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The Islamic bank is a financial institution that is established and managed under the principles of Islamic syari'ah and is universal in its practices in improving welfare for mankind. Right now, the Islamic bank is growing and developing rapidly. Even so, as time passes, the risk and challenges faced by the Islamic bank will become more complex and extensive; thus, the future of the Islamic bank is highly reliant on its abilities to anticipate changes in the financial world; such as the effects of globalization, the chain reaction of effects that can take place when a crisis occurs, and the rapid development of information technology. The financial sector is also more dynamic, competitive, and complex; and often creates a new risk in the financial system, such as the too-connected-to-fail risk or the displaced commercial risk. In performing various financial functions and services, the Islamic bank will certainly face various risks, both financial as well as nonfinancial. The bank should be able to manage various risks faced well, without reducing or sacrificing performance, service quality, operational ease, or targets set by the bank's owners. If the bank is able to manage risk appropriately, then not only will the bank avoid the more obvious risks, but the Islamic bank can also change that risk into a business opportunity that can generate profit for the bank.

The rapid development of Islamic banks has been followed by other Islamic financial institutions, such as Islamic insurance, Islamic leasing companies, Islamic venture capital, Islamic capital market, Islamic money market, Islamic microfinance institutions, and the like. These institutions often interact with one another, both directly and indirectly. Interconnection occurs through financial institutions between them, both on the asset side (financing or fund placement in other institutions); while indirect interconnection occurs through indirect investment activities (or issuing securities) in the financial market. Other than the interconnection between financial institutions, the product and operating activities of the Islamic bank are also developing into more complex and sophisticated forms, making it necessary to develop risk management and analysis that is also more comprehensive.

Like the sides of a coin, the rate-of-return and risk will always be attached to each other in a business. Islam admits the presence of profit the same way it admits the presence of risk. In a fiqh principle, it is stated, “al ghunmu bil ghurmi” and “al kharaju bidh dhamani,” also known under the modern financial term of “risk-return trade-off.” The application of reliable risk management is just as important as the application of various business strategies to optimize rate-of-return. A bank's birth is similar to that of a baby with permanent and inconveniencing disabilities; the bank will always exist in a state of permanent mismatch liquidity, and bears the risk from it. Even if the Islamic bank is able to reduce and even eliminate its financial risks, such as default risk, market risk, operational risk, rate-of-return risk, investment risk, and various other nonfinancial risks such as reputation risk, syari'ah-compliance risk, strategic risk, and other business risk, the Islamic bank will still face liquidity risk. This means that the bank's failure in managing various risks, other than liquidity risk, will worsen the bank's already-present “flaw.” Under extreme conditions, the bank will be paralyzed and unable to perform its role as financial intermediary.

A well-designed risk management approach, accommodating the distinct products and operating activities of an Islamic bank and performed with utmost prudence, is the prerequisite of maintaining the existence of the Islamic bank as a highly competitive institution: prudent, profitable and able to generate loyalty in its customers. Apart from that, a well-managed risk will also ease the regulator in performing its duties in monitoring the Islamic bank's risks and ensuring the banking industry's health, both on a micro as well as macro level. This is in line with the authority of regulators in every country related to the supervision and management of the banking industry and ensures that prudential principles are followed in a bank's business activities. These activities include risk management, bank governance, and the principle of knowing your customer; prevention against money-laundering and terrorism and criminal enterprise financing; and bank checks. The application of comprehensive risk management in the Islamic bank is expected to be able to protect the banking industry and depositors from various possible aberrations that can occur, as well as mismanagement.

The coverage of risk is very wide and is as extensive as the business process run by the bank itself. In principle, risk is attached to every business activity. To understand the framework of risk management comprehensively and holistically, the Islamic bank's business processes will first need to be understood in detail: the innovation process and development of banking products, the creation of contracts and their different maturities, the methods the bank uses to place itself in the customer's perspective as well as its stakeholders, and so on. Various questions on the bank's existence and survival need to be asked and answered to build a reliable risk management system for the bank. Related to that issue, various existing literature tend to choose one of two approaches: The first approach explains the risk management framework from the approach of risk measurement. In the first approach, each risk has a distinct characteristic, philosophy, and trait. For that, we often find one book that specializes in discussing various methodologies, methods, and market risk measurements. Other books specialize in discussing the measurement of credit risk, while yet others cover operating risk and the like. The second approach is the book or literature that discusses how risk management is built in part as a system, as in the application of enterprise risk management (ERM). In this book, it usually explains how a bank or another institution integrates risk management into the entire element of the business unit. Risk management is not treated as a separate business function, but is integrated with vision, mission, planning, and performance measurement. Whether the bank's goals are achieved or not is not only determined by the fulfilment of the bank's return target, but also by the risk measure applied.

