An-Najah National University 

 

Faculty of Graduate Studies 
 

 

 

 
 

 

 

 

 

 

UNSYSTEMATIC RISK IMPACT ON BANKING 

STABILITY: ISLAMIC VS. CONVENTIONAL 

BANKS IN PALESTINE AND JORDAN 

 

 
 

 

By 

Safaa Khalil Salah 
 

 

 
 

Supervisor 

Dr. Shatha Qamhieh 
 
 

This Thesis is Submitted in Partial Fulfillment of the Requirements for the Degree 

of Master of Finance, in the Faculty of Graduate Studies, An-Najah National 

University, Nablus, Palestine. 
 

2023 



ii 

 
 
 

 

 

 

 

 

 

 

 

 

 

 
 

UNSYSTEMATIC RISK IMPACT ON BANKING 

STABILITY: ISLAMIC VS. CONVENTIONAL 

BANKS IN PALESTINE AND JORDAN 

 
 

By 

Safaa Khalil Salah 
 

 
This Thesis was Defended Successfully on 16/03/2023 and approved by 

 



iii 

Acknowledgment 

Thank Allah for completing this work, and for the strength He gave me to go through 

this task. 

The path was not easy, but with help and support, it is done. Thank you for your 

considerable support in my life, Mom and Dad. 

To my supervisor, Dr Shatha Qamhieh, thank you for your supervision, follow-up and 

directives to complete this work. 

Special thanks to my dear husband for his encouragement and patience. 

Appreciation to An-Najah National University, which granted me to be part of the 

Department of Finance. 

  



iv 

Declaration 

I, the undersigned, declare that I submitted the thesis entitled: 

UNSYSTEMATIC RISK IMPACT ON BANKING 

STABILITY: ISLAMIC VS. CONVENTIONAL 

BANKS IN PALESTINE AND JORDAN 
 

I declare that the work provided in this thesis, unless otherwise referenced, is the 

researcher’s own work, and has not been submitted elsewhere for any other degree or 

qualification. 

 

 

 

  



v 

Table of Contents 
 

 

Acknowledgment ............................................................................................................. iii 

Declaration ....................................................................................................................... iv 

Table of Contents .............................................................................................................. v 

List of Tables ................................................................................................................. viii 

List of Figures .................................................................................................................. ix 

Abstract ............................................................................................................................. x 

Chapter One: Introduction ............................................................................................ 1 

1.1 Preface ........................................................................................................................ 1 

1.2 Study importance ........................................................................................................ 2 

1.3 Study problem ............................................................................................................. 3 

1.4 Study objective ........................................................................................................... 4 

Chapter Tow: Theoretical framework & Literature review ....................................... 6 

2.1 Introduction ................................................................................................................. 6 

2.1.1 Capital and stability ............................................................................................... 10 

2.1.2 Basel and stability .................................................................................................. 11 

2.1.3 Banking sector stability in Palestine and Jordan ................................................... 16 

2.1.4 Islamic and conventional banks stability ............................................................... 17 

2.2 Islamic and conventional banking ............................................................................ 18 

2.2.1 Balance sheet in conventional and Islamic banks .................................................. 19 

2.2.2 Islamic system ........................................................................................................ 21 

2.2.2.1 Murabaha ............................................................................................................ 22 

2.2.2.2 Bay’ Al-Muajjal .................................................................................................. 23 

2.2.2.3 Musharaka ........................................................................................................... 23 

2.2.2.4 Mudaraba ............................................................................................................ 24 

2.2.2.5 Al-wakala ............................................................................................................ 25 

2.2.2.6 Ijara ..................................................................................................................... 26 

2.2.2.7 Salam .................................................................................................................. 26 

2.2.2.8 Istisna .................................................................................................................. 27 

2.2.2.9 Qard Hassan ........................................................................................................ 27 

2.2.2.10 Sukuk ................................................................................................................ 27 

2.3 Unsystematic risk ...................................................................................................... 28 

2.3.1 Risk in Conventional banks ................................................................................... 29 

2.3.1.1 Credit risk ........................................................................................................... 29 



vi 

2.3.1.2 Liquidity risk ....................................................................................................... 30 

2.3.1.3 Market risk .......................................................................................................... 30 

2.3.1.4 Operational risks ................................................................................................. 31 

2.3.2 Risk in Islamic bank: ............................................................................................. 32 

2.3.2.1 Credit risk ........................................................................................................... 32 

2.3.2.2 Liquidity risk ....................................................................................................... 33 

2.3.2.3 Market risk .......................................................................................................... 33 

2.3.2.4 Foreign exchange risk ......................................................................................... 34 

2.3.2.5 Commodity price risk ......................................................................................... 34 

2.3.2.6 Mark-up risk ....................................................................................................... 34 

2.3.2.7 Equity investment risk ........................................................................................ 34 

2.3.2.8 Operational risks ................................................................................................. 35 

2.3.2.9 Business risks ...................................................................................................... 36 

2.3.2.10 Islamic Sharia Non-compliance Risk ............................................................... 37 

2.3.2.11 Risks Specific to Islamic Banking .................................................................... 38 

2.4 Palestine and Jordan economy and banking sector: .................................................. 39 

2.4.1 Israel, Jordan and Palestine economy: ................................................................... 39 

2.4.2 Banking sector ....................................................................................................... 41 

2.4.2.1 Palestinian banking sector .................................................................................. 41 

2.4.2.2 Jordanian banking sector: ................................................................................... 44 

2.4.3 The relation between banking and economy ......................................................... 47 

2.5 Literature review ....................................................................................................... 49 

Chapter Three: Methodology ....................................................................................... 54 

3.1 Data ........................................................................................................................... 54 

3.2 The PSTR model ....................................................................................................... 54 

3.3 Definition of variables .............................................................................................. 57 

3.3.1 Dependent variable ................................................................................................ 57 

3.3.2 Transition variables ................................................................................................ 57 

3.3.3 Bank-specific control variables ............................................................................. 58 

3.3.4 Macroeconomic control variables .......................................................................... 58 

Chapter Four: Result and Discussion .......................................................................... 59 

4.1 Introduction ............................................................................................................... 59 

4.2 Descriptive statistics ................................................................................................. 59 

4.3 Correlation matrix ..................................................................................................... 60 



vii 

4.4 Econometric findings ................................................................................................ 63 

4.5 Regression results ..................................................................................................... 64 

Chapter Five: Conclusions ........................................................................................... 69 

5.1 Conclusion ................................................................................................................ 69 

5.2 Recommendations. .................................................................................................... 70 

5.3 Limitation .................................................................................................................. 71 

References ...................................................................................................................... 72 

 ب  ................................................................................................................................ الملخص

 

 

 

  



viii 

List of Tables 

 

Table 1:Balance sheet in conventional banks ................................................................. 20 

Table 2:Balance sheet in the Islamic bank ...................................................................... 20 

Table3:Name, type, registration, No. of employees, No. of ATMs and No, of branches& 
office in Palestine at the end 2019 .................................................................... 44 

Table 4:Name, type, registration, No. of employees, No. of ATMs and No, of 
branches& office in Jordan at the end 2019 ..................................................... 46 

Table 5:Conventional and Islamic banks number per country ....................................... 54 

Table 6:Definitions, measures variable ........................................................................... 57 

Table 7:Description of quantitative variables ................................................................. 59 

Table 8:The correlation coefficients between the independent variables with the 
dependent variable and the independent variables together ............................. 62 

Table 9:Linearity tests ..................................................................................................... 63 

Table 10:Tests for the number of regimes ...................................................................... 63 

Table 11:PSTR models estimations ................................................................................ 64 

 

 

  



ix 

List of Figures 

 

Figure 1:Islamic Financial Intermediation ...................................................................... 32 

 

 

 

 

  



x 

UNSYSTEMATIC RISK IMPACT ON BANKING STABILITY: ISLAMIC 

VS. CONVENTIONAL BANKS IN PALESTINE AND JORDAN 

By 

Safaa Khalil Salah 

Supervisors 

Dr. Shatha Qamhieh 

Abstract 

The main objective of this study is to verify the relationship between credit risk and 

liquidity risk on the stability of banks for a data set of 35 Conventional Banks (CB) and 

Islamic Banks (IB) belonging to Palestine and Jordan - with the following distribution 

(11) conventional banks and (3) Islamic banks in Palestine, and (17) conventional 

banks and (4) Islamic banks in Jordan was observed during 2008-2019،By performing a 

panel smooth threshold regression model, where this model was used because it takes 

into account the linear and non-linear relationships. The Z-score (ROA) was used as a 

dependent variable, non-performing loans from loans, and the ratio of liquid assets 

from assets, a proxy for credit risk, and liquidity risks, respectively, refer to transition 

variables, in addition to a set of control variables associated with the characteristics of 

bank and the macroeconomics. The results show that the relationship between the 

bank's stability and credit risk, and the bank's stability and liquidity risk is non-linear, 

and is characterized by the presence of two optimal thresholds equal to 11.41% for 

credit risk and 20.15% for liquidity risk. The results showed that credit risks do not 

affect the stability of banks, while liquidity risks negatively affect stability. With regard 

to the control variables that are bank-specific, the results show that both size and capital 

adequacy have a significant positive effect on stability, and after the threshold, it 

becomes negative in both equations. In terms of macroeconomic variables, it was found 

that political stability has a strong effect on the stability of banks. It was also found that 

the type of bank affects stability, as conventional banks are more stable than Islamic 

banks in Palestine and Jordan. Therefore, to ensure the stability of banks, the study 

recommends that banks choose the appropriate restructuring to ease their small size and 

enhance capital.  

Keywords: credit risk, liquidity risk, stability, PSTR model, Islamic bank, 

conventional bank.  



