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1. Introduction
Islamic banking business seeks to generate profits from revenues of financing operations and costs incurred in mobilizing deposits. When an Islamic bank provides a facility such as al-bai-bithaman ajil (BBA) home financing to its customer, it has taken a position such that exposure to risk or potential loss will turn into real loss when the customer actually defaults on his debt obligation. In this way, an Islamic bank’s shareholders face many risks. The major risk is credit risk, where unexpected losses can erode a bank’s capital. Market risk is critical when dealing with volatility in the cost of funds as this may erode earnings. The 2008 subprime crisis in the USA, which severely paralyzed giants such as Lehman Brothers, Morgan Stanley and American International Group, saw increasing attention to operational risks (Caprio and Honohan, 2010).
An Islamic banking portfolio that is highly exposed to credit financing instruments such as BBA is not spared from loss due to default. Other unique risks faced by Islamic banks that can severely reduce their earnings are risk of return risk and displaced commercial risk. The former is the potential loss arising from loss of deposits to conventional banks when the profit rates on Islamic deposits are less competitive than interest rates on conventional deposits. The latter is the potential loss when the bank uses its own reserves to smooth rates on Islamic deposits. In recent times, a new type of risk called Shariah non-compliance risk provides a serious challenge to the legal and banking fraternity as the legality of BBA financing is put to question. It calls for immediate remedies to rescue Islamic banking from serious reputational risk and financial loss.
This paper examines two critical issues in Islamic risk management, namely, the nature of Shariah non-compliance risk in BBA financing and its measurement. First, it examines the nature of Shariah non-compliance risk within the credit environment of Islamic modes of financing in Malaysia. It gives a comparative look at the Shariah and civil requirement of the BBA contract and its documentation and traces the trigger for Shariah non-compliance risk when an Islamic bank seeks a court order to foreclose property as a result of a borrower’s default. Second, this study attempts to measure Shariah non-compliance risk...