Stress testing Islamic finance

Ayah el Said and Rachel Ziemba discussed risk management considerations comparing stress testing in conventional finance and the Islamic finance industry on RGEMonitor.

For Islamic financial institutions, a plausible scenario means factoring in possible contractions in several of the economies that have been the centers for Islamic finance as well as significant asset market corrections which would weaken the balance sheets of Islamic financial institutions. A stress scenario should factor in at least another 40% drop in property prices in Dubai and considerable drops in other markets. The increased risks of investment losses on the one hand, and rising non-performing loans on the other, adds to the vulnerability of Islamic banks.

Conclusion: There are several longer-term trends supportive of Islamic finance including demographic trends and diversification of portfolios within target regions despite the hard time expected in the short term. Yet, as noted in the FT’s most recent (and excellent) review of Islamic finance, one aspect of the crisis of confidence has been a freezing of some of the overly innovative structures especially delays in Islamic derivatives and hedge funds.

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