The Management of Refinancing Risk in Islamic Banks

Abstract

Islamic banks have access to only short-dated funding sources resulting in asset liability mismatches when financing assets with longer maturities. Maturity mismatches give rise to a risk that an unexpected increase in the cost of refinancing liabilities as they mature will not be offset by corresponding asset returns. Exposure to refinancing risk is exacerbated by paying returns to providers of off balance sheet funds which do not covary with the returns of corresponding assets as they would from a stricter application of sharia principles underlying these funding structures. The active hedging of refinancing risk by Islamic banks is also challenged due to a lack of suitable hedging instruments as well as differing sharia opinions concerning their permissibility. As an alternative to risk transference through hedging, this paper develops a framework to quantify a reserve to instead absorb refinancing risk which is distinguished from reserves already in use by Islamic banks, namely the investment risk and profit equalization reserves.

Keywords: asset-liability management, Islamic finance, Islamic banking, refinancing risk, income smoothing