Research Proposal on An Evaluation: The Importance of Financial Risk Management to Islamic Banks
An Evaluation: The Importance of Financial Risk Management to Islamic Banks
The working title of the study is initially drafted as – An Evaluation: The Importance of Financial Risk Management to Islamic Banks. Basically, financial risk management refers to the practice of the creation of business value, making use of financial instruments. These financial instruments are used in managing exposure to risk including credit risk and market risk. Islamic banking, on the other hand, system is based on Sharia (Islamic law), mandating risk- and profit-sharing, prohibiting interests payments and emphasizing ethical investments for the greater good of the society.
2.0 Background of the Study
Beams (2005) noted that although the resilience of the global financial system prevails because of the continued improvement of the corporate, financial and household sectors in many countries, there are several malevolent conditions that could contribute to the downfall. This was made possible by the growth of complex financial instruments aimed at spreading risk and thereby increasing instability especially during market fluctuations. Not to mention, such instruments are dependent on quantitative mathematical models for value, assessment and pricing. Another thing, even though risk management had been strengthened and became more sophisticated, financial institutions are still heavily dependent on having ready access to liquidity during ‘market stresses’. Other danger area is the eagerness of banks and financial institutions to consider increasing risk in the search for greater profits even in the face of declining opportunities.
There had been a significant growth in Islamic financial services in the recent years, and is continuing to do so. The visibility of Islamic retail banking is manifested by the expansion of the array of services and products which conform to the basic principles of Sharia as well as the emergent of Islamic banks and asset managers in key global financial centers including the United Kingdom (UK) and the United States (US). In the speech made by Mr. Malcolm D. Knight, General Manager of the BIS, although Islamic banking is fundamentally different from ‘conventional banking’, there are principles that apply to both such as strong corporate governance, rigorous risk management and sound capital adequacy requirements.
It was discovered that the Islamic financial institutions are almost unaffected by global financial crisis and that effects are limited due to the nature of Islamic banking. Another reason is that the Islamic system distances itself from market speculation taking place in Europe and US. Islamic banks diverged from debt trading and are not participating in buying and selling of debt unlike its European and American bank counterparts; banks need not to depend on bonds and stocks. In addition, the immunity of Islamic banks lies on the precautions taken against money laundering and caution against embarking upon projects that have inherent financial difficulties and risks. Islamic banks have several alternatives also compared to conventional banks, demonstrating that Islamic banks are sound, functional and systematic alternative banking (Al-Hamzani 2008).
Basically, the Islamic financial system is not limited to banking but also involves risk transfer. Risk is shared in the sense that interest is prohibited hence suppliers of funds are becoming investors rather than creditors. Financial transactions are in the form of a symmetrical risk-return distribution wherein in each party to the transaction will face. Islamic banks as the financial intermediary thereby shares risk with the investors. How the latter manages these risks and challenges and take advantages of the opportunities based on the principles of Sharia is fundamental to this research.
3.0 Statement of the Problem
The rationale behind this research is while the Islamic banking is still a part of the global financial institution; it is inevitable that the Islamic financial institutions are affected by unique financial risks because of its unique financial structure, with certain degree and in direct manner as well. Islamic banking is more particular on who bears the financial risk. Among the types of risks, nonetheless, Islamic banks have financial risk issues of liquidity, interest rate risk and equity risk. How do the Islamic banks addresses these risks in the UK is not known. There is a need therefore to investigate how does the Islamic banks approaches sustainability and whether the financial risk management framework of Islamic banks is effective or not or how it can be improved. Finally, is there a difference or differences in operating an Islamic bank in the UK compared to Islamic banks on Islamic nations is also not known.
The key question to be answered in this research is: How important is for the Islamic banks in the UK is the management of financial risks effectively? In lieu with this, the research will seek to answer the following research questions:
1) What are the financial risks that are being experienced by Islamic banks in the UK?
2) To what extent do these financial risks would affect the operation of Islamic banks in the UK?
3) What are the challenges and problems in managing financial risks in Islamic banks in the UK?