1 

Chapter One 

Introduction 

1.1 Preface 

Countries seek to achieve economic stability, but in light of globalization, and the 

increased international competition, it is difficult to define and even harder to measure 

but crisis situations seem to have a larger effect on the economic stability of many 

countries. Such a challenge requires attention to face both expected and unexpected 

events that could face the banking sector (Rupeika-Apoga et al., 2018; Kasri & 

Azzahra, 2020).A strong financial sector is a key ingredient for economic stability and 

should be able to withstand the various shocks Banking and financial institutions are 

essential intermediaries within the financial sector. Hence, the need to ensure their 

stability. (Odeduntan et al., 2016; Zaghdoudi, 2019).The financial sector is exposed to 

multiple risks like other sectors, therefore, in order to maintain its safety and stability, 

these risks must be known and understood and work to be well managed to reduce their 

impact, as risks can be divided into two types, the systemic risks that affect the 

economy completely but in varying proportions, such as interest rate risk, exchange rate 

risk, and non-systemic risks specific to a particular company, such as operational risk, 

liquidity risk and credit risk (Ghenimi et al., 2017). The transfer of short-term liabilities 

into long-term assets is the main activity carried out by banks, therefore, liquidity risk 

(unexpected withdrawal of funds by depositors) and credit risk (failure of borrowers to 

pay the loan amount and interest on time) are considered the most important risks 

Which banks are exposed to and need constant monitoring to maintain the stability of 

the banks (Smaoui et.al., 2020). 

If we go back a little in time, we see the world has witnessed many crises that affected 

the economy, but many considered the global financial crisis of 2007-2008 was one of 

the most dangerous crises the world had witnessed since the Great Depression. the crisis 

began when real estate prices fell sharply in the first half of 2007, which made the 

international financial markets, especially the United States suffered from defaults in 

the payment of financial obligations and dues from borrowers especially loans granted 

borrowers with low credit ratings (are called subprime mortgages loans) and difficulty 

in collecting these loans. This led to the spread of uncertainty and panic in the financial 



2 

markets, it helped increased requests for withdrawals by depositors because of the fear 

of a liquidity crisis (Crotty, 2009). The financial crisis has greatly affected the global 

economy, as its impact continues to this day. In order to avoid the recurrence of these 

crises, researchers and analysts working on knowing the financial causes of the crisis 

through studying and analysing financial institutions and the practices of the financial 

system, doubts were cast on the quality of risk management practices. so Banking put 

stricter regulations on liquidity according to Basel III (Vazquez & Federico, 2015). The 

financial crisis made the world more awake and focused on the importance of the 

stability and safety of the financial sector in light of the risks, because the impact of the 

crisis was not limited only to the financial sector, but also extended to other sectors. In 

light of the negative aspects that the world witnessed from the financial crisis but 

emerged the role of the Islamic financial sector Because was not affected like the 

conventional sector by its nature in avoiding risky financial products (Parashar, 2010). 

In recent years, several studies have examined the factors that ensure the stability of 

banks or those that destabilize them. In particular, credit risk and liquidity risk are 

retained by the majority of authors who considered them major risks, the empirical 

results show that the results are different, as these results can be divided into three 

types: the first supports the positive impact on stability for both liquidity and credit risks 

(Zaghdoudi 2019; Rupeika-Apoga et al. 2020), and the second type supports the 

negative impact of both risks on stability (Hassan, et al., 2019; Korbi & Bougatef 

(2017). The third proves the insignificant impact of these two risks on stability (Amara 

& Mabrouki, 2019), so the controversy about the relationship between liquidity risk, 

credit risk and stability is still not conclusive. 

1.2 Study importance 

Palestine and Jordan are considered interesting cases to study because they are 

considered small countries with limited resources that depend heavily on external 

support and resources and the lack of investment opportunities available due to the 

political situation, and the inability to use new financial methods due to the weak 

infrastructure of the financial markets (A Kasasbeh & Alzoub, 2019; Zaghdoudi, 2019). 

In addition to the link between the Palestinian and Jordanian sectors, where there are 14 

banks operating in Palestine, there are 7 of them Jordanian, so there is a major role for 

them in financing the Palestinian economy and the banking sector dominates the role of 



3 

financial intermediation. According to the statistics of the performance of the 

Palestinian and Jordanian banking sector for the year 2018, we find that loans constitute 

the largest part of the direct credit facilities they provide, as they constitute 82% for the 

Palestinian banking sector and 65% for the Jordanian sector, and the ratio of direct 

facilities to total deposits is 62% and 77% Respectively, These ratios confirm that the 

primary activity of banks in both the Palestinian and Jordanian banking sectors is the 

process of converting deposits into loans, and thus they are assumed to be highly 

exposed to liquidity and credit risks. In addition, the commercial banking sector 

dominated the banking system, where share of Islamic banks constituted 15% for 

Palestinian sector and 16.4% for the Jordanian sector, the presence of Islamic banks 

could threaten stability of conventional banks. Furthermore, Palestinian economy is 

linked to the Israel economy, according to the Paris Economic Agreement. Palestinian 

banks remain at the mercy of Israel policies regarding the acceptance of surplus cash in 

the shekel currency, which may affect the stability of Palestinian banks and increase 

liquidity risks, and the use of the US$, NIS and JD currencies legally valid for use in 

Palestine This exacerbates the difficulties facing banks operating in Palestine 

(Abdelkarim & Burbar, 2007), the safely of the banking sector is an indicator of the 

health of the economy so there need to study the effect of these risks on stability. 

1.3 Study problem 

Banking risks and impact on the banking sector had the attention of extensive 

researchers all over the world. Several researchers have investigated the relationship of 

stability with credit risk and liquidity, each of Amara & Mabrouki, (2019); Ghenimi et 

al., (2017) worked on studying the effect of liquidity risk and credit risk on the stability 

of the banking, while Zaghdoudi, (2019) added the effect of operational risks on 

stability, and each of Albaity et al., (2019); Smaoui et al., (2020) compared the stability 

of Islamic banks with Conventional banks. Albaity et al., (2019) as studied the effect of 

competition also. All these studies used a variable (z-score) as a measure of stability, 

while Hassan et al., (2019) worked on studying the relation between risks and stability 

by applying (Distance to Default and z-score) as a measure of stability, and all studies 

assumed the linear relationship between risks and stability, while Djebal i& Zaghdoudi, 

(2020) proved the nonlinear correlation among risks and stability, where he worked to 

determine the optimal limit for the use of risks and measure their effect on the bank's 



4 

stability using only a sample of commercial banks, to our knowledge there is no 

literature that has studied the relationship between risks and the stability of the banking 

sector in Palestine from a nonlinear perspective, therefore, this study is performed using 

the panel smooth threshold regression that was followed by Djebali & Zaghdoudi, 

(2020) but we added banking model type for comparison as an important part of the 

Palestinian and Jordanian banking system. Through this thesis, you will help understand 

the impact of unsystematic risks represented by liquidity and credit risks on the stability 

of the financial system; With regard to the type of business model for both Islamic and 

conventional banks, it stems from the difference in the features and framework of the 

business model of these banking types, as the framework of Islamic banks is based on 

compliance with the provisions of Islamic Sharia; Which differs from the Conventional 

interest-based banks, and therefore it is necessary to explore the presence of differences 

in the response of banking stability to the differences in banking business models 

represented by Islamic and conventional banks operating side by side in Palestine and 

Jordan. 

The study problem can be formulated with the following question: 

• Do unsystematic risks affect the stability of both Islamic and conventional banks? 

• Does the banking business model type affect banking stability? 

1.4 Study objective 

As mentioned previously, banking stability is an indication of the health and strength of 

the financial sector. Because of the basic activity of banks in financial intermediation, it 

is necessary to focus on credit risks and liquidity risks to represent unsystematic risks. 

Therefore, the main objective of this thesis is to: 

• Determine if unsystematic risks affect the stability of both Islamic and conventional 

banks. 

• Determine if the banking business model type affect banking stability. 

In addition to our specific objectives, through this research we will also be able to 

achieve general objectives, as we can: a) identify the expected effect of the stability of 

the banking sector on the development of the economy, b) identify the similarities and 

differences between the Islamic system and conventional banking system business 



5 

models, c) identify the unsystematic risks that the banking sector is exposed to, d) 

explore the Palestinian and Jordanian banking sector and knowing the risks they face, e) 

study the impact of macroeconomic factors on the stability of the banking system, f) 

study the impact of bank-specific factors on the stability of the banking system.  

  



6 

Chapter Tow 

Theoretical framework & Literature review 

2.1 Introduction 

Financial and monetary stability is important for the active performance of the 

economy. It establishes the groundwork for making rational decisions about the 

provision of actual resources over time, thereby improving the environment for saving 

and investing. Thus, preserving stabilization is a major goal of the financial authorities 

(Crockett, 1996).According to studies that dealt with financial stabilization and issues 

related to it, the interest in specialized questions on how to maintain financial 

stabilization has become clear, especially in recent decades. The reason for the growing 

concern about financial stabilization issues is the cause of the financial crises that have 

occurred. Academically, there are two well-known schools in the financial literature that 

dealt with the concept of financial stabilization. The representatives of the first school 

prefer to tackle the concept of financial instability. The representatives of the second 

school study the concept of financial stabilization. The first school finds that financial 

instability is related to savings and investment. It represents the deviations in saving 

plan due to the inefficiency in the performance of the financial management to employ 

the financial system or because of the instability of the system in the face of potential 

shocks. In terms of the second school, the concept of financial stabilization represents 

the ability of the financial system to achieve stabilization by avoiding imbalances in the 

structure so that it can resist shocks without having cumulative effects that would 

transform the provision of savings to investment opportunities, and payment and 

settlement processes in the economy (Tawfeq, 2015; Anatolyevna & Ramilevna, 2013) 

A stable financial system indicates that it is able to allocate resources efficiently, 

manage and assess financial risks, maintain employment levels close to the normal rate 

of the economy, in addition to eliminating the relative price movements of real or 

financial assets that will affect monetary stability or employment levels. The financial 

structure is considered in a state of stabilization when it absorbs shocks through self-

correcting mechanisms, which prevents them from causing a destructive effect on the 

actual economy or on other financial structures. As a result, the financial structure is 

said to be stable when it manages financial inequities that arise internally or because of 



7 

unexpected negative events. As a result, financial stabilization is important for 

economic development because the financial structure helps the mainstream of 

transactions in the actual economy. (Bank, 2015). Financial stabilization refers to the 

efficient operation of the financial structure's markets and institutions (as stability in one 

achieves stability in the other) (Crockett, 1996). 

