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Home » What are the unique risks in Islamic banking?

What are the unique risks in Islamic banking?

Islamic banking presents a distinct financial system governed by Sharia principles, which not only impacts its operational framework but also introduces unique risks. Unlike conventional banking, Islamic banking adheres to Islamic law (Sharia), which prohibits interest (riba) and promotes profit-sharing arrangements. This fundamental difference leads to unique risks that supervisors and practitioners must understand and manage effectively.

One of the primary risks in Islamic banking is asset price risk. Since Islamic banks engage in trade-based transactions, they often hold tangible assets as collateral. However, the value of these assets can fluctuate, exposing the bank to price volatility risk. Additionally, rate of return risk is a significant concern. Islamic banking products typically offer a predetermined rate of return, which may not align with market fluctuations, leading to potential income volatility for the bank and investors.

Another crucial risk is displaced commercial risk (DCR). DCR arises when Islamic banks substitute conventional products with Sharia-compliant alternatives. This transition can result in loss of customers and market share if the new products are not well-received or if they fail to compete effectively in the market. Furthermore, equity investment risk poses a challenge. Islamic banking emphasizes equity-based financing, exposing banks to risks associated with equity investments such as market fluctuations, business performance, and liquidity concerns.

In conclusion, Islamic banking introduces unique risks stemming from its adherence to Sharia principles. These risks include asset price risk, rate of return risk, displaced commercial risk, and equity investment risk. Supervisors and practitioners must comprehensively understand and manage these risks to ensure the stability and resilience of Islamic banking institutions in the global financial landscape.

(Response: Islamic banking introduces unique risks such as asset price risk, rate of return risk, displaced commercial risk, and equity investment risk.)