in the Islamic bank's database system, then the resulting measurement is invalid. Seen from the procurement costs, building a database and information system that are related to risk management is expensive. But the benefits received from the availability of such a risk database and information system, built according to the bank's need and specification, are much more significant compared to the cost outlay.
Organization-Based Risk Mapping
Modern risk management practice divides risk into several types. The division is very useful for Islamic banks to differentiate one type of risk from another, enabling them to more accurately identify, measure, and mitigate those risks. Other than dividing risks according to their types, Islamic banks also need to map those various risks to their sources and to the roles of various units in risk management. By mapping the risks, the Islamic bank can more easily identify, measure, and control various available risks. Figure 2.3 shows a simple risk-mapping method (only covering several types of risks) based on their sources and the responsibility of each unit in risk management.
Figure 2.3 Risk Mapping Based on Business Line and Unit Function
The source of risk can be mapped based on the line of business owned by the Islamic bank – that is, commercial bank, investment bank, and banking activity in the financial market. All transaction activity entered by a commercial bank generates credit risk, liquidity risk, and rate-of-return risk. Credit risk came from transactions channeling loans and financing done by the Islamic bank, and liquidity risk came from the Islamic bank's activity in assisting in the liquidation process of a customer's savings. All the transactions done by an investment bank also generate credit risk, liquidity risk, and rate-of-return risk, but with a degree, form, and transaction that are different from commercial banks. With mapping, the Islamic bank can more easily control its entire risk exposure. The risk management manager can easily see which line of business has contributed the most to the total risk faced by the Islamic bank; which business line has exceeded the risk limits set to them and should therefore reduce their risk exposure; and which line of business should receive special priority under certain conditions.
Measuring and Reporting Risk
After identification, risk needs to be measured consistently and presented in an easily understandable form, not just for purposes of risk mitigation by the bank, but also because it is usually required by the regulator. To ensure that a bank is not threatened by bankruptcy, the bank's capital must be ascertained to be enough in amount to weather the various risks currently faced by the bank. In evaluating whether the bank's capital is enough or not, the regulator requires that the bank calculate the potential loss that will be borne if the risk actually manifested as a real problem. Calculating risk is necessary not merely to measure the current capital adequacy ratio, but also to determine the minimum amount of additional capital that needed to be raised to fulfil it. The risk measurement model plays an important role in the entire risk management process, because from the model of risk measurement, the risk and return position of the Islamic bank can be known. Information related to risk and return is an important issue to consider in formulating the framework and guidelines of risk management applied by the Islamic bank, where they will determine every transaction done by every unit of the Islamic bank. A mistake in determining the risk measurement model will lead to a fatal consequence to the application of risk management as a whole, because any mistake in the risk measurement model will lead to a mistake in the calculation of risk and return profile by the Islamic bank. The simple way to measure and report the risk faced is that the bank can construct and utilize the risk matrix as in Table 2.1.
Table 2.1 Constructing the Risk Matrix
Risk Mitigation
Once a particular risk is identified and measured, hopefully its actual occurrence can be minimized. Yet if the probability of it happening is significant, or if (despite its level of rarity) it could do a significant amount of harm, then it is still important to enact mitigation efforts to minimize the effects as much as possible. The risk mitigation strategies that can be chosen by the Islamic bank are different for differing types of risk. The Islamic bank needs to put in place various mitigation techniques that are appropriate for all the risks it faces. To add to this endeavor, unlike a conventional bank, an Islamic bank also has other limitations in risk mitigation techniques. The principle of syari'ah compliance should always be put first, even when mitigating risk.
Risk and Return Trade-Off
Profit can only have its lawfulness admitted if it is accompanied by risk, effort, and responsibility done. This principle is in line with the hadith “al ghunmu bil ghurmi” (profit accompanies risk) and “al-kharaju bidh-dhamani” (income is received by taking a responsibility). This principle is in line with the concept of risk-return trade off that is already known in finance. Each party involved in a transaction has the right to a certain level of return because of their willingness to bear the corresponding amount of risk. In other words, every risk received by parties in a transaction should also have the possibility of being compensated with adequate level of return.
In the Islamic bank, the contract used can be grouped into two. The first group consists of contracts with a social purpose (tabarru') and contracts with a profit motive (tijari). The use of both types of contracts in a banking transaction generates a direct consequence to the application of the concept of risk and return. In a tabarru' contract, like a loan (qardh), the principle of risk-return trade-off cannot be applied, because it violates the principle of “al ghunmu bil ghurmi.” The capital owner in a loan contract (qardh) does not bear any risk from the loan given to the debtor. If the capital owner insists on charging the borrower with additional debt, then that addition is usury, making it into unlawful wealth. But what about the use of a sales contract (tijari') in which the client does not pay in a lump-sum payment, but in periodical installments? In that contract, the principle of risk-return trade-off is practiced when the murabahah contract is entered into. As a seller, the Islamic bank buys the object that becomes the transaction object from a supplier to then sell it again (with the agreed-upon margin) to the customer. The Islamic bank then faces the various risks associated with the ownership of that object. It is from the Islamic bank's willingness to bear the risk of owning the object that it gains the right to set the margin that is appropriate to compensate for that risk, and thus risk-return trade-off can be applied equally. But after the murabahah contract is over and is then continued with a loan contract (because the customer is unable to pay in cash), the size of the debt owed should refer to the exact amount in the murabahah contract, minus the down payment already paid beforehand. The Islamic bank is not allowed to request additional payment that can cause the total amount paid for the object to exceed the amount agreed upon in the murabahah contract.
Various Approaches on Risk Identification
The response of Islamic banks toward risk can be divided into several groups. The first is risk averse or risk avoidance. The bank tends to avoid transaction if the risk from that transaction cannot be compensated by an appropriate return. If the risk can be compensated by an appropriate return, then the bank will enter that transaction. The second is risk transfer. The bank transfers the risk of a transaction to a third party. This method is often used in the conventional insurance industry, where the insurance firm is willing to bear a certain amount of risk belonging to the insured. In the Islamic banking industry, this method is difficult to do because of the absence of institutions that can bear the financial risk and the difficulty in finding a form of contract that is in accordance with the Islamic syari'ah. The third is risk sharing. Unlike risk transfer, the risk in the risk sharing approach is borne together by all risk bearers. In the balance considerations of the Islamic syari'ah, this method is very plausible to use, even if it is not