Banks refrain from financing profitable projects during periods of insecurity. Payments 

may not arrive on time if asset prices deviate significantly from their intrinsic value. 

The true real value is better manifested here. Great instability causes a rush of banks, 

excessive inflation, or the collapse of the stock market, all of which can destabilize 

confidence in the entire financial structure and economy (Bank, 2015). 

Financial stabilization is related to the financial structure in banks, and its components 

and activities are associated with it. Therefore, this structure is subject to many risks. 

Risks can occur inside or outside the banking financial structure. Banks have distinctive 

contractual problems that arise from their primary function as a financial intermediary. 

The bank’s management can influence, in some cases, the volume of internal risks and 

the possibility of their occurrence through processes of regulation, control and crisis 

management. On the contrary, it is difficult to control the external risks that affect 

financial stabilization (Schinasi, 2005, 5-6). 

Conventional banks can offer additional agency services to depositors, making it 

possible to make illiquid loans that were previously only possible within a short amount 

of time at a low price due to the unlikeliness of a simultaneous liquidation of the law of 

large numbers. As long as borrowers and lenders trust the bank's ability to fulfill its 

contractual duties, it can be considered a conventional bank, contributing to value-added 

in the shape of improved information (summary information asymmetry) and more 

liquidity. As a result, the market's balance improves. 

(Running) in a bank is a result of confidence being lost in the bank, which is a well-

known phenomenon. The weakness of banks is due to an interaction among liquid 

liabilities that can be paid immediately and illiquid assets that may only be realized in 

little time by accepting discounts on book value (Diamond & Dybvig, 1983). 



8 

A bank's realization that it has an expanding portfolio of bad loans is typically cause for 

concern, but why do banks continue to make credit judgments that turn bad? Certainly, 

decaying recollections of previous bad experiences play a role (Kindleberger,1978). 

Furthermore, new research has shown that other phenomena, such as disaster myopia, 

herd behaviour, perverse incentives, the principal-agent problem, and negative 

externalities, have a systematic effect. These behaviours have an aspect of simple 

irrationality while being basically more difficult. The disaster of economic myopia 

(subjective expectations) about reality (objective possibilities) (Guttenta & Herring, 

1984) in addition, disaster myopia can result from a lack of foresight since disasters 

happen so rarely it is difficult to allocate a probability to their occurrence in the future, 

or a modification in policy can boost economic circumstances beyond the limits 

considered when making lending decisions. In addition to herd behaviour, it sometimes 

refers to a dissimilar way of lending procedures that often leads to problems. It may be a 

demonstration of irrationality; however, it also reflects normal maximization in 

situations of uncertainty (Davis, 1995). Negative externalities stand when some costs of 

firms accumulate decisions on strangers. It may happen in any industry, especially in 

the banking department due to the nearly small reserve of funds related to the total size 

of the balance sheet (Dewatripont & Tirole, 1994). 

Behavioural tools that lead to variability in financial organisations may refer to effects 

of competition and market dominance, or by their vulnerability to a contagion of failure 

across organisations. Contagion is said to occur in the financial industry for two chief 

reasons. First, via the interbank market, OTC derivatives transactions, and the payments 

and settlement system, there is a net of claims and overlapping liabilities (Schoenmaker, 

1996). Second, due to the inconsistency of publicly available information, creditors find 

it difficult to assess the financial institution's strength. As a result, the spread of bank 

failures is likely to be faster and more widespread, resulting in a greater number of 

failures and greater losses for creditors, harming the economy as a whole. Furthermore, 

a large portion of real estate is funded through borrowing and accepting real estate as a 

guarantee for a variety of financial activities. Therefore, any change in real estate prices 

will affect the financial structure. 

Banks constantly seek to reduce risks in order to protect bank clients from loss (the 

consumer protection aspect), decrease the risk of contagion (the systemic risk aspect), 



9 

evade losses for the deposit insurance fund or last-resort (the financial aspect), and 

develop resource provision in the financial aspect (the efficiency argument) (Quinn, 

1996). 

There are two approaches to banking regulation: one focuses on adjusting the activities 

of controlled organisations, while the other confirms that they have enough capital to 

cover the risks to which they are exposed. Under the Basel Capital Agreement, banks 

were requested to maintain a minimum level of capital concerning the credit risk of 

their portfolios. Supervisory authorities identified qualified capital, the risks of various 

asset classes, and the suitable ratio between the two. One of the main mechanisms that 

were usually used to reassure depositors is the lending mechanism of last-resort. As the 

capital increase has clear benefits, namely increasing the reserves against losses and 

thus the stabilization of the structure as a whole, informing the bank’s management of 

the need to appropriately pricing risks and finally reducing moral risks by increasing the 

share of private banks in the achievement of their risk management strategy (Crockett, 

1996; Hickson & Turner, 1999). 

The difficulty of analysing stabilization indicates that many crises are shown in a way 

that seems distinctive and continuously requires diverse policies to the treatment. The 

regular feature of most crises are always increased defaults and low profitability in the 

banking department, as studies have shown that the volume of non-performing loans 

increases sharply before and during the crisis. The performance of banks is important to 

the study of financial instability, due to their importance in transferring monetary policy 

and financial stabilization. They affect liquidity and credit expansion. Therefore, the 

money supply in the economy depends on the portfolio of the banking department 

(Tsomocos, 2003). 

There is substantial indication that banking problems are connected with a much deeper 

economic and financial fall. Banks play an important role in credit intermediation, 

directly and indirectly, as lenders, market makers, and providers of supportive liquidity 

and payment services. It is high financial as its liabilities consist almost entirely of debt 

with a very low proportion of equity. In many cases, the bank's limited liability and the 

bankers' short-term compensation structure create an incentive for them to maximize the 

bank's influence. Consequently, banks are particularly vulnerable to the possibility of 

bankruptcy because their liabilities consist largely of debt.  



10 

2.1.1 Capital and stability 

No property rights and insolvent: this is why banking capital regulation has attracted 

significant interest and controversy following the 2007-2008 global financial crisis 

because numerous banking institutions - especially the largest banking groups - were 

undercapitalized and highly leveraged. Understanding the role of bank capital, it is 

necessary to focus on the bank's balance sheet. First, the balance sheet describes the 

bank's assets, for example loans, investments, cash, buildings, and equipment. Second, 

the balance sheet lists its liabilities, which mainly include debt and equity. Debt 

liabilities include deposits and other borrowings. Share capital includes equity of paid-

in capital, i.e. the amount paid for a bank’s share on issue, which provides rights to all 

remaining assets including the bank’s ownership. Capital also consists of retained 

earnings, which is the bank's income at the end of the fiscal year, after deducting 

expenses, earned during that year, less any dividends paid to shareholders. The share 

capital also consists of preferred shares, which are entitled to specified dividends that 

may accrue if not paid, but which provide limited equity, the value of which may be 

permanent or have a fixed term. Preferred stock is a less pure form of capital that 

closely resembles debt and does not usually absorb the losses of a company as a 

continuous concern. The capital can also be the surplus profit from the sale of shares in 

excess of their face or declared value. Reserves, such as stock reserves, can also 

constitute capital when they are set aside from revenue to pay, e.g. dividends on 

preferred stock or large debt. (Alexander, 2015). 

The capital of the bank has four main purposes: absorbing losses, for example, 

depreciation of assets due to non-performance, expected losses due to insufficient 

reserves of loan losses, and ultimately bank failure; to provide financing for the start of 

early operations of the bank; to decrease losses in deposit insurance programs by 

offering a way to refund depositors' and creditors' claims against a failing bank, 

providing motivations for shareholders and directors to have greater caution in 

supervising the bank's processes. The capital of the bank acts as a storehouse from 

which any losses are taken, and provides a reserve from which depositors and creditors 

of the banks can be finally repaid when losses cannot be absorbed in the event of a bank 

failure. The bank is insolvent if liabilities exceed its assets. Balance is required by 



11 

regulators on a bank's balance sheet. The net worth and viability of a bank are primarily 

determined by the difference between assets and liabilities. (Alexander, 2015). 

If a bank is in severe insolvency, its assets may not be enough to fully compensate the 

deposit insurance company for its payments to insured depositors. However, having a 

larger stock reserve would give the bank the ability to absorb larger losses before 

becoming insolvent. The deposit insurance company would be less likely to incur losses 

as a result of bank liquidation. Essentially, bank capital is important at the micro-

prudential level of a bank to protect creditors, including depositors. (Herring, 2002) 

Balance sheet management 

The scope of a company is determined by its balance sheet. The value of its liabilities is 

typically determined by the scope of its balance sheet. Essentially, the greater a 

company's assets, the greater its liabilities to fund those assets. These liabilities are debt 

rather than equity, which introduces more leverage, makes the company appear riskier, 

and raises return expectations for both debt and equity investors. This ultimately results 

in a higher cost of capital (Adam, 2007). 

The bank's management is extremely sensitive to investor expectations and thus 

constantly monitors the size of the bank's balance sheet. As long as the decision to 

reduce assets is made, the options available are limited. Direct selling is an option, but it 

is hampered by two factors when the primary assets are loans. First and foremost, 

illiquid loans may be difficult to sell. Second, loan sales (usually to other banks) are 

unpopular with the borrower, who usually does not want to change his creditor group 

(Alexander, 2015). 

