Chapter – 10 RISK MANAGEMENT IN ISLAMIC FINANCE __________________________________________________________________________ True/ False Questions 1. Risk is associated with uncertainty, speculation, and obscurity in business transactions. Answer: True 2. Generally, risk is limited to the business environment since business transactions are subject to generating profits and sustaining losses. Answer: False 3. Despite the fact that excessive risk is prohibited in Islam, Islamic finance links profits with risks. Answer: True 4. A number of the Islamic finance products are inherently prone to risks. Answer: True 5. Unlike their conventional counterparts, Islamic banks are protected from business risks. Answer: False 6. The risks faced by the Islamic banking industry are the same as the normal risks of the banking industry. Answer: False 7. In addition to the risks faced by conventional banks, Islamic banks also face risks associated with the compliance with the Sharī'ah in Islamic finance transactions. Answer: True 8. Only debt-based transactions in Islam finance are associated with risk. Answer: False 9. The criterion of legality of any return on capital investment is risk. Answer: True 10. The risk management measures being applied by Islamic Financial Institutions (IFIs) are either Sharī'ah-based or contemporary conventional measures. Answer: False 11. Aleatory transactions are transaction completely anticipated by the parties engaging in contracts such as games of chance or throw of a die. Answer: True 12. Avoiding risk with zero profit in business activities is not allowed in Islam because this is equivalent to interest (riba) from loans. Answer: False 13. Avoiding risk with positive profit is allowed in Islam because such profit is not equivalent to interest (riba) from loans. Answer: False 14. Islam holds an impartial attitude towards risk management as risk management is barely addressed in the Holy Qur’an and Sunnah. Answer: False 15. Both the Holy Qur’an and Noble Sunnah urge Muslims to effectively manage risks associated with their worldly activities. Answer: True 16. The Islamic banks and financial institutions have utilized the conventional risk management techniques prior to the development of Sharī'ah-oriented framework for risk management. Answer: True 17. The fiduciary duty Islamic financial institutions owe their customers requires them to exercise due diligence in the management of the investment funds. Answer: True 18. While crafting its guidelines, IFSB considered every technique or mechanism that originates from the conventional banking industry to be non-Sharī'ah compliant. Answer: False 19. The new IFSB guiding principles were meant to replace the existing framework of Basel Committee on Banking Supervision (BCBS) guidelines used in all the banks and financial institutions across the world. Answer: False 20. Once Islamic banks and financial institutions decide to lend or extend financing facilities, then they would have exposure to credit risk. Answer: True 21. Failure to repay the debt within the time stipulated in the contract and in line with the terms of the contract constitutes a liquidity risk for the bank. Answer: False 22. The potential default of a bank’s customer to meet his or her obligations on agreed terms constitute a credit risk for a bank. Answer: True 23. Counterparties are retailers/consumers, corporate, or sovereign clients of the bank who obtain credit facilities based on agreed terms and conditions. Answer: True 24. The creditworthiness of the counterparties as well as the Sharī'ah compliance of newly proposed business projects should be properly reviewed and established once the credit has been approved to respective party. Answer: False 25. Each Islamic financial instrument must have its unique Sharī’ah-compliant credit risk mitigating technique. Answer: True 26. Equity investment in unlisted companies refers to the acquisition of equity (or ownership) participation in a joint venture company or a start-up. Answer: True 27. Equity investment in listed companies is considered to be of higher risk than for venture capital investment. . Answer: False 28. The relationship between the IIFS and Investment Account Holders (IAH) is a fiduciary relationship. Answer: True 29. IFSB guiding principles on equity investment risk require the IIFS to define and establish the exit strategies in respect of their equity investment activities, subject to the approval of the institution’s Sharī'ah board. Answer: True 30. According to IFSB-1, market risk is defined as the risk of losses in on-balance sheet positions arising from movements in market prices. Answer: False 31. The fluctuations in foreign exchange rates lead to market risk. Answer: True 32. Foreign exchange rate risk is the risk arising from the changes experienced in the currency exchange rates. Answer: True 33. Liquidity risk involves a kind of systemic failure on the part of the financial institution where it fails to meet expected and unexpected cash flow needs as they emerge from time to time. Answer: True 34. Just like the current account holders, the IAH have a share in the profits of the business of IIFS as investors. Answer: False 35. The current account holders do not participate in the sharing of profits realized in investment activities. Answer: True 36. The IIFS are under no obligation to maintain adequate liquidity at all times to meet all their obligations. Answer: False 37. Although Board of Directors (BOD) plays a vital role in a corporate entity, its role is very limited especially when it comes to the challenges of liquidity risk. Answer: False 38.The IIFS are discouraged from using