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THE RISKS PERTAINING TO MUDARABAH

There are few risks pertaining to mudarabah, such as:


A) Financial Risks
Financial risks are the exposures that result in a direct financial loss to the assets or the
liabilities of a bank. In the case of mudarabah investments, where the Islamic bank enters into
the mudarabah contract as Rabbul-mal (principal) with an external (agent), in addition to the
typical principal-agent problems, the Islamic bank is exposed to an enhanced financing risk on
the amounts advanced to the mudarib. The nature of the mudarabah contract is such that it does
not give the bank appropriate rights to monitor the mudarib (agent) or to participate in the
management of the project, which makes assessment and management of the financing risk
difficult. The bank is not in a position to know and decide how the activities of the mudarib
can be monitored accurately, especially if claims of losses are made. This risk is especially
present in markets where information asymmetry is high and there is low transparency in
financial disclosure by the mudarib.

B) Credit Risk

Credit Risk is the loss of income arising as a result of the counterpartys delay in payment on
time or in full as contractual agreed. In the case of profit-sharing modes of financing like
mudarabah the credit risk will be no-payment of the share of the bank by the entrepreneur
when it is due. The problem may arise for banks in these case because of the uneven
information problem where they do not have sufficient information on the actual profit of the
firm.

C) Equity Investment Risk

In applying mudarabah, Islamic financial institutions are exposed to equity investment risk in
profit and loss sharing investments on the assets side. Equity investment can lead to volatility
in the financial institutions earning due to liquidity, financing, and market risks associated
with equity holdings. There is financing risk in equity based assets and also considerable
financial risk of losing capital invested due to business losses. Mudarabah is profit sharing
contracts and are subject to loss capital despite proper monitoring. The degree of risk in equity
investments is relatively higher than in other investments and therefore, Islamic banks should
take extreme care in evaluating and selecting the projects, in order to minimize any potential
losses.
HOW ISLAMIC BANK REDUCE THESE RISKS?

The complex nature of risks faced by Islamic banks requires a comprehensive risk
management, risk reporting and risk control framework. Efficient risk management is essential
for reducing the overall risk exposure. Adequate resources need to be devoted to risk
identification and measurement as well as the development of risk management techniques.
The Islamic Financial Services Board (IFSB) has formulated a set of principles for sound risk
management. This set of principles should be followed by Islamic banks to mitigate various
risks they are exposed to.

Principles of Risk Management are :

i. Islamic Financial Institution shall have a sound process for executing all elements of
risk management, including risk identification, measurement, mitigation, monitoring,
reporting, and control.
ii. Islamic Financial Institution shall ensure an adequate system of controls with
appropriate checks and balances are in place.
iii. Islamic Financial Institution shall ensure the quality and timeliness of risk reporting
available to regulatory authorities.
iv. Islamic Financial Institution shall make appropriate and timely disclosure of
information.

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