2.1.2 Basel and stability 

There were major failings in risk administration, corporate governance, market 

transparency, and regulatory quality. Actually, there has been an overemphasis on 

company-specific risk management and inadequate realization of how system-wide 

risks can occur under stress.  

The Basel Committee's reforms tackle these faults via micro- and macroprudential 

scales. Obviously, micro and macroprudential improvements are inextricably linked, 

because more resilience at the individual bank level decreases the risk of system-wide 



12 

shocks. (Stefan Walter,2010). Post-crisis market developments have placed a greater 

emphasis on banks' ability to manage their "economic capital": the equity capital 

required for banks to mitigate the risk of expected asset losses. "Regulatory capital" 

addresses the risk of unanticipated losses. Basel I Capital classified assets using a few 

classes. The economic capital approach employs a model to calculate the riskiness of an 

asset portfolio and the amount of capital required. Basel II and Basel III seek to link 

regulatory capital to "risk sensitivity." 

The Basel Capital Accord is the primary global financial guideline agreement. The first 

agreement (Basel I) was signed in 1988 with two chief objectives in mind. First, 

internationally active banks must maintain a certain level of capital against their risk-

based assets. Second, it promotes equal opportunities in banking capital regulation on a 

global scale. 

Basel 1 demanded banks to hold 8% of supervisory capital on the majority of their 

credit risk assets. The 8% capital requirement is made up primarily of Tier 1 and Tier 2 

capitals. Tier 1 capital was critical and valuable to controllers because it primarily 

involved common stock and equivalent and reserved earnings that may reduce losses for 

the bank as a continuous concern. Tier 2 capital, on the other hand, is primarily made up 

of subordinated debt and other debt-like instruments, for example preferred stock and 

convertible instruments. Tier 2 capital has been less effective at containing losses than 

Tier 1 capital because these instruments can only absorb losses at the point of bank 

restructuring or failure as a continuous concern. For regulators, Tier 2 capital was less 

flexible as it could not enforce losses on the bank as a continuous concern. This is 

because Basel I required Tier 2 capital to account for no more than 50% — or 4% of 

risk-based assets — of the regulatory capital requirement of 8%. Tier 1 capital should 

account for at least 4% of risk-based assets, and at least 4% of 50% — or 2% of risk-

based assets — should be Tier 1 capital, which includes Common capital, equity shares, 

and retained earnings. Tier 1 seed capital was favoured by regulators because it could 

absorb losses completely for the bank while it was going on. 

Though Basel I attained its primary goal of developing the level of supervisory capital 

in the global banking structure, it included numerous national ratings, loopholes, and 

motivations for banks to make riskier short-term loans and offload less risky assets from 

their balance sheets. 20 In 1999, Basel II was offered to tackle many of these gaps. As a 



13 

result, Basel II introduced the concept of "three pillars" - I minimum capital, (ii) 

supervisory review, and (iii) market discipline - designed to complement one another 

and provide motivations for banks to improve risk assessment and running. Basel II's 

overall goal was to make regulatory capital more sensitive to the partial prudential risks 

that banks face, as well as to align regulatory capital with the economic capital that 

banks already had. 

Pillar 1 permits banks to gauge regulatory capital by using statistical models that 

estimate credit, market, and operational risk based primarily on historical default and 

loss data. The second pillar establishes controlling evaluation principles that allow 

regulators to demand banks to adhere to general corporate governance principles and to 

implement an Internal Capital Adequacy Assessment Process (ICAAP) designed to 

develop risk assessment and running. Pillar 3 employs market control to compel banks 

to offer more information to the market, allowing shareholders and creditors to more 

effectively supervise the bank's management so as to confirm the bank's safety and 

future plans. 

Basel II extended using risk weighting in assessing the risk of banks' assets. Some 

parameters govern asset risk weighting, such as loan maturity date, default probability, 

and the bank's loss and exposure in the event of a default). Lower risk weighted assets 

typically necessitate lower capital fees, whereas higher risk weighted assets necessitate 

higher capital fees. Short-term corporate loans have lower risk weights (lower capital 

fees), whereas long-term corporate loans (seven years or more) have higher risk weights 

(higher capital fees). 

The Basel II operation offered banks motivation to advance their risk running by 

providing condensed regulatory capital if they can show that their risk-based models 

sufficiently measured the risks that the bank met separately against creditors and 

depositors. However, the risks that Basel II emphasized were essentially a partial 

precautionary risk; that is, risks that were mainly external to the bank's balance sheet 

rather than risks that the bank creates for the financial structure - the so-called internal 

risk - due to its size, interdependence, and exposure to liquidity risk. As a result, Basel 

II did not demand banks to hold sufficient capital to handle the social costs incurred by 

banks, as well as systemic risk. 



14 

The main problem in Basel II regarding regulatory capital was that the models of 

economic capital used by banks had been accepted by regulators as valid reference 

points for calculating regulatory capital. Basel II economic capital models fail to 

anticipate macro prudential risk. Basel II essentially exemplifies the failure of financial 

policymakers and regulators to integrate systemic risk into the design of regulatory 

capital and risk management. 

Recent amendments to the Basel Capital Agreement, otherwise known as Basel III, 

raise important issues regarding whether banking capital regulation has become 

sufficiently macro prudential in its focus and objectives. Although Basel III is largely 

based on the Basel II framework, it attempts to address many of Basel II's flaws that 

contributed to the crisis. Basel III raises the core regulatory Tier 1 capital requirement 

from 2% to 4.5 %, plus a 2.5 % capital protection reserve, as well as a stricter definition 

of Tier 1 capital to comprise only common stock and reserved earnings (excluding 

instruments of equivalent value) (Alexander, 2015). 

It also established the international liquidity standard to add capital regulation. As 

capital is an essential condition for bank flexibility, it is insufficient. As a result, I 

requested that banks be able to withstand a system-wide liquidity shock for 30 days, in 

addition to preserving a more vigorous structural liquidity profile. Undoubtedly, this 

will increase the cost of financing in usual times and have an impact on business 

models. Actually, banks should do more to insure themselves against tight liquidity 

periods, as they must hold capital to deal with unforeseen losses, so liquidity should not 

be regarded as a free good and should be appropriately priced. (Stefan Walter,2010). 

The Committee supported the Pillar II guiding review process in Basel II, which 

included corporate governance, risk appetite, risk pooling, and stress testing, in addition 

to improved Pillar 3 transparency requests for more complex capital market activities, 

resulting in considerably improved risk coverage. Banks should keep enough capital on 

hand for less liquid and credit-sensitive assets that have much longer holding periods. 

Regarding macroprudentiality discussed in Basel III, it tried to address the defects 

revealed by the financial crisis, through the leverage ratio. It played a role in easing the 

burden of risk-based requirements. According to a latest study conducted by the Basel 

Committee's Regressive Capital Adjustment Group, the leverage ratio performed the 



15 

best job of distinguishing between banks that eventually required formal sector support 

and those that did not. Tangible common stock to risk-based assets was the only risk-

based ratio that did well. Nonetheless, the leverage ratio serves a macroprudential 

function. It stops the growth of excessive leverage in due times and thus reduces the 

dynamism of deleveraging in bad times. Besides, the leverage ratio shields the system 

from the unpremeditated consequences of the risk weighting system. Many asset classes 

can appear to be low risk when regarded through the eyes of a single company. 

However, when you look at the system level, it may pose significant threats to financial 

stabilization. 

Aside from increasing capital levels in due times so that it may be withdrawn in bad 

times to decrease pro-cyclicality. If the bank's capital plummets below the 2.5% 

precautionary reserve, the managers will limit distributions and bonuses, tackling the 

pre-crisis challenge of teamwork, i.e. market pressure to continue paying dividends. 

Actually, this will guarantee that capital is preserved in the event of a decline and 

rebuilt in the recovery. They also worked to establish a capital reserve to counteract 

cyclical fluctuations and protect the system from excessive credit growth, as the most 

tough problems are preceded by credit bubbles. Actually, when these bubbles burst, the 

banking industry is the first to suffer. As we cannot continuously be able to avoid such 

bubbles, we can help banks be more adaptable. In addition, Basel III reforms 

significantly increase capital and liquidity requirements for the most systemically risky 

trading, derivatives, and funding activities. 

Increasing public ownership of the banking department from 7% to 8% decreases the 

yearly likelihood of a banking problem by at least 1%. Reducing the likelihood of a 

problem by one percentage point results in an expected annual production benefit of 

0.2%-0.6%. They are known approximations. However, it is clear that a better 

capitalized banking department has significant economic benefits. As a result, the Basel 

Committee, in collaboration with the Financial Stability Board, is developing a method 

for assessing the systemic significance of international financial organizations that 

includes quantitative and qualitative indicators. It also assesses the extent to which 

global systemic banks will absorb losses. Lastly, this additional loss-absorption capacity 

is expected to be met through both common stock and equity (Stefan Walter,2010). 

 



16 

2.1.3 Banking sector stability in Palestine and Jordan 

The value of the overall index of financial stability ranges between zero and one. The 

closer the value is to zero, indicating a weakness in the financial structure, the closer it 

is to one, and the greater the degree of stability in the financial structure. 