4) Under what circumstances the effective financial risk management would be advantageous for the Islamic financial system?
5) What is the implications effective financial risk management among the Islamic financial institutions in the UK?
6) Is there a need to change or improve the current financial risk management structure as applied in the UK?
4.0 Objectives of the Study
The main purpose of this research is to analyze the importance of financial risk management among Islamic financial institutions in the UK. To accomplish this aim, the following specific objectives will be addressed:
§ To investigate the nature and dynamics of common financial risks among Islamic banks in the UK
§ To explore the manner by which Islamic banks are managing these financial risks
§ To recommend changes and/or improvements on Islamic bank’s financial risk management structure
5.0 Brief Literature Review
The Islamic financial system has a set of rules and laws as its basic framework, governing economic, social, political, and cultural aspects of Islamic communities. Such principles could be summarized as prohibition of interest, risk sharing, money as potential capital, prohibition of speculative behaviour, sanctity of contracts and Sharia-approved activities. Initially, the central tenet of the system is riba which literally means ‘an excess’ and interpreted as ‘any unjustifiable increase of capital whether in loans or sales.’ Iqbal (1997) noted that “any positive, fixed, predetermined rate tied to the maturity and the amount of principal is considered riba and is prohibited. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of "interest" as widely practiced.” Since interest is prohibited, suppliers of fund become investors and not creditors, thus sharing business risk in return for shares of the profits. Money becomes actual capital only when it joins hands with other resources to undertake a productive activity; Islam recognizes the time value of money. Moreover, hoarding and transactions that features extreme uncertainties, gambling, and risks are prohibited. Islam upholds contractual obligations and the disclosure of information as a sacred duty and that business activities that do not violate the rules of Sharia qualify for investment.
Iqbal (1997) also outlines the Islamic financial instruments: murabaha, ijara, mudaraba, mushakara and bay' mu'ajjal and bay'salam. The first one is trade with mark-up or cost-plus sale, the most widely used instrument for short-term financing. Leasing, or ijara, designed for financing vehicles, machinery, equipment, and aircraft. Profit sharing agreement or mudaraba is identical to an investment fund in which managers handle a pool of funds with maturity structure ranging from short to medium term and is more suitable for trade activities. Musharaka is classical joint venture where both entrepreneur and investor contribute to the capital of the operation in varying degrees and agree to share the returns. Deferred payment sale and deferred delivery sale are contracts used for conducting credit sales.
In the UK, on the other hand, Islamic financial products are provided in a number of High Street banks. The very first wholly Shari’a-compliant retail bank in the West is in UK known as the Islamic Bank of Britain. Principal Islamic banking products include commodity murabaha, ijara and murabaha. Islamic banking is recognised as an evidence of the diversity of UK’s financial landscape (FAS, 2009).
6.0 Overview of Methodology
The research philosophy adopted for this dissertation is interpretive epistemology which simply refers to the philosophical underpinning of the research. Interpretive epistemology has a basic assumption that knowledge can only be created and understood from the point of view of the individuals who live and work in a particular culture or organisation. Therefore, every individual acts in situation and makes sense of what is happening based on experiences of the situation and the expectations people bring into it. This means that there may be different understandings and interpretations of reality and interpretive epistemology leads to accessing meanings made by others and describe how they come to make those meanings (Hatch and Cunliffe, 2006, p, 14). The choice of this philosophy is important because it guides the research design, the research approach, choice of methods, analysis of the findings, and even the presentation.
Further, an instrumental case study approach would be used since this enables the researcher to make generalisations based on the findings although only one case study organisation will be considered. In an instrumental case study, the particular case is less important than the insight it can provide into a specific issue of theory. Thereby, the goal of this case study is to understand something more general than the case but nothing generalisable to other contexts (Colwell, 2006, p. 331). Denzin and Lincoln (2005), however, contend that the case, although it is of secondary interest, plays a supportive role and facilitates the understanding of important concepts. Investigating the case in-depth has a purpose of pursuing an external interest (p. 445).
