Islamic Banking and Risk Management with a Focus on Shariah-Compliant Hedging Techniques

Abstract

This work aims at examining the difficulties and activities related to risk management in Islamic banking sector with an emphasis on hedging strategies in line with Shariah standards of operation in Indonesia. The effective management of financial risk therefore poses a major challenge to most Islamic banks given the strong principles of Shariah Law with regards to prohibition of charges of interest, volatility or uncertainty that is unreasonable, and the prohibition of speculative contracts. This empirical study explores the application of specific Shariah compliant with hedging strategies like Tawarruq, Wa’d, and Murabaha and the layout of their efficiency and incongruities. Interviewing thirty financial gurus and professionals in the Islamic banking system, the study finds that there are challenges such as a wafer thin offerings of Islamic financial assets, lack of shariah standardization, high costs of transaction, lack of clarity in rules and regulation and poor client awareness of the Islamic financial system. These studies show that while risk management using Shariah compliant hedging instruments can be effective these are seldom fully implemented because of these limitations. Interviewed participants called different issues to focus on: the expansion of product portfolios, enhanced regulation requirements, and clients’ awareness regarding the positive outcomes and mechanisms of shariah-compliant risk management. This research contributes to the existing literature and practical knowledge of Islamic finance in Indonesia with regard to the best practice of Shariah hedging and risk management techniques.