In Palestine, the data indicates a failure in the value of the index from 0.52 points in 

2018 to 0.41 points in 2019 and another decline in 2020 to 0.30, as the financial stability 

index relies on evidence from the banking department, the capital market and the 

insurance sector and macroeconomic indicators, but the indicator shows the significance 

and role of the banking department indicator in guiding the overall indicator of financial 

stability. It improved in 2020 to 0.03 compared to 0.26 in 2019 due to improved 

liquidity. However, it still reflects a good degree of stability of the financial structure in 

Palestine. (PMA, 2020). As for capital adequacy, a circular was issued to implement 

capital adequacy requirements in accordance with the decisions of the Basel II 

Committee, whereby banks were asked to raise the percentage weight of claims against 

the Palestinian government from 10% to 15% as of the financial statements on 

12/31/2019 and to increase To 20% as of the financial statements ending on 12/31/2020, 

however, the capital adequacy ratio remained at the level of both local and foreign 

banks higher than the minimum limits stipulated in the recommendations of the Basel 

Committee (the percentage should not be less than 9%) and according to the Monetary 

Authority (The percentage should not be less than 12%), and the requirements of the 

Basel Committee indicated that the indicator of the extent of basic capital coverage of 

the bank’s total assets should not be less than 3%.  

In Jordan, the Financial Stability Index improved in 2019 as it reached 0.55, compared 

to 0.46 in 2017 and 2018. This indicator was developed in 2016 after studying many 

international experiences in building its own financial stability index. The indicator 

showed that the degree of stability of the financial structure in Jordan is considered 

good, taking into account the political and economic changes in the region and their 

influence on financial stability. (PMA, 2020)  

The financial sector in Palestine and Jordan is still characterized by a sound and stable 

financial sector compared to some countries that developed the index with almost the 

same methodology used, as Jordan ranked third compared to 20 other countries. 



17 

2.1.4 Islamic and conventional banks stability 

The financial structure is considered to be unstable in the case of high price fluctuations 

and excessive dependence on debt. Thus, financial stability is significantly affected in 

the event of inefficient treatment of both financial risks, financial crises and external 

factors. The financial system helps to manage the economy because of its financial 

intermediation services (savings mobilization) and transactional facilities for individuals 

and companies. Two financial systems in the world, the conventional system and the 

Islamic system, are dealt with. When considering the returns of both systems, there is no 

big difference, however, the nature of the financing and the risks differ greatly between 

them. The conventional financial system was established in accordance with the 

principles of capitalism, as capital is a factor of production, since the main source of 

revenues and costs is interest; it is collected through lending and deposit acceptance. 

Thus, interest (increasing its stabilization on the principal amount without participating 

in the business process) is the main engine of operations of conventional banks. The 

purpose of financing is to pool wealth and increase fixed assets (Hanif, 2014). 

According to the Macroeconomic Approach, it is clear that in the event of an economic 

boom, conventional financial centres become heavily indebted. As they prefer debt 

financing over property rights, the economy is therefore highly vulnerable to debt 

contraction because the investor is encouraged to enter into high-risk activities 

following speculation. Once these activities are financed in addition to their debt duties, 

they have higher interest rates. If the return does not win the amount of the debt, this 

will lead to bankruptcy of speculators. In the conventional system, therefore, it relies on 

the financing of speculative activities rather than real investments. This provides 

evidence of the fragility of the conventional financial structure. It also poses the 

problem to the central bank to act, as it raises interest rates and tightens Monitory 

policy. It can therefore cause an increase in the debt deflation crisis. While the partial 

economic approach focused on importance of asymmetric information and illogical 

behaviour of investors, rumours in circulation may cause panic among depositors, so it 

will lead to large withdrawals, making the bank in a state of instability, as an example 

of the weakness of the global crisis (2008) caused by the lack of market instability; it 

will make bubbles explode (Belouafi, et al., 2015). 



18 

In view of these bailouts facing the conventional system because of excessive reliance 

on debt and financial leverage, there was a need to focus on another financial system 

that could deal with these problems in a better way. The Islamic financial structure was 

more efficient than the conventional system during the financial crisis. This system is 

based on the basis of Islamic sharia, since banks are prohibited from forming money. 

Money is a mere means of exchange. The Islamic system relies on a set of principles 

first sharing profits and losses, as it conducts its operations through various financial 

contracts in order to obtain profits (which is variable based on the nature of the business 

activity). Portion of the losses must be borne if they occur. In addition, it relies on 

financing patterns based on equity financing and the principle of avoiding uncertainty. 

They may not enter into unclear contracts and (speculation) to obtain wealth easily, or 

by coincidence, (gambling); one person wins, others lose, as the permitted financing is 

compatible with Islamic Sharia only, meaning they must avoid forbidden activities, in 

addition to the principle of supporting its investments with real assets. This principle is 

considered an advantage of the Islamic system. This allows the system to accept more 

shocks than the conventional system. Based on that way, the Islamic financial system, if 

applied in the right way, guarantees justice for both parties (the source of money and its 

user): the stability of the financial sector and prosperity of the economy: Despite this, 

there are many challenges it faces, such as the additional risks resulting from financing 

and the lack of skilled human resources in an application the Islamic system accurately, 

working in an inappropriate environment in light of the spread of conventional services. 

In addition, Islamic banks cannot claim interest on the mandatory reserve that is held 

with the central bank and cannot claim the time value of the defaulters’ money. It also 

invests only in Sharia-compliant financial securities, meaning not all stocks are 

available to them. Despite all of this, they must compete with conventional banks. The 

growth in the Islamic system constitutes 66% all around the world (Bourkhis & Nabi, 

2013; Hijazi & Hanif, 2010). 

2.2 Islamic and conventional banking 

The global financial crisis not only cast doubts on the tasks of the conventional banking 

business, but led to an increase in interest in Islamic banking as well. Due to the 

principles of fixed lending, Islamic financial institutions are becoming more successful 

even with non-Muslims in the world. Sharia is a combination of Islamic and modern 



19 

principles, and its services are available to both Muslims and non-Muslims. Since the 

start of the global credit crisis, non-Muslim investors have been looking for less risky 

alternatives. 

A financial structure helps in managing the economy by offering certain services. It 

mobilizes savings from savers to businessmen. It provides public utility services such as 

money transfer, international trade facilitation, advisory services, safekeeping of 

valuables, and any other fee-based service. There are no restrictions on Islamic banks 

providing such services because they do not contradict Sharia, as Islamic banks operate 

in the same societies as conventional banks and perform all of the functions expected of 

a financial institution. However, the mechanism for mobilizing money from savers to 

entrepreneurs differs. Savings mobilization is divided into two stages: accepting 

deposits and extending financing and investments (Hanif, 2014). 

2.2.1 Balance sheet in conventional and Islamic banks 

The balance sheet structure shows the nature of banks and their role as a financial 

intermediary. Deposits are taken from savers in both types of banks in exchange for a 

reward, regardless of whether the bank operates under a conventional or Islamic system. 

The distinction is in the reward agreement. It is fixed and predetermined in the 

conventional system, whereas in the Islamic system, deposits are accepted through 

participation and speculation, as the reward is variable. The second stage of funding and 

investment is represented by mobilizing savings to expand credit facilities for business 

and industry for the sake of return. Both Islamic and conventional institutions provide 

funding for production channels in exchange for a reward. The funding agreement is 

what makes the difference. conventional banks provide a loan with a fixed reward, 

whereas Islamic banks cannot do so because interest cannot be collected. Profits on 

investments may be charged by Islamic banks, but not interest on loans. Customers 

receive three types of loans from conventional banks: short-term loans, overdrafts, and 

long-term loans. Nonetheless, Islamic banks can only make interest-free loans, Qard 

hassan (Hanif, 2014). The Islamic system is founded on the link between the financial 

sector and the real sector. Islamic financial institutions cannot provide credit facilities 

without deducting the support of the real sector. Funding is done through risk and profit 

sharing, or it should be supported by assets. Also, a distinctive feature of the Islamic 



20 

financial structure is speculation that can play a catalytic role in transforming society 

into wealth by offering capital facilities to skilled people who lack capital. 

Table 1 

Balance sheet in conventional banks 

Assets Liabilities 

Loans and advances to customers Customers deposits 

Cash and balances with other banks 
Due to banks and other financial 

institutions 
Investments Other liabilities 

Financial assets held for trading Sundry creditor 
Cash and balances with the central bank Equity and reserves 

 

We may see much more diversification on the asset side of the conventional balance 

sheet. This distinction is created by marketable securities, trading accounts, and even 

corporate and consumer lending. Liabilities are created through deposits without 

considering the goal of using money on the asset side; this contradiction arises between 

liabilities and assets because the liquidity generated by short-term liabilities covers 

long-term assets. It raises the bank's chances of encountering a maturity mismatch. 

Table 2 

Balance sheet in the Islamic bank 

Application of financing Sources of financing 

Cash balances Demand deposits (amanh) 
Funding assets (murabaha, salam, ijara, 

istisna) 
Investment accounts(mudarabah) 

Investment assets (mudarbah, 
musharakah) 

Special investment account (mudarabah, 
musharakah) 

Fee-based services (ju’ala , kafala) Reserves 
No banking assets (property) Equity capital 

 

In Islamic banks, the balance sheet consists of the assets side of qardhassan and 

investments (musharakah and mudarabah) in addition to financing and trade contracts 

(murabahah, salam, istisna and ijarah). On the liabilities side, there are deposits in 

addition to unrestricted investment accounts. xxxx. (2018). 

  



21 

2.2.2 Islamic system 

The Islamic system is similar to conventional banking services in that it earns profits on 

capital by investing a portion of its profits in Sharia-compliant projects. Islamic banks 

do not conduct business on an interest-based basis. It is governed by Islamic Sharia 

principles known as Fiqh al-Moamalat (Islamic Guidelines for Transactions). The 

fundamental principle of Islamic banking is the sharing of profits and losses, as well as 

the prohibition of usury. The main argument against usury (interest) is that money 

should be earned by selling goods and services rather than as a commodity with which 

one can profit. 