The two approaches require a basic understanding of an Islamic bank's business process and also of the characteristic, philosophy, and distinct trait of each risk faced. Up until now, we have yet to encounter a single book or literature that tries to clearly explain the two prerequisites. As such, we endeavor to analyze various business processes present in Islamic banking. We try to identify the existence of risk and its type, as well as understand the characteristics, philosophy, and distinct character of each risk. All these we have tried to write in this book. This book does not begin from a case study of any particular Islamic bank, but discusses the common traits of Islamic banking around the world. The approach that we use is a combination of regulation analysis, literature study and analysis of field practices on several Islamic banking institutions. Various findings and analyses of field practice are used as a basis to draw general conclusions on the character and practice of the Islamic banking industry.

This book consists of five parts. Part I is the introduction and consists of two chapters: Chapter 1 discusses the basic philosophy of the Islamic financial system, including the banks. Specifically, this chapter will discuss the characteristics of Islamic finance and the concept of usury that is prohibited in Islam. Chapter 2 will explain Islamic banks and risk management, various global institutions related with an Islamic bank's activities (e.g., the Islamic Financial Services Board [IFSB], the Basel Committee on Banking Supervision [BCBS], and the Accounting and Auditing Organization for Islamic Financial Institutions [AAOIFI]), as well as best practices of bank governance. The chapter also discusses the philosophy of risk management, especially related to the meaning and concept of risk, the understanding that risk is inseparable from the Islamic bank, the stages of risk management practices, the relevance of risk and rate-of-return, Islamic perspective on risk, risks faced by the Islamic bank, various approaches to recognizing risk and the benefits that can be reaped by the Islamic bank from good risk management.

Part II discusses the risk management framework in the Islamic bank. This part consists of three chapters: Chapter 3 discusses the history of risk management development in Islamic banks. It begins by discussing why the bank will need to be managed and supervised, why various regulations emerged, and why it is necessary to create an agreement on operating ground rules in the global financial system, then continues with discussions of Basel I, Basel II, and Basel III. The framework and coverage of these three frameworks are discussed to understand the reason for various amendments and revisions. Then, Chapter 3 specifically discusses Islamic bank accounting standards. This discussion is important considering various measurements, methods, and risk models are based on accounting systems and reporting. The end of Chapter 3 discusses the risk management framework in the IFSB as a community of global Islamic financial institutions, and various regulations that are specifically issued by Bank Indonesia as Indonesia's banking regulator. In Chapter 4, this book discusses the risk management process in an Islamic bank. Specifically, the chapter explains the philosophy that risk management is a continuous process, then enters the topic of risk management models in an Islamic bank along with the risk identification process, the development of the risk matrix, the risk mitigation process, and the risk review process. The final part of Chapter 4 will discuss various facilities and infrastructure necessary for the construction of a reliable risk management system. Chapter 5 covers the Islamic bank's financial statements and related analyses. In this chapter, we will explore the details related to the structure of financial statements (on balance sheet, income statement, off balance sheet, etc.), the philosophy of financial statement construction, the available financial statement analysis tools, and how to integrate financial statement analysis into the risk management framework.

Part III will specifically discuss the characteristic, profile, philosophy, coverage and distinct character of all the risks faced by the Islamic bank. Apart from that, there will also be an explanation of the identification process of “key risk factors” of the business process of each product and the bank's business activities, how the tools and policies of risk mitigation are constructed, and various issues related to those risks in the framework of developing the Islamic banking institution. This part consists of seven chapters. Chapter 6 discusses financing risk in an Islamic bank, including the function of the Islamic bank, the urgency of financing risk management in an Islamic bank, the Islamic bank's financing risk profile, the definition and scope of financing risk, the role of rahn (asset collateral) and kafalah (third party guarantee), and various other factors that determine financing risk. Afterward, the urgent need for an independent rating agency is also discussed, as are the role of financing risk provision, financing limit strategies based on risk profile, concentrated financing portfolio risks, the management of financing portfolios, and how to construct the best practice of financing risk management by optimizing the synergic relationship between interrelated institutions. Chapter 7 discusses the Islamic bank's operational risk; it covers the concept and definition of operational risk, the relation between operational risk and Islamic bank's business, the importance of building consciousness on the presence of risks when operating the business, the definition and scope of operational risk, identification of the various determining factors of operational risk, how to measure operational risk in an Islamic bank, and how to build a reliable operational risk management in an Islamic bank.

