This document discusses rate of return risk in Islamic finance. It defines rate of return risk as the potential impact of changes in market rates of return on an Islamic bank's net income or equity value. Rate of return risk exists for Islamic banks because they use conventional interest rates as benchmarks, exposing them mismatch risk between asset and liability rates. The document outlines various techniques Islamic banks can use to manage this risk, such as diversifying assets, securitization, and off-balance sheet hedging methods. Managing rate of return risk is important for Islamic bank profitability and competitiveness.

1. RISK MANAGEMENT
IN
ISLAMIC FINANCE
Mahyuddin Khalid

2. Rate of Return Risk
Content
Definition rate of return risk
Identification of rate of return risk in Islamic
Bank
Type of risk in rate of return risk
Differentiation between rate of return risk
and the interest
Rules to help Islamic Bank to manage the rate
of return risk
Implication rate of return risk in Islamic Bank
Risk mitigation techniques of rate of return
risk
Learning Outcome
• To explain definition and feature
of Rate of Return Risk
• To state Rate of Return Risk and
their contract
• To explain ways to manage Rate
of Return Risk in contract
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3. Introduction
Islamic Banks use the conventional benchmark rate to
mark-up their financial instruments, in absence of an
Islamic benchmark.
As a result of using market interest as a benchmark to
determine the rate of return on deposit and also the
financing rate, Islamic Banks are exposed to the problem of
Rate of Return Risk.
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4. Return is the profit or income generated by savings and
investing.
Total Return on investment expressed as a percentage of
the amount of money invested.(Total return divided by
amount of money invested will get rate of return risk)
Fundamental Relationship between Risk and Return
 The greater the risk, the greater the expected return
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5. Definition
Refers to the potential impact on an Islamic Financial
Institution’s (IFI) net income/net income margin or market
value of equity arising from changes in the market rate of
returns.
According to IFSB, rate of return risk is uncertainty in
returns earned by Islamic Banks on their assets.
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6. Rate of Return Risk in Islamic Banks
This risk is associated with overall balance sheet exposures
where mismatches arise between the assets and liabilities
of Islamic financial institutions.
Revenue and expenses are generally accounted for an
accrual basis when deriving the exposure and the Islamic
financial institutions are exposed to the expectation of IAH
when allocating their profits.
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7. Identification
The operations of Islamic banks are riskier and less
profitable than conventional banks.
 This is due to the special nature of investment deposits in Islamic
banks whereby their capital value and rate of return are not
guaranteed.
Rate of return risk is present to a certain extent
 It is because in practice, they actually use the market interest
rates as a benchmark in pricing their products.
It is from uncertainty in return earned by Islamic Bank on
their assets.
 This uncertainty can cause a divergence from expectations that
investment account holders have on liabilities side.
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8. Alludes to the potential effect on an Islamic Financial
Institution's (IFI) net wage/net pay edge or market
estimation of value emerging from changes in the market
rate of profits :
 Gap/ Mismatch risk
 Re-pricing risk
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9. 1.Gap/ Mismatch Risk
Mismatch risk designates the gap between maturities and
interest rate reset dates of assets and liabilities.
Banks tend to lend medium or long-term while securing
financing in the short end of the market.
Mismatch risk is not specific to banks.
Many financial entities and vehicles, such as securitization
vehicles, tap liquidity in the short-term market while asset
maturity is much longer.
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10. 2. Re-pricing Risk
Arises from timing differences in maturity (for fixed rate)
and repricing (for floating rate) of bank assets, liabilities
and off balance sheet positions.
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11. Differentiate Between The Rate-Of-Return Risk and
The Interest
 Since conventional banks operate on interest-based, fixed
income securities on the assets side, there is less uncertainty in
the rate of return earned on investments held until maturity.
Since Islamic banks have a mix of markup-based and equity-
based investments, this uncertainty is higher.
 The return on deposits in conventional banks is predetermined;
in contrast, the return on deposits in Islamic banks is
anticipated, but not agreed beforehand. In addition, the return
on some investments that based on equity partnerships are not
known accurately until the end of the investment period. Islamic
banks have to wait for the results of their investment to
determine the level of return that investors-depositors will earn.
If, during this period, the prevailing yields or expected rates of
return change, the investors may expect to receive similar yields
from the bank.
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12. Islamic Banks Managing The Rate Of Return
Risk
Placing an appropriate systems for identifying and
measuring the factors which give rise to rate of return risk.
Gapping method as Islamic banks should employ the
gapping method when calculating a rate of return for
allocating positions into time bands with remaining
maturities or re pricing dates, whichever is earlier.
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13. Cash flow forecasting for instruments and contracts where
Islamic banks are required to simulate and assess their
behavioural maturity, underlying assumptions and
parameters, which must be reviewed periodically for
reliability.
Islamic banks are encouraged to employ balance sheet
techniques to minimize their exposures using the following
strategies, among others:
 Determining and varying future profit ratios according to
expectations of market conditions.
 Developing new Shariah-compliant instruments; and
 Issuing securitization tranches of Shariah permissible assets
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14. Implication
 Islamic banks may not be able to pay competitive rate of return
as compared to their peers and other competitors
 the depositor will have the incentive to seek withdrawal and to prevent
the withdrawal, the bank will need apportion part of their share of
profits to the depositors.
 The practice of forgoing part of all of shareholders profits may
be adversely effect the bank capital
 this may significantly affect their profitability and competiveness as well
as increase their vulnerability to external stocks.
 Some of profit-sharing investment account holders’ asset
(PSIA) risk are absorb by shareholder
 the DCR is potentially an efficient and value‐creating means of sharing
risks between two classes of investor with different risk diversification
capabilities and preferences.
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15. Risk Mitigation Techniques
 Islamic Banks should diversify into equity financing
 The flexibility on the asset side, where the Return on assets(ROA) can
be altered according to prevailing market interest rate, can make
Islamic banks more responsive to the changes in the market interest
rate.
 Through securitization
 Which allows banks to manage their risk exposures, while at the same
time allowing banks to be more aggressive in risk taking which involves
devoting a higher portion of their assets to more risky activities such as
bank lending and derivatives.
 The off‐balance‐sheet and on‐balance‐sheet techniques
 Using the off‐balance‐sheet techniques, banks can hedge the RORR by
using derivatives like interest rate future contracts and forward rate
agreements.
 Using on‐balance‐sheet techniques, banks can use floating rate loans
and adjust the asset or liability durations.
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16. Conclusion
The fact that Islamic banks transactions are free from
interest, movements in the interest rate have significant
effects on Islamic banks' performance.
Furthermore, the development of Islamic banking
side‐by‐side with the conventional banking system poses
rate of return risk.
One of the reason the risk occur is when the depositor
withdraw their money from Islamic Bank because they
know that Conventional Bank could give more return
rather than Islamic Bank.
As conclusion, Islamic Bank have to mitigate the risk well so
that they could manage their profitability and stability.
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17. Mahyuddin Khalid
End of Chapter
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