Islamic banks typically use the following products, according to well-known Islamic 

finance theories and models: profit and loss sharing (mudaraba), joint venture 

(musharaka), cost plus (murabaha), custody deposit, lease (ijara), and Islamic insurance 

(takaful). Interest, gambling, and taking excessive risks are all prohibited. promotes 

social equality and safeguards the interests of all market participants (Ahmad, 2000;  

Chapra, 2000). Islamic banking, according to Iqbal & Molyneux (2005), is based on the 

principles of friendship and mutual assistance. It is known as a system of distributing 

equity, risk, and profit. Islamic finance broadens the system of investor and fund user 

participation and collaboration. 

Sharia is defined in Arabic as "the right path to take." Sharia is primarily derived from 

(1) the Qur'an (Muslims' holy book). It is Allah's word, (2) the Sunnah (the principles 

and practices of Prophet Mohammed, may Allah bless him and grant him peace) or 

hadith (narrations related to Prophet Mohammed's actions and sayings, may Allah bless 

him and grant him peace), (3) consensus (agreement among classical Islamic scholars 

on explicit issues not mentioned in the Qur'an or the Prophet's Sunnah), and (4) hadith 

(narrations related to Prophet Mohammed's actions and sayings, may Allah bless him 

and (5) Qiyas (methods of judging matters not mentioned in the Qur'an or Sunnah). 

While some scholars combined consensus and qiyas into a single category known as 

ijtihad. It refers to Muslim scholars' reasoning and agreement (Hassan, 1989; Masood, 

2011, p. 229). There are four primary schools of legal thought: (1) Shafi, (2) Maliki, (3) 

Hanafi, and (4) Hanbali. They all recognize the Qur'an and Sunnah as the primary 

sources of Islamic Sharia. Islamic banks are not financial intermediaries between 

depositors and borrowers, but rather direct investors. Because Islamic banking 



22 

operations are based on the parties sharing profits and losses, the relationship between 

the investor and the debtor is redefined in Islamic banks as opposed to conventional 

banks (Grassa, 2012). 

According to the following ethical principles, which are founded on the Islamic system, 

Islamic banks should behave when making investments (Warde 2000; Lewis & Algaoud 

2001; Gait & Worthington 2007;  Hussein 2010). Islam forbids making projections 

about a loan's profitability. It favors a proportion of the borrower's business venture 

profits and losses over a fixed return on the loan amount (which is viewed as unfair 

behavior). Gambling is prohibited, as are games of pure chance (Hassan and Lewis, 

2007), making money off of the agreement's other party (Kamali, 2000, p. 152) and 

avoiding gharar (uncertainty) in transactions. The imposition of zakat, an Islamic tax 

with the meaning "purity," is a method of wealth redistribution that may assist every 

Muslim in maintaining a decent level of living. The annual cash or in-kind savings that 

Muslims make from all types of assessed wealth are subject to a 2.5% tax that is 

required under Islamic Sharia. Investment in unlawful pursuits that go against Islamic 

principles, such as the sale of alcohol, prostitution, gambling, and pork, is forbidden. 

Murabaha (cost plus profit margin), mudaraba (profit and loss sharing), musharaka 

(joint venture or partnership company), salam and istisna (forward contract), ijara 

(leasing), and qardhassan are the seven Islamic banking tools (Seddiqi 2008). 

2.2.2.1 Murabaha 

A-Rahman (2010) claims that the majority of short-term financing for Murabaha 

contracts is done through Islamic system institutions. In Murabaha contracts, the 

phrases "consumer goods, raw materials, real estate, machinery and equipment, and 

documentary credits" are actually commonly used. In this kind of financing, the bank 

buys the asset and then sells it to the client for a predetermined price plus a profit 

margin that may be established by deferred payment or a flexible repayment schedule. 

The pricing and payment terms are agreed upon by the two parties, the bank and the 

consumer, prior to the contract. The customer won't be charged any further fees if he 

misses the deadline for payment. 



23 

Prior to the contract, the two parties, the bank and the customer, agree on the price and 

payment terms. If the customer fails to pay within the specified time frame, he will not 

be charged any additional fees. 

The fundamental elements of a murabaha contract differ. First, the merchandise must be 

clearly specified and categorized in accordance with the accepted criteria, and it must be 

present at the time of sale. Second, the product's cost price should be stated at the time 

of sale. This should be made clear to the client. Third, the bank must own the goods or 

property at the time of sale. Fourth, specify the time for payment and delivery of goods 

(Iqbal & Molyneux, 2005; Obaidullah, 2005; Lewis & Algaoud, 2001). 

Iqbal & Al-Omar (2000) Murabaha and Ijara contracts account for a large portion of 

Islamic banks' assets due to their ability to fairly predict the return on these tools. 

Furthermore, these two tools provide consistent cash flows, which help the Islamic bank 

meet its liquidity requirements. 

2.2.2.2 Bay’ Al-Muajjal 

Is indeed a financing technique used by Islamic banks in which the bank profited from 

the purchase price and allowed the buyer to pay the price of the goods in one payment 

or in instalments at a later date; it is a type of credit sale. 

2.2.2.3 Musharaka 

According to Siddiqui (2008), musharaka financing is commonly used by banks for 

trade finance, imports, and the issuance of letters of credit in agriculture and industry. 

Islamic banks share equity and risk with the customer in this mode of financing. Profits 

are distributed among the partners in accordance with the agreed-upon ratio, and losses 

are distributed among the partners in accordance with their proportion of equity. 

Ayub (2007) asserts that when partners collaborate, they can determine that one partner 

will run the company with no input from the other partners. According to a contract, an 

Islamic bank lends funds to be used in conjunction with funds from other organizations 

and the business sector (Rammal & Zurbruegg, 2007). The partnership agreement has 

the following characteristics: (1) It is a short-term contract for a specific project; (2) 

earnings will be split in accordance with a predetermined ratio; and (3) losses will be 

split in accordance with capital investment. 



24 

2.2.2.4 Mudaraba 

This type of legal contract is entered into by two parties to share profits and losses in the 

course of doing business, uniting human and financial resources. One of the parties is 

the rab al-mal (financier), and the other is the mudarib (entrepreneur). The contract 

states that one party invests in the project while the other manages it based on its 

expertise. The profit percentage is predetermined between the two parties; however, the 

financier bears losses only if the speculator is negligent or fraudulent in his handling of 

the funds (Henry & Wilson, 2004; Siddiqui, 2008). The most common example of this 

type of financing is the profit and loss account, in which the customer deposits money 

in the bank for investment and the bank invests that money in profitable projects. 

The general rules for speculative transactions are as follows:  

a. Profits must be divided among the parties in previously agreed-upon proportions. It 

cannot, however, be a guaranteed return or a lump sum on investment. 

b. The investor shall not suffer losses in excess of his invested capital. 

c. The speculator is not liable for financial losses unless they are the result of his own 

negligence. 

Due to the fact that the bank lends to the person who runs the business, mudaraba is 

seen as a high-risk technique by Islamic banks. An Islamic bank often reduces these 

risks by taking the appropriate measures to make sure that the suggested business 

strategy is implemented correctly and that it is taken seriously (Elasrag, 2011). 

1. Two-tier Mudaraba 

Two types of Mudaraba contracts are the original Islamic banking concept in which the 

Islamic bank participates. One is from the depositor, and the other is from the person for 

whom the bank is providing financing. The first is between the bank and the customer 

who has extra money (the depositor), and the last is between the bank and the customer 

who is seeking financing. The depositor deposits his money in the bank with no 

assurance that it will be returned in its entirety or that the bank will make a profit on the 

investment it makes on his behalf, but he is responsible for all losses and receives a 

percentage of any gains in accordance with the percentage agreement. 



25 

Second-degree speculation occurs between the bank and those who receive bank 

financing. In this case, the bank is the owner of the funds, while the lender is the 

speculator. Except in the case of fraudulent activities by the speculator, the bank is 

responsible for all losses incurred by the business and shares profits with the customer 

in accordance with previously agreed ratios (Kettell, 2011). 

2. Restricted Mudaraba vs Unrestricted Mudaraba 

According to El-Tiby (2011), mudaraba contracts are classified into two types: 

restricted investment accounts and unrestricted investment accounts. Restricted 

investment account: In this type of mudaraba contract, the depositor (investor) has the 

right to authorize Islamic banks to invest their money through agency contracts with 

certain restrictions on where, how, and why their money is invested. 

Unrestricted Investment Account: In this case, the depositor does not impose any 

conditions on Islamic banks when investing their funds. The bank has complete freedom 

to invest this money in mudaraba or wakala contracts. This is appropriate for banks to 

pool their funds and invest them in a pooled portfolio. 

2.2.2.5 Al-wakala 

It is a type of mudaraba contract because the depositor places money with the bank and 

the customer-bank relation is trustworthy. The bank receives a fixed fee for its services 

under this contractIt is an agency agreement because one party (the investor) pays a fee 

to appoint another party (the bank) as an agent (agent). The bank invests in a pre-

agreed-upon asset in the best interests of the investor and charges a fee for the profits 

made from investing the funds, and returns any remaining profits to the investor (the 

principal). 

Agency contracts are classified into several types, including agency in purchase, agency 

in sale, restricted agency, unrestricted agency, general agency, and private agency. 

According to Van Greuning & Iqbal (2008), there are two types of agency contracts: 

unrestricted and unrestricted agency. The bank is not limited in unrestricted agency 

contracts. It can invest in any asset without restrictions, and the bank only charges a fee 

to the investor rather than becoming a profit and loss partner (Hassan et al., 2013). 



26 

2.2.2.6 Ijara 

Ijara is an Islamic method of leasing or hiring in which physical assets are rented. Ijara 

is a contract in which a customer purchases the right to use an asset for a set period of 

time. It is, in general, a contract for leasing tangible assets (such as property or goods), 

but it also refers to the rental of services for a fee. 

