Risk Management Framework in Islamic Banking: Basel II and III, Challenges and Implications in Islamic Banking

The time to fix the roof is when the sun is shining risk management has not been uppermost on the Islamic banking sector’s agenda in recent years. It is crucial for Islamic banks (IBs) to have comprehensive risk management framework as there is growing realization among IBs that sustainable growth critically depends on the development of a comprehensive risk management framework. Islamic banks should be dustingoff their ladders now. If Islamic banks are serious about playing a greater role in the financial system, they will need to get to grips with risks which may not currently be well understood or well managed. In this paper a frame work for Risk management in Islamic Banks will be discussed firstly, then generic risk associated with banks and unique risks exposed to Islamic Banks will be categorized. The contractual complexity of Islamic banking transactions which gives rise to awkward operational risks, and the uncertainties associated with Shari'ah compliance leave them exposed to a few risks including fiduciary and reputational risks which will be briefly reviewed in the paper. Although Basel II standards, do not account for the specific risks related to the nature of Islamic banks’ activities however the fundamental tenet of Islamic finance is that of fairness, and Islamic financial institutions at a most basic level are often structured towards fee-based revenues for services rendered and profit- and loss-sharing structures. Thus, in essence, Islamic financial institutions are closer in spirit to asset management companies than to conventional banking institutions, and the impact of their operations on the balance sheet is unique. These particularities highlight the unique characteristics of Islamic banks and raise serious concerns regarding the applicability of the Basel methodology to Islamic banks. Islamic banks’ activities differ in substance and in form from conventional banks’ operations and they thus face a different risk profile. Then the paper gets grips with Basel II accord and share challenges on adopting Basel II in Islamic Banks.JEL Classification: E5, E58, G32.