Hedging Profit Rate Risk:
Navigating the Rough Seas With
Sharia Compliant Strategies

Balancing the Unique Risks

The foundation of Islamic banking lies in participation and not in simple financial intermediation. The range of risks may be considered greater in Islamic banking due to their participation as a partner, investor, buyer and seller, as compared to the status of lender in conventional banking. While they share major risks such as credit, market, operational, concentration and liquidity risks, Islamic banking also faces equity investment risk, margin risk, displaced commercial risk, rate of return risk and Shariah non-compliance risk.

Risk Management

Islamic banks use similar techniques as conventional banks in managing credit risk mitigation of the financing proposals, through techniques such as asset collateral, monitoring of project or asset activity and the diversification of credit exposure through various industry and sectorial limits. The management of market risk, and operational risk, is also similar in the two systems. While these major risk categories are dealt with in similar ways, there are unique risks to Islamic banking. These unique risks are as follows:

Margin Risk

The first of these is margin risk, the equivalent of interest rate risk in conventional banks. The Shariah system avoids interest-bearing transactions but works on Islamic financial instruments such as Murabahah contracts, which operate based on a mark-up. Murabahah is a deferred payment contract in which the customer buys an asset at a cost-plus profit margin. Adverse changes in the benchmark rate can create risk for Islamic firms and can lead to opportunity losses, due to a lower mark-up and vice-versa.

Equity Investment Risk

Equity investment risk arises because of a potential decrease in the fair value of the equity position held by the firm. A bank’s equity participation can range from direct investment in projects, or joint venture businesses, to indirect Shariah compliant investment, such as stocks.

Displaced Commercial Risk

A third risk is displaced commercial risk, which arises when owners are forced to pay returns to depositors even if the underlying assets don’t earn profits. This risk is managed by building reserves during good times and utilizing them in bad times[1].

[1] Qadeer Abdullah, M. (2015). Risk Management in Islamic Banking. Gulf News

Shariah Non-Compliance Risk

Finally, and perhaps most importantly, Shariah non-compliance is a major risk that can have a severe impact on both the earnings of an institution and the confidence of customers, depositors and shareholders. It can occur due to misinterpretation and incorrect implementation of approved transactions and procedures.

What is Profit Rate Risk?

Profit rate risk or rate of return risk is the risk that the Islamic financial institution (IFI) will incur a financial loss because of a mismatch in the profit rate on the IFI’s assets and unrestricted investment accounts. The rate of return risk arises because of unexpected changes in the market rate of return, which adversely affect the IFIs earnings. On the other hand, in a conventional financial institution, returns are fixed; both the firm and fund providers know in advance what their returns will be. But in an IFI, the rate of return risk stems from uncertainty in the returns earned by the Islamic financial institute on their assets. This uncertainty can cause a divergence from the expectations that investment account holders have on the liabilities side. The larger the divergence, the bigger is the rate of return risk.

A common product in the Islamic Finance industry is the profit rate swap. The International Islamic Financial Market (IIFM) and International Swaps and Derivatives Association, Inc. (ISDA) developed standardised documentation for the Profit Rate Swaps designed to be used with the ISDA/IIFM Tahawwut Master Agreement.

Mubadaltul Arbaah (profit rate swap) can be defined as an agreement to exchange profit rates between a Mu‘addal Ribh Thabit (fixed rate) party and a Mu‘addal Ribh Mutaghayyer (floating rate) party, or vice versa, implemented through the execution of a series of underlying Shariah compliant contracts.

Three types of the Mubadaltul Arbaah (profit rate swap) structures are in practice in the market as follows:

  1. Two sale structure
  2. Single sale structure
  3. Pure Murabahah structure

This paper analyses profit rate risk and the Shariah compliant structures to manage these risks

Man Balancing over rope