Chapter 8 discusses syari'ah-compliance risk. This risk needs to be covered in higher detail, considering many Islamic banks carry the mission of manifesting the principles of Islamic syari'ah in the Islamic bank's business practices. In this chapter, the basic principles of Islamic financial system and economy are discussed; the basic philosophy that syari'ah is the principle and spirit in business, as well as the various prohibitions in mu'amalah. Why the Islamic bank should be syari'ah-compliant in its business is also discussed, as well as the ways that syari'ah-compliance should be an integral part of policies and management processes at all levels of the Islamic bank, the urgency for the national syari'ah council and the existence of a syari'ah supervisory board in an Islamic bank, and the relationship between the syari'ah supervisory board and the syari'ah-compliance audit as part of a framework. The final part of this chapter discusses the syari'ah-compliance risk identification process and how to build risk management and mitigation for syari'ah-compliance in an Islamic bank.

Chapter 9 covers an Islamic bank's strategic risks. This chapter specifically discusses the concept of strategic risk for the Islamic bank, the scope and definition of strategic risk, the determinants of strategic risk, and how to mitigate it, as well as the issues relevant to strategic risk. Chapter 10 discusses investment risk in an Islamic bank. This chapter covers syirkah as a distinct characteristic of Islamic banks, the basic concept of investment risk, the forms of investment risk and its mitigation, as well as covering several issues related to investment risk in an Islamic bank, such as the basis of determining profit-sharing ratios, the policy of profit equalization reserve (PER), investment risk reserve (IRR), and investment risk (IR) support in reducing fraud and moral hazard in a profit-loss-sharing-based contract.

Chapter 11 discusses an Islamic bank's market risk. The beginning of the chapter will touch on the basic differences between the market risk of a conventional bank and those of an Islamic bank. Then, we will discuss the identification process and measurement of market risk in an Islamic bank, the mitigation method that is appropriate to the Islamic bank's character, and the application of risk mitigation methods in an Islamic bank. Chapter 12 discusses liquidity risk in an Islamic bank. This chapter specifically discuss the definition, basic concept, and philosophy of liquidity risk for a bank, as well as the definition and scope of liquidity risk, asset, and liability management in an Islamic bank. Last, liquidity risk management for Islamic banks will also be discussed.

Part IV discusses the potential and challenges of the Islamic bank in the future. This part consists of four chapters. Chapter 13 covers the development of the Islamic financial market, both from the institutional side as well as from the financial products traded. Chapter 14 discusses the development of pricing methods in the Islamic bank. It discusses the urgency for Islamic banks to develop their own pricing systems independent from a usurious reference rate, such as the market interest rate. Various approaches are discussed, such as the microeconomic of banking approach, the real sector's rate-of-return, the productivity-based pricing model, and the like. Specifically, we provide an illustration of pricing construction on a salam product; from this, the pricing method for other Islamic financial products can consequently be developed. Chapter 15 covers the pathways of risk management in an Islamic bank and various related issues, beginning from correcting any possible misapprehension on the Islamic bank, and how the Islamic bank itself is an actual implementation of risk management. The Islamic bank is an alternative and practical solution compared to the weakness of the current conventional financial system. After this, we will discuss sequentially the challenges faced by Islamic banking in Indonesia as well as the blueprint for Islamic banking. Other important issues are the potential for moral hazard and the lack of a global super-body institution, such as an international arbitrage and mediation institution for Islamic banks, an international syari'ah judicial institution, or a global regulator. This chapter also discusses the development potential of Islamic banks and their challenges, the strategic issues of risk management application in an Islamic bank, as well the form of Islamic banking risk management in the future. The pros and cons of syari'ah-based products and syari'ah-compliant products will be discussed, as well as the risks behind the usage of profit-loss-sharing scheme, the implications of mudharabah mutlaqah versus mudharabah muqayyadah, and how the Islamic bank answers the challenge of creating a syari'ah-compliant product. Then, Chapter 16 discusses the future agenda of Islamic bank's risk management development, the potential for synergy between Islamic financial institutions, the requirements and competencies that must be built and prepared for, and the direction of regulation in the future. To build Islamic banking risk management in the future, continuous development of the risk management system and an integrated risk management landscape development. Finally, Part V is the conclusion of this book.

Imam Wahyudi

Fenny Rosmanita

Muhammad Budi Prasetyo

Niken Iwani Surya Putri

Depok, March 2015