Financial contracts, risk and performance of Islamic banking

Purpose - The purpose of this paper is to focus on various modes of Islamic finance and examines their risk and other characteristics by conducting a selective literature review. Design/methodology/approach - Due to the Islamic prohibition of interest and in compliance with injunctions on permissible trade contracts, the savings and investment contracts offered by Islamic banks have a different risk profile than those of conventional banks. This gives rise to a number of regulatory issues pertaining to capital adequacy and liquidity requirements. Operational issues also arise as Islamic banks are limited in their choice of risk and liquidity management tools such as derivatives, options and bonds. All these issues are theoretically examined and various performance indicators of two Islamic banks are also examined to compare them with traditional banks that practice mark up pricing. Findings - The balance sheets and various performance indicators show that there is evidence that Islamic banks in Pakistan tend to engage in little long-term project financing. However, on the plus side these banks have shown good performance with respect to the returns on their assets and equity and have also demonstrated better risk management and maintained adequate liquidity. Research limitations/implications - A larger set of banks across various countries needs to be examined before any substantive conclusions can be reached about the relative performance of Islamic versus conventional banks. Practical implications - These largely pertain to central bank prudential regulations which must ensure that a level playing field is created for Islamic banks to compete with traditional banks. Originality/value - The paper is a commentary on the risk characteristics of Islamic banks and also analyzes for the first time the performance of the only two purely Islamic banks currently operating in Pakistan.