stability within the Islamic financial industry. IFSB concentrates on the establishment of risk management, capital adequacy, corporate governance, and transparency standards, as well as market discipline for Islamic financial institutions. IFSB was established in November 2002 and started operating in 2003; it is headquartered in Kuala Lumpur, Malaysia. IFSB is the result of a long and extensive consultative process that lasted more than two years between the governors and senior employees of central banks and monetary authorities of various countries, with support from IDB, the International Monetary Fund (IMF), and AAOIFI. The purpose of the formation of IFSB is to develop a new standard or adopt an existing one and give a recommendation on how to implement it; to provide an effective guide on effective governance and supervision; to establish cooperation between international standard-setting bodies with its member countries; to improve and coordinate the initiative in developing instruments and procedures; to develop instruments and procedures for the efficient management of risk and operations; to encourage cooperation between member countries; to facilitate capacity-building and the development of human capital; to research Islamic financial institutions, as well as publish the results of such studies and surveys; and to build a database of Islamic financial institutions and banking, as well as expertise in the industry.
Fatwa Committee in International and Domestic
The development of Islamic banking cannot be separated from the role of the fiqih-experts (ulama) in issuing fatwa or opinions with regards to products, procedures, and operations that are in accordance with the syari'ah principles. There are some differing schools in the application of Islamic syari'ah, and this may give the impression that some of the fatwas issued contradict each other. To address the problem, the Islamic Fiqh Academy was established on January 1981 in Jeddah, supported by the Organization of Islamic Cooperation (OIC) as an international conduit for countries with a Muslim majority. The Islamic Fiqh Academy published various guides on moral issues; included within those are medical ethics, socioeconomic issues, and problems like finance. In the economic field, this fatwa committee will publish rules (that are called fatwa) so that the product and the operations of an Islamic bank are in accordance with the principles of the Islamic syari'ah.
Other than on the international level, every country also possess a fatwa committee that is usually called the National Syari'ah Board. This national fatwa committee has a prerogative right in deciding on a syari'ah compliance issue or independent fatwa; the regulators do not intervene and leave to the market with regards to the how syari'ah-compliant as well as the integrity of the process. The National Syari'ah Board performs its duty assisted by the Syari'ah Supervisory Board. The main responsibility of the Syari'ah Supervisory Board is to study fatwa, to oversee banking activity, to ensure that the operation of Islamic banking is in accordance to syari'ah rules, to issue fatwa related to banking operations and financial transactions, and to ensure that the fatwa is binding for all of the Islamic banks that are its members. The other responsibility of the Syari'ah Supervisory Board is to assist the bank in determining which accounting policy to adopt, how to determine the profit-sharing ratio between the bank and the customer, how to determine the calculation and payment of zakat, and how to determine the income that is distributed and the cost (windows) that is charged.
Single versus Dual Banking System
The dual banking system is a set of systems, rules, and applications for the Islamic financial industry that run in parallel with those of conventional banking. There are several reasons why several countries apply a dual banking system through the use of Islamic banking windows. The first reason is about gradual implementation: It takes time to build a customer base, educate the public, change the regulatory environment, develop the capability of the human resources, and build adequate infrastructure. The second reason is related to efficiency. Acquiring the various prerequisites needed to develop Islamic banking requires not only time, but also cost. Using the shortest amount of time possible and the lowest cost, an Islamic banking window is far more profitable than establishing a full-fledged Islamic bank. By enacting an Islamic banking window, an established bank can ensure that the use of infrastructure and human resource allocation in its efforts are as optimal as possible and prevent avoidable duplication of resources. The third reason is effective development. The Islamic banking industry can instantly increase the number of players as well as fund-gathering capabilities, provide product variations, and increase the performance of Islamic banks along with the increase of competition in the industry. With the wide and well-established network of a parent conventional bank, the Islamic window can hitchhike the marketing network of the parent company and mimic the products of the parent bank that are already popular in the general public and can be adjusted to become syari'ah compliant. The fourth reason is the benefit of a well-established technology and system from the parent conventional bank, in the form of standard operating procedures, information systems, control and monitoring systems, as well as information related to the database of existing customers. The fifth reason is the possibility to capture the non-Muslim segment of the market as well as the floating customers.
Even if it is more practical to use an Islamic banking window, some countries prefer that Islamic banks do not develop from the Islamic windows of a conventional bank, but directly in the form of a full-fledged Islamic bank. This policy of course necessitates the consideration of several things. First, the new Islamic bank must ensure the syari'ah implementation of an its operations in all aspects, including the prevention of the intermixture of funds with the usury-based conventional bank and the prevention of conflicts of interest in management goals and organizational barriers. Second, for the regulator, it is easier to compare the performance between the two institutions, to regulate and ensure that the syari'ah requirements are fulfilled. Third, it preserves the essential idea and image of Islamic banking and to attract international investors, especially from the Middle East. Fourth, in the perspectives of an economic system, a full-fledged Islamic bank creates many new jobs as it proceeds to find people with the relevant, specific knowledge and competence to fill the ranks of its employees and management.
Risk as an Integral Part of Islamic Bank
Risk can be defined as the consequence of a choice that contains uncertainty, with the potential to generate an unwanted result or other negative consequence experienced by the decision maker. From that definition, risk has several dimensions: opportunity cost, potential loss, uncertainty, and receiving a result that is not as expected. Risk is also not related to the size of the cost that has to be borne by an individual or institution. In risk management terms, those expenses are expected loss or cost. The real sorts of risk are expenses that occur suddenly through unexpected ways, directly eroding the wealth that was previously accumulated. Both terms, expected and unexpected losses, are two important concepts that are often used in applying risk management, especially in relation with measuring every sort of risk. Most people are able to identify, estimate, calculate, and mitigate expected loss, but fail at anticipating unexpected loss. Events causing unexpected loss happen rarely, but once they happen, the magnitude of the negative effect is large and can cause a large loss. Rare events causing unexpected loss are usually considered unthinkable before they happen.
In many literatures, risk is often defined more precisely. For example, risk is the volatility of net cash flow of business (or department in the bank, loan portfolio, single debtor, or even the bank as a whole). With that definition, risk is often measured by standard deviation. If we apply this to the context of the cash flow of the bank, the higher the standard deviation of the bank's cash flow, then the wider the spread of the cash flow values from the bank's average cash flow. As a consequence, the bank will often face conditions where the cash flow is outside the average; it can be larger or smaller. Thus, the higher the standard deviation of the bank's cash flow, then the higher the degree of uncertainty of the bank's possible cash flow.
Risk: Imperfect Information, Uncertainty and Gharar
Risk begins from imperfect information in various decision-making aspects as well as their results: “Risk
