Shariah Risk

As we know, Islamic financial products are becoming more complex and complicated which lead to rise of Shariah risk.

Shariah risk is defined as a potential loss to the banks or financial institutions arising from cost of litigation execute by clients as a result of contract invalidation through the court of law.

Factors contribute to Shariah risk are:

• Form over substance
• Contracts and legal documentation are not consistent
• Sale without warranties
• Purchase undertakings in Musharakah sukuk

It can be avoided by attending to:

• Financial reporting requirement - must hold ownership of the asset and recorded as fixed asset.
• Legal documentation requirement - transfer of ownership from banks or financial institutions to clients with warranties
• Maqasid Shariah requirement - principle of benefit outweighs harm.

Of the above, will effect the income statement of the banks and financial institutions which are:

• Client will only return the principle facility
• Banks or financial institutions will write-off earned profit
• Banks or financial institutions will bear the opportunity cost of principle facility

Upon the realization of Shariah risk, the banks or financial institutions are:

• Paying compensations and damages to clients
• Returning profit entitled from the facilities
• Bearing cost of court proceeding
• Tarnishing its reputation (i.e. reputation risk)