The scope of reward and risk in Islamic finance : an application to Malaysian banking practice

Abstract

The problem investigated by this study is the lack of dedicated discussion on the parameters of reward and risk according to their normative definitions in Islamic finance. Hence, this study will attempt to define those parameters as they are presented in the literature. Furthermore, an application of such parameters will be conducted on selected Islamic banking products as they are practiced in Malaysia to judge the causes of compliance or non-compliance and propose new theoretical definitions for the parameters of reward and risk to allow for flexibility and ensure greater compliance. The study begins with a qualitative analysis of the literature to established the current definitions of reward and risk and then reviews industry practice through industry literature such as product disclosure sheets and regulator policy documents to judge embodiment of such parameters or lack thereof with respect to these products in the Malaysian Islamic banking practice. Further critical qualitative analyses will be conducted to explore the purpose of compliance or non-compliance to the reward and risk parameters and finally propose new parameters to harmonize the normative parameters with industry practice. The most important findings are that first, the normative of reward and risk are one, financing transactions need to comply to ownership, market and capital loss risk requirements, observe „other‟ risk requirements, equitable sharing of costs, feature value-adding, and finally comply with conditions of financing using capital. In judging the practice, it is concluded that conformity to the reward-risk parameters is only done in form and not in substance in the Malaysian Islamic banking financing products context. The alternative parameters which are considered by the practice maqasid, prevalent financial intermediation model, the consideration for excessive reward and risk, needs and necessities. The justifications for the alternative parameters are the parameters of reward and risk are susceptible to alternative interpretations which has been demonstrated at the end of the findings. This study recommends that a proper adaptive framework be developed by standard-setter which helps standardize the embodiment of the spirit of Islamic finance such as elements of equity through reward-risk instead of merely focusing on enforcing rigid structural rules.