
Wa’ad

• Scenario: The bank anticipates receiving €1 million and locks in an

exchange rate of 4.00 QAR/EUR.
• Outcomes:
– With Wa’ad:
• Locked rate: 4.00 QAR/EUR
• Amount received: €1 million x 4.00 = 4 million QAR
– Without Wa’ad:
• If EUR/QAR falls to 3.80
• Amount Received: €1 million x 3.80 = 3.8 million QAR
• Loss Avoided: By using Wa’ad, the bank avoids a potential loss of 200,000 QAR.
• Conclusion: The Wa’ad effectively mitigates currency risk, ensuring
financial stability and compliance with Shariah principles.
53
Islamic Profit Rate Swap

1. Term Murabaha: Islamic Bank A sells 10 cars on installment to

Islamic Bank B at the rate of 10$ per car (9$ cost + 1$ mark-up) to
be repaid in 5 equal monthly installments.
• Advantages for Islamic Bank A:
– Immediate cash flow: Receives $100 upfront, enhancing liquidity for operational needs
or investments.
– Profit assurance: Clear profit margin of $1 per car provides predictable income for better
financial planning.
– Asset management: Reduces inventory of cars, minimizing costs associated with storage
or depreciation.
– Islamic compliance: Engages in transactions that align with Islamic finance principles,
avoiding interest.

54
Islamic Profit Rate Swap

1. Term Murabaha: Islamic Bank A sells 10 cars on installment to

Islamic Bank B at the rate of 10$ per car (9$ cost + 1$ mark-up) to
be repaid in 5 equal monthly installments.
• Advantages for Islamic Bank A:
– Immediate cash flow: Receives $100 upfront, enhancing liquidity for operational needs
or investments.
– Profit assurance: Clear profit margin of $1 per car provides predictable income for better
financial planning.
– Asset management: Reduces inventory of cars, minimizing costs associated with storage
or depreciation.
– Islamic compliance: Engages in transactions that align with Islamic finance principles,
avoiding interest.

55
Islamic Profit Rate Swap

2. Revolving Murabaha: Islamic Bank B at the time of each

installment payment will instead sell 2 cars to Islamic Bank A at the
rate of $9+LIBOR per car.
• Advantages for Islamic Bank B :
– Asset acquisition: By purchasing cars from Bank A, Bank B expands its inventory, which
can be sold or leased to customers, thus generating revenue.
– Cost management: Linking purchases to LIBOR helps mitigate the risk of rising financing
costs.
– Cash flow control: Strategic selling back of cars allows Bank B to time cash inflows while
managing liabilities effectively.
3. Settling installments: the difference between LIBOR and $1 will be
netted out
56
 Islamic Profit Rate Swap

Term Murabaha

Installment 4:

Installment 3:

Installment 2:

Installment 1:
Installment 5:

$20

$20

$20

$20
$20 Sells commodities
Islamic Islamic
bank A Sells commodities bank B

Murabaha 5 : 2 cars + LIBOR

Revolving Murabaha 4 : 2 cars + LIBOR
Murabaha
Murabaha 3 : 2 cars + LIBOR
Murabaha 2 : 2 cars + LIBOR
Murabaha 1: 2 cars + LIBOR
57
Term and Revolving Murabaha

58
Islamic Profit Rate Swap

Islamic bank A Islamic bank B

Pays $9 + LIBOR (one car)

Pays $20 as first installment
Pays $9 + LIBOR (second car)
to Islamic Bank A
= $18 + LIBOR to Islamic Bank B

Suppose LIBOR cost is $2.5

Islamic Bank A pays
Net settlement of $0.5
$20.5 to Islamic Bank B

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Islamic options (Urbun)

• Urbun is a Shariah-compliant option contract, commonly used by

Islamic banks to hedge against price fluctuations.
• Contract nature: Similar to a conventional option, Urbun gives the
buyer the right – but not the obligation – to purchase an asset at an
agreed price in the future.
• Upfront payment: The buyer pays an initial deposit, which becomes
part of the final payment if the purchase proceeds. If the buyer
decides not to proceed, they forfeit the deposit.
• Purpose: Primarily used to manage price risks for volatile assets, such
as commodities.
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Islamic options (Urbun)

• How it works:
– Agreement: The bank and seller agree on a future purchase price for the asset.
– Deposit payment: The bank pays a non-refundable deposit, which will go
toward the final price if the transaction is completed.
– Exercise or forfeit: If market conditions are favorable, the bank completes the
purchase at the agreed price. If conditions are unfavorable, the bank forfeits the
deposit and avoids a larger loss.
• Advantages for Islamic banks:
– Offers price protection without violating Shariah principles.
– Allows the bank to decide based on market conditions, limiting risk to the
deposit amount if it chooses not to complete the transaction.

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Islamic options (Urbun)
• Scenario: A Qatari Islamic bank expects oil prices to rise and wants to lock in a favorable rate.
• Contract details:
– Price per barrel: $50
– Quantity: 10,000 barrels
– Deposit (Urbun): $2 per barrel (total deposit = $20,000)
– Total purchase price if completed: $500,000
• Possible outcomes:
1. If oil prices increase:
• Market Price Rises to $55: The bank buys oil at the agreed $50 rate.
• Total Savings: $5 per barrel, equating to $50,000.
• Final Payment Due: $480,000 (total price of $500,000 - $20,000 deposit).
2. If oil prices decrease:
• Market Price Falls to $48: The bank forfeits the $20,000 deposit and avoids buying at $50.
• Loss Mitigation: Loss is limited to the deposit, saving the bank from a less favorable purchase.
• Conclusion: Urbun helps Islamic banks manage price risk within Shariah guidelines, using
deposits to secure options without engaging in speculative activities.
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References

Akkizidis, I., & Khandelwal, S. (2008). Financial risk management for

Islamic banking and finance. Palgrave Macmillan.
Boot, A. (2000). Relationship Banking: What Do We Know? Journal of
Financial Intermediation, 9, 7–25.
Heffernan, S. (2005). Modern banking. John Wiley & Sons.
Salem, R.A. (2013). Risk Management for Islamic Banks. Edinburgh
University Press.

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