knowing what you are doing.” This information imperfection will bring about uncertainty. There is always a degree of uncertainty in living in the world, as no one knows for certain what will happen tomorrow. There are no guarantees that our efforts (ikhtiar) will always bring us profit. Before any event happens, what exists is mere uncertainty. With this understanding, then, these words are very true: “Risk is Allah Ta'ala's fate, and only Allah Ta'ala knows what will happen tomorrow.” Each person need to realize that risk and the uncertainty feeding it are part of Allah Ta'ala's secret. Perfect information is not achievable for any mortal and belongs only to Allah Ta'ala.
In Islam, the closest term to this condition of imperfect information is gharar. The condition of imperfect information can emerge naturally without any actual intention from the parties in the transaction. This is the definition of gharar. If there is an intentional element causing the uncertainty from one or more of the parties manipulating information or hiding it, then this is called fraud (tadlis). Islam prohibits the presence of gharar and tadlis in a transaction.
Natural risk refers to gharar that is minor, easily ignorable, and still attached to the contract, even after one try to alleviate it, and further efforts to alleviate it will only bring a greater cost than the possible cost of leaving the gharar in the contract. But if the gharar itself is major and can be alleviated, and yet is left in a contract on purpose, then this falls into synthetic risk. Synthetic risk happens when various principles and terms of making a contract according to syari'ah are not fulfilled. As such, this definition of risk is closer to syari'ah compliance risk.
Risks Faced by an Islamic Bank
The Islamic bank is a financial institution receiving profit from its successes in bridging different liquidity and risk profiles within the public and between parties with surplus funds and deficit in funds, while converting risk into return. The risk that is faced by the Islamic bank is varied and complex, as are the innovations in the financial and banking products that they offer to the public.
Credit Risk
Terminologically, it is more appropriate to use the term credit risk in a conventional bank. The term credit risk is generally used for interest-bearing loans. The more accurate terminology in Islamic banks is financing risk, because it covers the risk in various other forms of financing contracts, like interest-free loan (qardh), sale-based contract (salam, murabahah, istishna'), and lease-based contract (ijarah). Traditionally, what is meant by credit risk is the risk that emerges because of the failure of the customer or other parties to fulfill their liabilities to the Islamic bank according to what is already contracted. This failure in payment/default can be caused by two things: the inability to pay, or the unwillingness to pay the defaulted loan. In various risk management literature, this risk is also called default risk, financing risk, rating downgrade risk, and contract completion risk.
Market Risk
Market risk is the risk that occurs from adverse market movement, for example, in the stock price and sukuk price, commodity price, and foreign exchange value of the various assets held in a portfolio by the Islamic bank; this can of course, cause actual loss. This risk only occurs when the bank holds the asset, but not to be owned or held until its maturity period is up, but to resell at some time in the future. Generally, the coverage of market risk included exchange rate risk, commodity price risk, and equity price risk as well as benchmark rate risk.
Liquidity Risk
Liquidity risk is the risk that emerges from the Islamic bank's potential inability to fulfill obligations that have reached their maturity date. This risk occurs as a consequence of the temporal mismatch among the sources of the bank's funds, the third-party funds, and the financing contract to the bank's various debtors, especially if the financing done by the bank often defaults or experiences returns that are less than what is initially expected. Often the main trigger of bankruptcy experienced by banks, both large and small, isn't from the losses they experienced, but due to the inability of the banks to fulfill their liquidity shortage.
Operational Risk
Operational risk is the risk of loss that is generated by inadequate internal control systems, the failure of internal processes, human error, system failure, and/or the possibility of some external events that can disturb the bank's operations. An Islamic bank can also fail to follow the rules and principles of Islamic syari'ah, and this falls under the category of compliance risk. Business risk is often included in the category of operational risk. Counterparty risk embedded in financing risk where the involvement of every party – the Islamic bank itself, buyers, renters, business partners, suppliers, and the like – can also cause operational risk.
Legal Risk
Legal risks occur from the possibility of a lawsuit and/or a weakness in the judicial aspects of some of the bank's operations. Some experts place legal risk in operational risk because lawsuits usually accompany failure or weakness in a written contract. Some of the ways this risk can manifest, among others, are through a filed lawsuit and the absence of laws and regulations particular to the contract, or any weakness in the contract, like the failure to fulfill the validity requirements of a contract, or imperfect binding of the collateral.
Reputational Risk
Reputational risk occurs when the trust of the stakeholders in Islamic banks is reduced, which is caused by a negative perception toward Islamic banking. This risk occurs, among others, because of media coverage and/or rumors about Islamic banking that are negative in nature, along with Islamic banks' ineffective communication strategy. Negative publication toward one Islamic bank has the potential to smear the reputations of other Islamic banks, even if they aren't involved in the stated incident or action, just by dint of association.
Strategic Risk
Strategic risk happens due to an Islamic bank's inaccuracy in making and/or executing a strategic decision, as well as the Islamic bank's failure to anticipate changes in the business environment, both internal and external. This risk emerges, among others, because the Islamic bank applied a strategy that does not align enough with the vision and mission of the Islamic bank, the Islamic bank did not complete a comprehensive strategic environment analysis, and/or there is a strategic plan mismatch between strategic levels. Other than that, strategic risk can also occur because of the Islamic bank's failure to anticipate the changing business environment, such as technological changes, changes in macroeconomic conditions, dynamics of market competition, and policy changes of related authorities.
Compliance Risk
This risk occurs when the Islamic bank does not obey and/or does not comply with the rules and regulations that are in effect and with the principle of Islamic syari'ah that is manifested in the form of the syari'ah board's fatwa. In addition to fulfilling all the regulations and rules that are in effect, like a conventional bank, an Islamic bank should fulfill the principles of Islamic syari'ah in their business activity. The Islamic bank should purely operate based on Islamic syari'ah.
Rate of Return Risk
Rate of return risk occurs due to changes in the rate of return paid by the Islamic bank toward its customers, which affect customer behavior. When placing their funds in an Islamic bank, the customer has expectations on the rate of return that he or she wishes to attain. The dispersion from expectation can be caused by internal factors, like a depreciation of the bank's assets, a decrease in the bank's profit–loss share from debtors, or an increase in defaulting debtors, as well as external factors, like the increase in the rate of return offered by other Islamic banks, the increase in interest rate in conventional