Ijara is classified into two types: (1) simple ijara and (2) complex ijara (operational 

ijara). The financier buys the asset and rents it to the customer for a set period of time in 

this type of ijara. (2) WataqniIjara (Financial Ijara): In this type of ijara, the financier 

and the customer agree to transfer ownership of the asset at the end of the lease term. 

The customer is responsible for paying the rent as well as the progressive payment of 

asset ownership (Van Greuning & Iqbal, 2008). The ijara contract is similar to the 

Conventional lease agreement of a bank. However, the ijara contract requires the 

leasing agency to retain ownership of the leased object for the duration of the term. The 

second distinction is that there is no compound interest if the customer fails to make 

timely payments in accordance with the terms of the ijara contract (Masood, 2011). 

2.2.2.7 Salam 

Salam is a contract for the sale of goods in which the seller receives cash in advance and 

the merchandise is delivered to the customer at a later date. According to Iqbal & 

Mirakhor (2007), in a salam contract, the quantity and quality of the product are fully 

determined at the time of the agreement. 

It entails purchasing goods and deferring delivery. It functions similarly to 

Conventional futures contracts but differs in terms of payment agreement. A specific 

product that has to be supplied at a later time is paid for in full in front. The primary 

advantage of this contract is that it relieves the buyer of anxiety regarding the future 

price of the commodity while providing the manufacturer with the full purchase price 

up front to invest in production (Masood, 2011). 

  



27 

2.2.2.8 Istisna 

A set number of products is sold at a predetermined price at a later time under the 

Islamic financing method known as istisna. It is comparable to salam, however in the 

case of the istisna contract, the buyer does not pay the whole cost of the goods upfront 

(Iqbal & Llewellyn, 2002; Vogel & Hayes, 1998). 

Iqbal & Mirakhor (2007) outline three requirements for istisna contracts: (1) 

manufacturing of the underlying asset or product; (2) flexibility in payment and delivery 

terms; and (3) cancellation of the contract prior to manufacturing. 

2.2.2.9 Qard Hassan 

According to Siddiqui (2008), this type of financing is available to the poor in society. It 

is, in essence, interest-free financing. The financier has a negative net present value. 

2.2.2.10 Sukuk 

It is a bond founded on Islamic values. It is issued as proof of funds received by the 

recipient (the beneficiary), granting some rights to the assets. Sukuk bonds are a type of 

asset-backed security. 

Sukuk are classified into three types: leased sukuk, sukuk based on shares, and sukuk 

based on sale. These are similar to bonds in conventional banks, but the difference is 

that sukuk are asset-backed and refer to the holder's ownership of tangible assets. There 

are various types of sukuk that rely on complementary instruments. Sharia-compliant 

terms include Mudaraba, Musharaka, Murabaha, Agency, Ijarah, and Istisna' (Kamil, 

2008). 

Equity-based sukuk, which are issued in exchange for physical assets and serve as a 

note or certificate demonstrating ownership of an asset, are the most significant and 

popular type of sukuk. In order to invest their reserve assets, the central banks of 

Islamic nations introduced sukuk in the year 2000. Sukuk was employed as a tool for 

risk management. Awan, 2009; Hassan et al., 2013). 

  



28 

2.3 Unsystematic risk 

Banks suffer from several risks due to the nature of their work. Risks are categorized 

into systemic and unsystematic. Systematic risks are associated with the market and the 

country's economy and Unsystematic risks are associated with unique assets or a 

specific company and cannot be reduced through mitigation techniques in a diversified 

portfolio. Unsystematic risk is another name for diverse risk. There are three general 

risk mitigation strategies, according to Oldfield and Santomero (1997): risk elimination 

or avoidance through simple business practices, risk transfer to other participants, and 

effective bank-wide risk management (risk acceptance). 

Uncertainties caused by adverse fluctuations in profits and losses are thus defined as 

risks. According to the researcher, identifying risks is the first step in the risk 

management process, and it serves as the starting point for subsequent steps such as risk 

assessment, risk analysis, and risk control; organizational and risk factors (conditions 

that increase the chances of loss and profit) and risk (cause of unexpected loss) 

exposure to resources (things that experience losses and gains). The critical step is 

identifying risks, and it is necessary to spend time on this activity after identifying risks. 

It is necessary to identify the prevailing uncertainties, understand the nature of the 

market in question, the social, political, and legal environment, and comprehend the 

risk-related activities. Because the process of identifying risks is complex and not fixed, 

banks must implement procedures to ensure that all risks faced by the company are 

captured. There are some concerns about identifying risks. Banks must verify that a 

single transaction contains numerous risks that must be identified. Banks must also 

consider the level of risk associated with specific transactions. The bank is also required 

to assess its business conditions and corporate governance system. Identifying risks is a 

comprehensive activity that includes determining the sources and causes of risks, as 

well as whether the risks are caused by internal or external factors. External causes 

cannot be avoided, but they can be mitigated through careful planning. Oldfield & 

Santomero (1997). Following the determination of the scope, the potential risks are 

classified in terms of risk severity and probability in relation to the effect (chance of 

limits). This informs the bank of its willingness to take on such risks. Risk assessment is 

a continuous process that involves evaluating the risk response, scope, objectives, and 

controls. The risk assessment process begins with a qualitative assessment, and then 



29 

sufficient data is extracted in a timely manner to aid in risk and resource allocation 

decisions. The most basic type of assessment is a qualitative assessment, which 

categorizes potential risks. 

Risk assessment is linked to the distinction of primary and secondary risks. The next 

step is to prioritize the risks after they have been measured. They are compared after 

receiving and analysing data about the risks. As a result, the bank must determine the 

level and type of acceptable risks that can be controlled. Furthermore, the bank must 

clarify the risks that must be transferred to a third party. 

2.3.1 Risk in Conventional banks 

conventional banking products are classified into two categories: liability products and 

loan products. Customers can open savings accounts, current accounts, and fixed 

deposit accounts with liability products, whereas loan products include fixed loans, 

current financing, and term loans. 

2.3.1.1 Credit risk 

Credit risk is one of the most visible risks in the banking industry, and it refers to a 

counterparty's failure to pay debts or meet contractual obligations. Credit risk is an 

important component of fixed income investment. As a result, rating agencies assess 

corporate issuers' credit risks. 

Credit risk is actually divided into several components (Bessis, 2011). The risk of 

default occurs when the borrower fails to repay the entire or a portion of the loan 

amount. There are numerous cases of default, such as loan repayment delays, borrower 

bankruptcy, and debt restructuring due to the borrower's poor credit standing. The 

migration risk refers to the direct loss caused by internal and external rating, as well as 

possible indirect losses caused by credit carry-over, which increases the likelihood of 

non-payment. Actually, exposure risk is the risk of losing money due to the future value 

of the money lent. Loss due to default indicates that a portion of the loan amount has 

not been repaid. 

  



30 

2.3.1.2 Liquidity risk 

One of the most significant risks that banks face is liquidity risk. Liquidity risk arises 

when a bank is unable to pay its obligations due to a mismatch between the maturities 

of assets and liabilities, as banks with a large number of off-balance-sheet items are 

more vulnerable to liquidity risk. Finance is all-encompassing, which is why liquidity 

risk does not appear in the bank on its own, but rather as a result of the consequences of 

credit risks, market risks, and interest rate risks, to name a few. 

Effective liquidity risk management contributes to the development of market 

confidence and the maintenance of relationships with borrowers by meeting their loan 

requirements on time and refraining from selling assets at low prices in order to 

generate funds. 

1. Liquidity risk includes the following risks: Financing risk: the risk of substituting net 

cash flow for unanticipated withdrawals or deposits that have not been replenished 

by depositors. 

2. Time risk: the risk of not receiving the expected money flows. 

3. Call risk: the risk of obtaining contingent commitments and being unable to obtain 

useful employment opportunities when needed. 

2.3.1.3 Market risk 

Market risk is defined as the possibility of incurring losses on and off the balance sheet 

as a result of market price fluctuations (Ghosh, 2012). They result from changes in the 

market value of interest rates or exchange rates, as well as price changes in bonds, 

stocks, and commodities.  

Market risk factors include: 

1. Interest rate risk 

a. It happens as a result of fluctuations and changes in interest rates on assets. For 

example, when interest rates rise, the value of the bond falls, and when interest rates 

fall, the price of the bond rises. Banks bear the following types of interest risk. 

b. Baseline risks: They occur when the return on assets and the cost of liabilities are 

calculated at different rates, such as the London interbank rate versus the US main 

interest rate (Bhattacharya, 2010). 



31 

c. Prising risk arises when assets and liabilities are reissued at different times and 

rates. When the loan has a variable interest rate, the lender may earn more income as 

the interest rate rises, but it may lose money in the lower price lane. (Vyas & Singh, 

2010). 

d. Option risk: This risk arises as a result of the variety of assets and liabilities 

available. option risks arise, for example, in mortgage loans when payments are 

made early due to interest rate fluctuations, resulting in a loss of income for the 

lender. This type of risk is challenging to assess and manage. (Vyas & Singh, 2010) 

2. Foreign exchange rate risk 

Foreign exchange risks, sometimes referred to as currency risks or exchange rate risks, 

are influenced by exchange rates and manifest as variations in profits as a result of tying 

revenues and expenses to exchange rates or as changes in the value of assets and 

liabilities denominated in foreign currencies. This kind of import and export transaction 

is typical (Vyas & Singh, 2010). 

2.3.1.4 Operational risks 

They are direct and indirect risks resulting from the failure of internal processes, 

personnel, and systems, as well as external events. The failure of the information 

system, reporting system, internal risk control rules, and internal procedures designed to 

carry out the procedures creates these risks. 

Bessis (2011) explains operational risk levels: 

1. Human Errors / Fraud Operations: These include lack of experience, internal or 

external fraud, and employee practices that may lead to the bank's loss. 

2. Processes: They include insufficient procedures and controls for reporting, 

monitoring, decision-making, organization and management, and inefficiency in 

technology, which cause losses to the bank. 