balance sheet techniques to minimize exposure to risks. Answer: False 39.Rate of return risk management entails that necessary steps must be taken to mitigate any mismatch between the assets and balances from the funds of the investors. Answer: True 40. Operational risk can be defined as a risk that arises from the execution of the business functions of an Islamic bank. Answer: True 41. It is unlikely that operational risk leads to withdrawal of funds by the fund providers and ultimate closure of accounts costing Islamic banks substantial losses in tangible and intangible terms. Answer: False 42. Operational risk includes risk arising from non-compliance with the Sharī'ah requirements. Answer: True 43. The risk management techniques or systems for Islamic banks and financial institutions are meant to mitigate, transfer, avoid, or absorb the risk in particular business undertaking. Answer: True 44. Any measure undertaken to reduce the effect of any form of risk will be regarded as risk management or risk mitigation techniques. Answer: True 45. Gap analysis is a tool that helps companies to compare actual performance with potential performance. Answer: True 46. Risk-adjusted return on capital (RAROC), and gap analysis are standard Sharī'ahcompliant techniques used for risk identification and management for Islamic banks and financial institutions. Answer: True 47. Gap analysis is also called need-gap analysis, needs analysis, and needs assessment. Answer: True 48. Risk-adjusted return on capital (RAROC) is meant to give decision-makers the ability to compare the returns from different projects with varying risk levels. Answer: True 49. Risks that cannot be eliminated nor transferred in the business of an Islamic bank must be ignored by the financial institution. Answer: False 50. In Islamic finance, “entitlement to return is related to the liability of risk”. Answer: True 51. Any futures, forwards, swaps, or options contracts involving market speculations are not Sharī'ah compliant. Answer: True 52. Market speculators are allowed to deliberately expose themselves to risk in order to gain profit from currency fluctuations. Answer: False 53. Hedging is applicable in all cases regardless of the purpose being to maximize profit or to protect against loss of value as a result of various factors such as currency fluctuation in the transaction involving an underlying real asset. Answer: False Multiple Choices Questions 1. a) b) c) d) The most common risks faced by the banking industry include: credit risk equity investment risk market risk all of the above 2. The followings are some of the most common risks associated with the banking industry EXCEPT: a) liquidity risk b) job security risk c) rate of return risk d) operational risk 3. meaning entitlement to the return of an asset is associated with the risk resulting from its possession. a) al-ghunm bi al-ghurm b) al-kharaj bi al-daman c) sadd al-dhari’ah d) aleatory transactions 4. The Islamic Financial Services Board (IFSB) issued the Guiding Principles of Risk Management for Institutions which: a) offers both conventional and Islamic financial services (other than Insurance Institutions) b) offers only Insurance Services c) offers only Islamic Financial Services (other than Insurance Institutions) d) offers only retakaful services 5. The new IFSB guiding principles were meant to: a) replace the existing framework of Basel Committee on Banking Supervision (BCBS) guidelines used in all the banks and financial institutions across the world. b) complement the existing framework of Basel Committee on Banking Supervision (BCBS) guidelines used in all the banks and financial institutions across the world. c) specifically cater for the needs and unique nature of institutions offering Islamic financial services d) b and c 6. The non-financial risks that Islamic banks are exposed to include: a) operational risk b) legal or Sharī'ah risk c) reputation risk d) all of the above 7. __________________is a type of banking risk that relates to the repayment of a debt at the appointed time in accordance with the terms of such debt loan a) credit risk b) market risk c) displace commercial risk, d) operational risk 8. Which of the following risks is considered to be the most important type of risks faced by banks and financial institutions in their relationship with the owners of wealth due to the frequent defaults on payments? a) liquidity risk b) regulatory risk c) credit risk d) displace commercial risk 9. According to IFSB-1, the proposed framework of credit risk for IIFS should include an effective and practical system to: a) monitor the condition of ongoing individual credits b) manage problem credit situations according to an established remedial process c) ensure that adequate provisions are allocated. d) all of the above 10. The risk involved in the most popular Islamic finance instruments Mudarabah and Musharakah is known as equity investment risk since a) mudarabah and Musharakah are equity-based products b) mudarabah and Musharakah are based-on joint venture through the partnership of capital provider and the entrepreneur c) both parties of the contract undertake to share the business risk, such as losses d) all of the above 11._____________________are the bank’s customers who opt for the investment account of the Islamic bank, which yields legitimate returns of predetermined share of profits a) Investment Account Holders (IAH) b) entrepreneurs c) financial experts d) special Account Holders (SAH) 12.The IFSB guiding principles on equity investment risk management stipulate that IIFS shall a) ensure that their profit sharing methods are appropriate and consistent, b) have in place appropriate strategies for risk management and adequate reporting processes. c) define the fiduciary relationship between the contracting parties. d) all of the above e) none of the above 13. a) b) c) d) __________________ is also known as systematic risk credit risk liquidity market risk operational risk 14. In some cases, market risk in a lease contract may arise from the: a) default of payment on the part of the lessee due to price variation b) default on the asset delivery by the bank/lessor c) termination of the lease by the lessee earlier than the contractual term either through default in payment or due to some other factors d) All of the above 15.