Deeper look at risks and their mitigation in a Mudarabah transaction

In-Depth Analysis

In article 94, the author had explained the essential and prohibited risks to be considered by parties while contemplating to enter into an Islamic finance transaction. Is there a third category of risks? Yes, it is 'permissible risks.' These are those risks which do not fall in the two extremes — essential and prohibited — and therefore can either be taken or avoided. If such risks are opted to be undertaken, at times it becomes necessary to hedge against them by using Shariah-compliant mechanisms, modes, and contracts which can loosely be termed as Islamic derivatives. An example of permissible risk is the exposure to currency exchange fluctuations in trade transactions — either import- or export-based. Here, the trader can avail of the Islamic alternative to the conventional currency hedge or swap. Since Islamic financial institutions offer a wide variety of products and services to customers which are either based on a financing (sale) contract, an investment contract (which includes the Mudarabah contract — the subject of the current discussion), or a hybrid one, it becomes important to understand the clear line of distinction between Islamic finance and conventional lending in relation to risk management and mitigation techniques. Financing or sale contracts are those in which an institution transfers its ownership risk to its customer through a sale transaction by creating a debt payable by the customer in installments (for example in Murabahah), or acquires the ownership by paying the full purchase price of a commodity to be delivered to the institution on an agreed future date by the customer (as in Salam). In these transactions, the more relevant risk is the credit risk in Murabahah since the ownership to the goods sold stands transferred to the customer who in turn gets indebted to the institution. However, interestingly, if the Salam commodity received by the institution is sold by it on a deferred basis, the ownership and market risks get transformed into credit risk — from where the Salam transaction had started. Investment contracts are those where the institution forms a partnership either by investing through a customer (as in Mudarabah and investment agency or Wakalah) or with the customer (as in Musharakah or joint venture). In these transactions, the institution does not transfer the risk of ownership and there is no debt obligation on the customer, and therefore it continues to bear all the risks which an owner endures. Nonetheless, if the customer violates any of the investment contract terms, it ceases to be a trustee and at once becomes liable to fully compensate the institution. In such a situation, the equity risk shall transform into credit risk.