Regular and Islamic finances have since grown and more people are getting used to their services in the financial and mortgage sectors. Islamic finance has gained recognition in recent times with its first establishment being traced back in Egypt in 1963 when the first formal Islamic financial institution was established. Currently there are over 200 institutions dealing with Islamic finances with combined assets of more than 200 billion dollars in more than 50 countries in the world. The penetration of Islamic banking in the financial market has gained recognition considering the attention in the international arena where there are different participants competing with one another.
Islamic banking operates in four basic principles which are coined from the holy book of Quran, for instance, there is risk sharing between the parties involve, material finality linked to the transaction, no party is exploited and finally they do not finance sinful activities or investments which are prohibited by the Islamic holly book. Regular financial institutions have been in existence for longer time and operate under the principles of risk elimination. They pass the risks to their clients and enjoy the benefits with no cost sharing as in the case of Islamic. They are not obligated to any religious law and are regulated by the national financial regulatory authority of its country.
Both Islamic and regular financial sectors have defined various ways to keep up with the emerging risk and uncertainties that occur in the day to day running of the business including fluctuation of foreign exchange rates, credit and operational risk.
Risk management in regular finance
Risk management is very essential for any organization to realize its productivity and minimizes the chances of loses. Various scholars have come up with different definitions and what risk management entails, for instance, according to Financial Times Ltd (2011), risk management involves the process of identifying and controlling the risks that the business faces since its activities are uncertain and is associated with some risks. Organizations are oftenely faced with financial failures and other challenges which are overcome through risk management team set by the organization. It may be impossible for the organization to avoid all the risks they encounter in their day to day running of the organization, it is important for the stakeholders to fully understand and come up with ways on how to deal with risks that arises in the course of operation.
According to Tarantino & Cernauskas (2010, p.2), risk management is meant to identify and measure uncertainties before developing an action plan without necessarily eliminating it. They state that risk management entails measures used to minimize the impacts of risks which can not be entirely avoided in the organization. Organizations would be relying on lucks to avoid disasters if they do not incorporate risk management systems since they would be having no strategies in place to assist in risk management which would otherwise be avoided or minimized. Organizations with no risk management strategies are likely to attract less investment which results to lower productivity leading to organizational failure. This has been the trend which has forced many organizations to take actions against disasters which might disrupt their operations. Organizations with risk management are seen to be performing and gaining more stakeholders since they feel they are protected unlike other organizations.
Different organizations have come up with various techniques in minimizing the effects of risk that are associated with the running of business operations; they employ different strategies depending on the nature of the risk which are likely to be incurred. For instance, Swithson (2008, p. 173), argues that an organization may resort to the use of Currency Swap to transform the cash flow to another currency. Currency swap is a technique used by organizations to deal with the financial risk associated with the fluctuating currency exchange of different countries across the world. Organizations may decide to supply goods at a fixed rate of currency to minimize the effect of exchange rate which would affect its performance by spending more money in exchange rate. Currency swap is characterized by fixed values which are not affected by the exchange rate hence it shield organizations from the risk associated with the fluctuation of currencies.
Government’s entities and financial sectors are using derivatives as a measure to risk management. Derivative is used in financing different projects through diversified sources of funds and is aimed at saving by issuing structured securities. It is also employed to manage debts specifically in countries which borrow from different countries to minimize the impacts of currency exchange which may increase interest rate resulting to more debt accumulation (Smithson, 1998, p.137).
Financial institutions have been avoiding their exposure to places which are associated with the higher market risk as a technique in managing the risks. For instance, financial organizations reduces amount of its capital base which serves as a guarantor to its clients if they see the external market not promising as a result of adverse conditions. This will assist the organization in reducing the market risk by operating at a low level (Madura, 2008, p.543). Madura further explains that integrated management is essential technique in managing risk associated with liquidity, credit and interest rates.
Risk Management in Islamic Finance
Risk management in Islamic finance is related to the teachings of the Quran which has set the way on the management of the finances and how the risks are managed. The development of risk management strategies by a financial institution in a bid to control the devastating effects of such risks is indeed an important for ant financial institution. It is indeed paramount for an organization to understand the various possible risks that may befall it and then create viable strategies of curbing them (Ahmed & Khan, 2001). It includes identifying the risks and putting measures which would be used to curb and restore the organizational operations based on the Islamic teachings. Risk management in Islamic finance is unique in various ways regarding how it operates and the parties involved since it characterizes and borrows much from the Islamic teachings.
Risk management in the Islamic financial sector is an every day activity with the business success and failure determined by the ability to manage the risks associated with it. Islamic finance has its own structured ways and objectives making it not comply with the everyday practice of modern risk managements (Lqbal, 2009, p. 274). The basic underlying principle in Islamic finance is that they rely on the Islamic law that states that you can never make money out of money (Mahlknecht &Hassan, 2011, p 345). According to the Islamic teachings, one should accumulate his money or capital from the selling and buying of goods. Shariah laws agitates for selling and buying of individual assets to aid in getting money and does not recognize wealth or money which is generated from money like in the case of interest earning and paying to the financial sectors.
