Risk Mitigation

      Once a particular risk is identified and measured, hopefully its actual occurrence can be minimized. Yet if the probability of it happening is significant, or if (despite its level of rarity) it could do a significant amount of harm, then it is still important to enact mitigation efforts to minimize the effects as much as possible. The risk mitigation strategies that can be chosen by the Islamic bank are different for differing types of risk. The Islamic bank needs to put in place various mitigation techniques that are appropriate for all the risks it faces. To add to this endeavor, unlike a conventional bank, an Islamic bank also has other limitations in risk mitigation techniques. The principle of syari'ah compliance should always be put first, even when mitigating risk.

      Risk and Return Trade-Off

      Profit can only have its lawfulness admitted if it is accompanied by risk, effort, and responsibility done. This principle is in line with the hadith “al ghunmu bil ghurmi” (profit accompanies risk) and “al-kharaju bidh-dhamani” (income is received by taking a responsibility). This principle is in line with the concept of risk-return trade off that is already known in finance. Each party involved in a transaction has the right to a certain level of return because of their willingness to bear the corresponding amount of risk. In other words, every risk received by parties in a transaction should also have the possibility of being compensated with adequate level of return.

      In the Islamic bank, the contract used can be grouped into two. The first group consists of contracts with a social purpose (tabarru') and contracts with a profit motive (tijari). The use of both types of contracts in a banking transaction generates a direct consequence to the application of the concept of risk and return. In a tabarru' contract, like a loan (qardh), the principle of risk-return trade-off cannot be applied, because it violates the principle of “al ghunmu bil ghurmi.” The capital owner in a loan contract (qardh) does not bear any risk from the loan given to the debtor. If the capital owner insists on charging the borrower with additional debt, then that addition is usury, making it into unlawful wealth. But what about the use of a sales contract (tijari') in which the client does not pay in a lump-sum payment, but in periodical installments? In that contract, the principle of risk-return trade-off is practiced when the murabahah contract is entered into. As a seller, the Islamic bank buys the object that becomes the transaction object from a supplier to then sell it again (with the agreed-upon margin) to the customer. The Islamic bank then faces the various risks associated with the ownership of that object. It is from the Islamic bank's willingness to bear the risk of owning the object that it gains the right to set the margin that is appropriate to compensate for that risk, and thus risk-return trade-off can be applied equally. But after the murabahah contract is over and is then continued with a loan contract (because the customer is unable to pay in cash), the size of the debt owed should refer to the exact amount in the murabahah contract, minus the down payment already paid beforehand. The Islamic bank is not allowed to request additional payment that can cause the total amount paid for the object to exceed the amount agreed upon in the murabahah contract.

      Various Approaches on Risk Identification

      The response of Islamic banks toward risk can be divided into several groups. The first is risk averse or risk avoidance. The bank tends to avoid transaction if the risk from that transaction cannot be compensated by an appropriate return. If the risk can be compensated by an appropriate return, then the bank will enter that transaction. The second is risk transfer. The bank transfers the risk of a transaction to a third party. This method is often used in the conventional insurance industry, where the insurance firm is willing to bear a certain amount of risk belonging to the insured. In the Islamic banking industry, this method is difficult to do because of the absence of institutions that can bear the financial risk and the difficulty in finding a form of contract that is in accordance with the Islamic syari'ah. The third is risk sharing. Unlike risk transfer, the risk in the risk sharing approach is borne together by all risk bearers. In the balance considerations of the Islamic syari'ah, this method is very plausible to use, even if it is not commonly in practice in the current banking industry. The bank can also divide and transfer risk by diversification, subcontracting, outsourcing, takaful, or entering into a musyarakah-based business. Once the bank has decided to accept risk, the bank should also decide on the scope of the risk, the tolerance limit, and the risk measurement used, as well as develop a reliable monitoring system.

      The Importance of Risk Management for an Islamic Bank

      The urgency in applying risk management in an Islamic bank is to minimize the effects and potential of risk occurrence. Because banks will certainly face risk, what is important is to consider how to minimize its occurrence and effects by managing risks properly. This is also not without its own set of benefits. The first is that, with good risk management, the Islamic bank is then capable of providing information and perspective to management about all risk profiles, about basic changes in products and services offered and changing market conditions, about changes in the business environment, as well as changes that are necessary in the risk management process that will later influence the bank's business decisions. Secondly, with risk management, sources of large problems can be tracked down, easing the formulation of risk management policy as well as how to review risk. Third, risk management also allows the Islamic bank to calculate and measure the size of the risk exposure faced. Fourth, with knowledge about risk exposure, the Islamic bank is expected to be able to determine the allocation of the sources of funds, as well as to measure risk limits more accurately. Fifth, with better risk management, the Islamic bank is able to avoid an overly concentrated investment portfolio. Sixth, without risk management, it will be difficult to estimate the amount of reserve necessary to anticipate the occurrence of the most probable risks according to the risk calculation and measurement that has been done. Seventh, by minimizing risks, the Islamic bank is able to avoid even larger potential losses.

      Other than the importance of risk management for the Islamic bank itself, other stakeholders also have some hopes and expectations on the bank's application of good risk management. The central bank or the related regulator overseeing the banking industry in each country of course expects all banks under its supervision to be prudent and healthy banks, able to generate a real contribution to the nation's economy. For the customers, the Islamic bank that is able to manage its risks well will be able to provide the optimum service as well as the best rate of return. The customer will trust the Islamic bank as an institution that is trustworthy (amanah) in managing the investment that they planted, and trust is the most important capital for a bank to have to guarantee its continued survival. For investors as stock owners, other than receiving a satisfying rate of return, they also require adequate information. This will be used as a basis to consider investments, and because of this, transparent information, including the bank's own transparency efforts and risk profile, is an absolute necessity for the Islamic bank. Stockholders also expect the Islamic bank as a place of investment will always be of going concern, has a stable profit as well as providing added value to society, one of which is blessings to society. For the business partners of the Islamic bank, like suppliers, providers, agency, and other parties, they expect that the Islamic bank in question will become a trustworthy bank, with a good image and reputation, and will enter into good and mutually beneficial cooperation.