__________________ is a commodity sale involving an advance payment where the delivery of the commodity is deferred. a) Ijarah contract b) murabahah contract c) salam contract d) restricted investment contract 16. Changes in exchange rates affect: a) the value of investment by the IIFS b) IIFS that engage in export and import business activities c) IIFS that engage in international investments d) all of the above 17.Liquidity risk can be caused by: a) unanticipated change in cost capital b) abnormal behavior of financial markets c) risk activation by secondary sources d) all of the above 18.The major funds directly managed by the IIFS include: a) current account holders b) unrestricted Investment Account Holders (IAH) c) both of the above d) none of the above 19.Apart from general withdrawal needs, the withdrawals made by IAH may be the result of a) lower than expected or acceptable rates of return b) concerns about the financial condition of the IIFS c) non-compliance by the IIFS with Sharī`ah rules and principles d) all of the above e) none of the above 20. In their pursuit to retain their fund providers in order to avoid insolvency and an ultimate liquidation, IIFS might: a) guarantee fund providers a healthy return on their investments. b) waive some of their rights by giving up their share of profits in the mudarabah arrangement with the IAH c) involve fund providers in the assets management d) all of the above 21. _______________________is the amount appropriated by IIFS out of income of IAH, after allocating the Muḍārib share, in order to soften the effects of the risk of future investment losses on IAH a) displaced commercial risk (DCR) b) a Profit Equalization Reserve (PER) c) an Investment Risk Reserve (IRR) d) profit Rate Swap (PRS). 22. Operational risks can arise from: a) strict compliance with the Sharī'ah requirements b) failures in the internal controls of a financial institution involving processes, people and systems c) abnormal behavior of financial markets. d) the fluctuations in foreign exchange 23. Failure of financial institution to uphold the fiduciary relationship with its customers may result in: a) loss of investments b) an overall balance sheet exposures c) inability of IIFS to meet their obligations d) none of the above 24.________________is the potential that counterparty fails to meet its obligations in accordance with agreed terms. a) liquidity risk b) rate of return risk c) market risk d) credit risk 25. Risk mitigation generally includes the followings EXCEPT: a) risk avoidance / elimination b) risk bearing c) risk absorption / management d) risk Transfer 26._________________ is a tool that helps companies to compare actual performance with potential performance. a) SWOT analysis b) quantitative analysis c) gap analysis d) risk analysis 27. Risk avoidance or elimination techniques in Islamic banks include: a) measures that promote risk sharing start from the contractual stage; most contractual terms in Islamic commercial transactions were legislated to share risks b) all business-related documents must be standardized in line with the requirements of the Sharī'ah and endorsed by the Sharī'ah Board of an Islamic bank. c) all processes, procedures and services rendered by the financial institution should also be subject to the approval of the Board of Directors of an Islamic bank. d) all of the above 28. In order to effectively absorb or manage various types of risk, the financial institution should adopt the following techniques: a) collateral (security against credit risk) b) guarantees (supplements collateral to avoid absorb credit risk) c) loan loss reserves d) all of the above 29.Risk transfer involves: a) the use of derivatives for hedging b) changing borrowing terms and selling or buying of financial claims c) excluding all elements of uncertainties (gharar) and interest (riba) from the contract d) a and b 30. The Sharī'ah-compliant risk transfer mitigation techniques developed by experts in the Islamic finance industry include: a) swaps such as debt-asset swap, swap of liabilities, deposit swap. b) options include parallel contracts, such as bay al-arbun c) futures include salam and commodity d) all of the above 31. Derivatives are: a) financial instruments or securities whose value depend upon or derived from one or more underlying assets, or from the value of a rate or index of asset value. b) proactive business positions intended to reduce the impact of potential loss that may be incurred by a companion investment. c) contingency plans in order to effectively mitigate instances of liquidity risk. d) none of the above 32. The Islamic perspective on hedging is that: a) hedging can be modified to suit the requirements of the Sharī'ah b) hedging is applicable in all cases regardless of the purpose being to maximize profit or to reduce risk and protect investments c) any futures, forwards, swaps or options contracts are Sharī'ah compliant d) all of the above