How is the management of operational risk in Islamic financial institutions conducted in the UK?

Management of Operational Risk in UK Islamic Financial Institutions

Introduction and Research Background

            The big role played by Islamic banking institutions in economic development has significantly increased (Chachi, 2005). This increase means that there has been a similar increase in the number of financial institutions committed to the provision of Islamic banking services and products.

            Just like any other financial institutions, Islamic banking institutions are faced with the growing challenge of exposure to risks. Yet risks in banking have proven to be among the most common cases of turbulence and even failure in not just individual financial institutions but also in entire financial sectors across the world (De Fontnouvelle, De-Jesus-Rueff and Rosengren, 2006).

            The interconnectedness of the financial sector with other sectors of the economy – as well as between any given nation’s financial sector and the financial sectors of the other nations – makes it quite difficult for emerging financial stresses and other troubles to be controlled when they occur (Greuning and Iqbal, 2008). Therefore, managing risks is a much better and more effective way of reducing the exposure of Islamic banking institutions to shocks that could and in turn greatly undermine these institutions’ operations.

            While many risks exist, one of the most common yet least addressed risks in banking in general and Islamic baking in particular is operational risk (Chachi, 2005). At least since the global financial crisis and the enactment of the Basel II regulations, operational risk has been identified as a potentially major cause of banking stress and other troubles (Chachi, 2005).

            Like most other risks, an operational risk is either hard or impossible to accurately and totally control. Therefore, managing it instead – ensuring that the Islamic financial institutions concerned are mitigated from the risk – is a more effective approach than dealing with and/or addressing it (Cihak, and Hesse, 2008).   

Research Problem and Rationale

            Islamic banking has increased across the world largely due to globalization (Ebrahim, 2007). As more people of the Islamic faith migrate from their  traditional birthplaces in mostly the Middle East, North Africa, and parts of Asia to the West, the need to have appropriate financial services provided to them wherever they are (in the West) has increased (Fiennes, 2007). However, and in spite of the presence of large populations of the Muslim community in Western nations, financial services that meet their needs (such as Islamic banking) have not been adequately provided. Even where there are such services, they are far from ideal (Fiennes, 2007).

            More importantly, application of Islamic banking services has proven difficult, even impossible, especially due to the many operational risks that have been brought about by factors like new technology and cultural differences (Chorafas, 2004). This has in turn negatively impacted Islamic banking in such Western states as the United Kingdom (UK). Identification and mismanagement of operational risk in Islamic banking institutions in the UK is therefore an issue that needs urgent attention (Fiennes, 2007).

Aim and Objectives of the Study

            The main aim of this study is to explore the management of operational risk in Islamic financial institutions found in the UK. Its objectives include the following:

1. To determine the extent to which operation risk management is essential in Islamic financial institutions in the UK.
2. To critically evaluate the application of operational risk management in Islamic financial institutions in the UK.
3. To ascertain the effectiveness of the various methods and/or processes used in operational risk management in Islamic financial institutions in the UK.
4. To make recommendations for improvement of operational risk management practices in Islamic financial institutions in the UK based on the global best practices.

Main Research Question

1. How is the management of operational risk in Islamic financial institutions conducted in the UK?

Supplementary Questions

1. To what extent, if at all, are Islamic financial institutions in the UK prone to operational risks?
2. Do Islamic financial institutions in the UK prioritise operational risk?
3. In which way(s) is the management of operational risk in Islamic financial institutions similar or different from non-Islamic financial institutions?
4. To what extent can operational risk management practices in Islamic financial institutions in the UK be said to conform to the global best practices?
5. From the point of view of the UK Islamic financial institutions, how does operational risk compare with credit risk and market risk?
6. What more can be done or needs to be done to improve the management of operational risk in Islamic financial institutions in the UK?

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