The research will be exploratory because it aims to determine the present facts as well as facts that are not yet explored about the phenomenon (Saunders et al, 2003). Exploratory research will enable the study to look at the problem in both descriptive and exploratory manner. This approach is a preferred mean of finding out “what is happening to seek new insights” or “to ask questions or to assess phenomena in a new light” (Saunders et al, 2003; Robson, 2002). This study will use the principal ways of conducting exploratory research, which include: literature search; talking to experts about the subject; and conducting focus group interview.
Sources and Acquisition of Data
In this study, primary and secondary research will be both incorporated. The reason for this is to be able to provide adequate discussion for the readers that will help them understand more about the issue and the different variables that involve with it. The primary data for the study will be represented by the survey results that will be acquired from the respondents. Respondents of the survey will be the representatives of Islamic bank and may include employees in clerical, administrative and executive positions. A structured questionnaire will be developed and it will be used as the survey tool for the study. It is planned that the questionnaire will have a 5 point Likert Scale, as well as ranking questions. The researcher will survey representatives on their knowledge on financial risk management within their respective Islamic banks where they are working.
On the other hand, the literature reviews to be presented in the second chapter of the study will represent the secondary data of the study. The secondary sources of data will come from published articles from journals, theses and related studies, books, company reports and official statistics. Sometimes, secondary research is required in the preliminary stages of research to determine what is known already and what new data are required, or to inform research design. Acquiring secondary data are more convenient to use because they are already condensed and organized. Moreover, analysis and interpretation are done more easily. Internet databases will be also consulted including Questia, Highbeam and Emerald. Document analysis, nonetheless, will focus more on the annual reports of Islamic banks in the UK.
The data obtained will be analysed with descriptive statistics analysis using SPSS version 14.0. The data results of the study will be analyzed by determining their corresponding frequency, percentage and weighted mean. The following statistical formulas will be used:
1. Percentage – to determine the magnitude of the responses to the questionnaire.
% = -------- x 100 ; n – number of responses
N N – total number of respondents
2. Weighted Mean
f1x1 + f2x2 + f3x3 + f4x4 + f5x5
x = --------------------------------------------- ;
where: f – weight given to each response
x – number of responses
xt – total number of responses
Form of Presentation
The dissertation will be presented in written form with the addition of data charts which will present the project’s results. The first chapter of the study will present and discuss the problems and objectives of the study. The second chapter on the other hand will present the various related literatures that were reviewed for the study. Chapter 3, on the other hand, will discuss the methods and procedures that will be used in the study. Chapter 4 will present the results of the study in tables along with their specific interpretations. Finally, the fifth chapter will present the conclusion and discussion of the study. Further, some of the analysed data will be illustrating using pie charts and network charts but this may not be confirmed until survey data had been analysed.
Al-Hamzani, M 2008, Islamic Banks Unaffected by Global Financial Crisis, Asharq Alawsat – Arabic International Daily.
Beams, N 2005, Global financial system faces growing risks, World Socialist Website, International Committee of Fourth International (ICFI).
Colwell, R 2006, Handbook of Research Methodologies, Oxford University Press, US.
Crane, D B, Bodie, Z, Froot, K A, Mason, S P, Perold, A F and Merton, R C 1995, The Global Financial System: A Functional Perspective, Harvard Business Press, Boston, USA.
Cunningham, A 2007, ‘How Big is “Islamic Banking?’ Middle East Economic Survey, vol. 41.
Denzin, N K & Lincoln, Y S 2005, The SAGE handbook of qualitative research, Sage Publications Inc, UK.
Hatch, M J & Cunliffe, A L 2006, Organization Theory: Modern, Symbolic, and Postmodern Perspective, Oxford University Press, Oxford.
Iqbal, A 1997, Islamic Financial Systems, World Bank Publications.
Islamic Banking in the UK, Financial Services Authority (FAS), retrieved on 21 January 2010, from http://www.fsa.gov.uk/pages/About/Media/notes/bn016.shtml.
Malcolm, M D, 2007, The growing importance of Islamic finance in the global financial system, Speech at the 2nd Islamic Financial Services Board Forum, Frankfurt.