3. Technical: It includes technical risks and the lack of sufficient instruments to 

measure the risks in banks. 

4. Information Technology: The possibility of loss due to system failure or 

insufficient information system. 



2.3.2 Risk in Islamic bank:

Figure (1) depicts how an Islamic bank is designed to raise funds from depositors and 

invest it in a variety of sharia

Figure 1 

Islamic Financial Intermediation

Funding/ Resources Mobilization Investment/Revenue Generation

 

 

 

 

 

 

 

2.3.2.1 Credit risk 

Credit risk arises in Islamic financial instruments such as murabaha contracts, which are 

riskier due to the nature of the contract and its adherence to Islamic Sharia rules and 

regulations. Credit risk arises when a customer defaults 

receiving assets from the bank. Similarly, in murabaha contracts, the buyer has the right 

to refuse to deliver the product purchased by the bank, and the bank is also subject to 

market and price risks as a result of credit risk.

reasons, according to Vogel & Hays (

the goods are of poor quality; and the salam and istisna contracts were not fulfilled. 

Credit risk arises in the mudaraba contra

Because of the nature of the project, the bank can only act as a financier and cannot 

manage the mudaraba contract, just as Islamic banks cannot assess and manage credit 

risk. This situation will increase the credit 

32 

 Risk in Islamic bank: 

) depicts how an Islamic bank is designed to raise funds from depositors and 

invest it in a variety of sharia-compliant instruments.  

Islamic Financial Intermediation 

Funding/ Resources Mobilization Investment/Revenue Generation

Credit risk arises in Islamic financial instruments such as murabaha contracts, which are 

riskier due to the nature of the contract and its adherence to Islamic Sharia rules and 

regulations. Credit risk arises when a customer defaults on outstanding duties after 

receiving assets from the bank. Similarly, in murabaha contracts, the buyer has the right 

to refuse to deliver the product purchased by the bank, and the bank is also subject to 

market and price risks as a result of credit risk. The customer defaults for the following 

reasons, according to Vogel & Hays (1998): the bank did not deliver the goods on time; 

the goods are of poor quality; and the salam and istisna contracts were not fulfilled. 

Credit risk arises in the mudaraba contract, according to Hassan & Lewis (

Because of the nature of the project, the bank can only act as a financier and cannot 

manage the mudaraba contract, just as Islamic banks cannot assess and manage credit 

risk. This situation will increase the credit risk of Islamic banks. However, in the case of 

) depicts how an Islamic bank is designed to raise funds from depositors and 

Funding/ Resources Mobilization Investment/Revenue Generation 

Credit risk arises in Islamic financial instruments such as murabaha contracts, which are 

riskier due to the nature of the contract and its adherence to Islamic Sharia rules and 

on outstanding duties after 

receiving assets from the bank. Similarly, in murabaha contracts, the buyer has the right 

to refuse to deliver the product purchased by the bank, and the bank is also subject to 

The customer defaults for the following 

): the bank did not deliver the goods on time; 

the goods are of poor quality; and the salam and istisna contracts were not fulfilled. 

ct, according to Hassan & Lewis (2007). 

Because of the nature of the project, the bank can only act as a financier and cannot 

manage the mudaraba contract, just as Islamic banks cannot assess and manage credit 

risk of Islamic banks. However, in the case of 



33 

musharaka contracts, Islamic banks will be exposed to credit risk if the customer or 

entrepreneur fails to pay the bank's profit. 

Islamic banks face credit risks that are similar to those faced by conventional banks. As 

a result, the processes for calculating minimum capital requirements for credit risk 

exposure are similar to those used by conventional banks. (Kahef, 2005) 

2.3.2.2 Liquidity risk 

Islamic banks can offer two different types of liquidity: (1) Insufficient resources to 

access Islamic banks to meet the bank's financial obligations, it might be challenging to 

turn illiquid assets into liquid ones when there is a lack of liquidity in the financial 

markets. (ii) The Islamic bank is unable to raise money at a competitive price when the 

financing market is constricted (Iqbal & Mirakhor, 2007). The primary source of 

liquidity risk in Islamic instruments is a lack of sufficient liquidity. According to Ariffin 

et al., converting financial instruments into convertible financial instruments is not 

acceptable (2009). If you incur a debt, it is transferable, but only at face value. 

In Islamic banking, the following factors contribute to liquidity risk: 

1. Inadequate legal money market availability 

2. The absence of an effective interbank money market as a result of the legal 

prohibition on interest rate on transactions. 

3. A scarcity of secondary markets is also a major source of liquidity risk. 

4. Islamic Sharia allows for real estate transactions and borrowing. As a result, 

tradable asset-backed securities, such as Islamic financial institutions' sukuk bonds, 

are required. 

2.3.2.3 Market risk 

Market risk is linked to negative price direction in rate of return, foreign currency rate 

risk, profit rate risk, equity risk, and commodity price risk, claim (Iqbal&Mirakhor 

2007 and Van Greuning & Iqbal 2008). Islamic banks are not exposed to interest rate 

risk because they do not engage with various governmental and public financial 

instruments. The erratic nature of the current and prospective asset markets is what 

generates market risk. Market risk also applies to derivative instruments including 

options, interest derivatives, currency derivatives, and stock derivatives. 



34 

2.3.2.4 Foreign exchange risk 

Banks face exchange rate risk as the exchange rate between domestic and foreign 

currencies fluctuates, according to Van Greuning & Bratanovic (2009). Foreign 

exchange risk arises in contracts in which an Islamic bank is required to receive 

payments in another currency and the exchange rate falls over time, or when Islamic 

banks make payments in foreign currency and the exchange rate rises. 

2.3.2.5 Commodity price risk 

According to Akkizidis & Khandelwal, (2008) commodity price risk arises when banks 

own various assets with the intention of selling them in the future. Commodity price 

risk occurs when an asset's commodity price falls and the bank is forced to deliver that 

commodity at a low price. Commodity price risk is present in Islamic finance types such 

as salam, istisna, ijara, mudaraba, and musharaka, according to Hassan & Lewis (2007). 

2.3.2.6 Mark-up risk 

On the loan that is provided to the customer, Islamic banks impose a fixed rate profit 

margin. The profit rate is established using LIBOR because Islamic banking does not 

have any criteria for doing so. If the benchmark rate is greater than the prior rate and 

there is speculation involved, there is a risk to the profit margin because the bank cannot 

charge a higher rate to an existing customer. The profit margin is determined once and 

used during the entire time period, just like in Islamic banking. Similarly, when it comes 

to participation, Islamic banks use LIBOR as a criterion to calculate the profit-loss ratio. 

Because the rates were predetermined, the bank cannot enjoy a higher return on 

previous contracts if the benchmark rate rises (Iqbal & Mirakhor, 2007; Hassan & 

Lewis, 2007). 

2.3.2.7 Equity investment risk 

Van Greuning & Iqbal (2008) claim that Islamic banks also participate in equity 

investments including stock market shares, private equity funds, and involvement in 

particular projects. Additionally, these investments are vulnerable to market, credit, and 

liquidity risks. If such risks exist, the bank's financial profits will be volatile, as will the 

capital invested in those shares. Among the risks associated with stock investing are: 

improved monitoring is required to reduce informational gaps. Islamic banks must 



35 

actively participate in monitoring, financial disclosure, reporting, and project 

supervision. 

To avoid equity losses, proper monitoring and evaluation of mudaraba and musharaka 

contracts is required. Because the degree of risk in these contracts is high, extra care 

must be taken to evaluate and select the project in order to minimize future equity 

losses. 

Investing in stocks other than those listed on the stock exchange is risky due to a lack of 

organized and proper secondary markets, which raises the cost of pre-exit. 

2.3.2.8 Operational risks 

Operational risks are associated with system failures and issues related to technology 

and its operation, including weak internal policies, actions, and processes of Islamic 

banks, which can result in bank losses. Operational risks arise as a result of internal and 

external operations failing, resulting in direct and indirect losses for Islamic banks 

(Bassis, 2002; Iqbal & Mirakhor, 2007; Ahmed & Khan, 2007). 

Sundararajan (2005) claims that the following issues in internal control systems to 

handle issues with operational procedures and back office functions, technology risks, 

potential risks related to the enforcement of Islamic contracts in a complex legal 

environment, the risk of non-compliance with sharia rules and regulations, and the 

potential cost of monitoring are the main sources of operational risks in Islamic banks 

(Van Greuning & Iqbal, 2008). 

Legal risks (Archer & Abdullah, 2007; Djogosojito, 2008; Venice, 2007; Khan & 

Ahmed, 2001; Sundarajan, 2005), Shari'a non-compliance (Islamic Financial Services 

Board, 2007, Islamic Financial Services. 2005), credit risk (Islamic Financial Services 

Board, 2005), and reputational risk are all factors to consider (Archer & Abdullah, 

2007; Akkizidis & Bouchereau, 2005; Venice, 2007; Standard & Poor, 2008). 

For Islamic banks, operational risk is a major concern and one of the most visible 

threats they face. According to Khan & Ahmed (2001), managers in Islamic banks 

believe that operational risk is more important than profit risk. According to Khan & 

Ahmed (2001), operational risks in Islamic finance are higher in salam and istisna 



36 

contracts and lower in murabaha and ijara contracts. The instruments' higher risk 

ranking indicated that banks find it difficult to implement these contracts. 

2.3.2.9 Business risks 

According to Van Greuning & Iqbal (2008), business risks arise as a result of 

macroeconomic and policy concerns, legal and regulatory factors, and financial sector 

infrastructure. Rate of return risk, drawdown risk, liquidity risk, and reputation risk are 

all examples of business risks. 

1. Risk rate of return (ROR) 

Because Islamic banks' returns on investments are uncertain, there is a risk of rate of 

return