Islamic finances use various techniques in minimizing the risks, for instance, financial institutions have established huge capital base to avoid the use of investors capital or deposits in cases of loss. It is a common practice by investors to fly to safer grounds incases where the organizations are not performing to their expectation. Huge investment of the capital by the financial sector will ensure the organization manages the risks which might cause liquidity crisis leading to clients leaving the organization (Sundararajan & Errico, 2002, p 8). Islamic finance is associated with sharing the profits and loses between the involved parties depending on the market rate. The burden incurred is shared among the involved parties as per the teachings of the Quran.
According to Mohamed (2011,p. 44), Islamic finance has to deal with financial risks which are categorized as credit, market and liquidity. Market risks are avoided through disposing the client asset at a market value and using the advanced payment. Credit risks are managed through the selling of the client’s product since there will be no interest charged on the money borrowed to the client and failure to pay will lead to selling on the property with no additional interest charged on the client.
Similarity in performance between regular and Islamic finance
Both regular and Islamic finances have similarity in the way they operate since they are both financial institutions responsible for money circulation. They operate globally as financial institutions characterized by strong competition and technological changes in the global arena.
They have almost similar operating structure with different provisions in policies since Islamic finances are based and operate on the principles of sharia law. In both cases, there is a provision of guarantor by the client who will be responsible for payment should the client default (Usmani, 2002, p. 54). Regular banks demands for a guarantor in transactions where large amount of money are involved as a cautious remedy from incurring risk. This is also enforced to assist incases where the client fails to pay within the stipulated time frame hence gives them a chance to resort to the guarantor to pay on behalf of the client. Although the guarantor may be charged some interest incase the client fails to pay within the agreed duration depending with the regular bank, Islamic banks has no penalty for the guarantor as it seen as a form of interest which is prohibited. Both the Islamic and regular finances are financial intermediations. They acts as a middleman between the savers who are making the money flow through taking it to the financial institutions and the borrowers of the money from the financial institutions. Both perform the role of distributing the money in various individuals from the investors as well as keeping the money for the investors who wants to save (Pock 2009, pp 74). They both aim at maximizing their profits which is the ultimate goal only that it follows some principles. In Islamic banks, profits maximizations are restricted by shariah unlike in conventional where the guiding principles are state laws.
Differences in operations
Islamic finances operate under the principles of Islamic laws making it different from the conventional banks on the basis of cultural background and practices they operate under. They are operating in a unique spirit which is confined and has to conform with certain Islamic laws unlike the conventional finances which operates freely (Farhad, 2009, p. 37)
As regular institutions impose interest in aiding the recovery on their defaulters, Islamic finance does not. Interest (riba) is completely forbidden in Islamic finance based on the teachings of the Quran and at whatever level, the loss or gain will be shared with no party bearing the full burden or benefit from the outcome ( Thomas, Cox & Kraty, 2005, p.1). In regular finance, there is payment of interest rate either by the buyer or the seller depending on the agreement will leads to one party gaining at the expense of the other in contrary to Islamic finance (Broyles, 2003, p. 400). This is seen to be advantaging one party incase the interest rate rises above the initial when the contract was signed. Conventional banking strategize their operations by avoiding and eliminating risks in contrast to Islamic banks which bear the risks incase there is a transaction.
Conventional finances offer financial services by borrowing and lending including assets and liabilities which are in contrary to Islamic finances. Islamic finances operates in an elaborated manner through being innovative to satisfy their clients that’s why there are many Islamic modes like musharakah, murabaha among others to meet the clients demand and expectation. As both conventional and Islamic fiancés are concerned with managing risks factors from credit and market, Islamic has additional risks which is shariah. Islamic finance has to comply with the shariah law which limits its penetration and innovation compared to conventional finances. Conventional finances are freely in operation and are not compelled to such religious laws making it enjoy adverse freedom in its operations.
Conventional banks are involved in transactions with clients where they do not take risk and liability. They are often striving to benefit from their clients inform of imposing interest. Islamic banks on the other hand bear the liabilities and risks in any transaction with the consumer; this is in practice to the Islamic teachings which states that getting benefits without bearing liability is regarded as haram which is not allowed (Schoon, 2009, p.171).
Regular financial institutions does not discriminate on who to give the loan as an individual meets the basic requirements, Islamic institutions vets individuals whom they carry the transactions with and it does not finance sinful activities like production of alcoholism and drug use( Grais & El-hawary, 2010, p.3).
Risk management is an essential element in organizational performance and expansion to meet the competition in the financial sector. Both the Islamic and regular finance institutions must manage the risks which might rise as a result of infidelity and defaulting clients. The organization’s heads should channel and diversify their revenue sources to shield them from any risk that might originate from one source. They should invest huge capital in the financial sector to minimize liquidity that may arise forcing clients to move away and default the payment. More investments will also insure the organization against being placed under statutory management which would otherwise tint the organizational image.
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