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Modern Economy, 2012, 3, 73-80 doi:10.4236/me.2012.31011 Published Online January 2012 (http://www.SciRP.org/journal/me) 73Adapting Risk Management for Profit and Loss Sharing Financing of Islamic Banks* Irawan Febianto Faculty of Economics and Business, University of Padjadjaran, Bandung, Indonesia Email: i_febianto@yahoo.com, irawan.febianto@fe.unpad.ac.id Received October 9, 2011; revised November 25, 2011; accepted December 22, 2011 ABSTRACT The low level of participation of the Islamic banks in profit and loss sharing (mudharabah and musharakah) financing models has become one of the problems in the development of the industry. These arrangements are unique to Islamic banking and account for its superiority over conventional banking on grounds of ethics and efficiency, but the majority of Islamic banks have limited themselves to less risky trade-financing assets, that tend to be a shorter maturity. This paper intends to analyzes why Islamic banks are reluctant to indulge in mudharabah and musharakah financing. Finally, it explores the risk management concept that might solve the problems. Keywords: Islamic Banks; Profit and Loss Sharing Arrangements; Risk Management 1. Introduction The concept of Islamic banking is essentially based on the idea that Islam prohibits riba, but permits trade and profit- loss sharing arrangements. The two forms of profit and loss sharing, which is frequently mentioned in fiqh litera- ture, are mudharabah and musharakah. These equity- based products are unique to Islamic banking and in some sense, account for its superiority over conventional banking on grounds of ethics and efficiency. Specialists attempting to find an alternative to interest- based finance build up their hopes on Islamic banks to provide a significant amount of profit-sharing (PLS) fi- nancing. They called them the primary Islamic modes of finance and considered the rest as secondary modes. Pri- mary modes would have economic effects similar to direct investment and produce a strong economic devel- opment impact. Theoreticians have provided some argu- ments in favor of profit-sharing financing over fixed re- turn-on-capital financing. However, in practice, profit- sharing finance has remained negligible in operations of Islamic banks [1]. The objective of this paper is to discuss why Islamic banks tend to avoid profit and loss sharing arrangements and how the risk management concept can offer solutions for this problem. 2. Literature Review A financial system is usually defined as a set of rules and regulations governing and controlling the flow of funds from the surplus spending units (SSU) to the spending deficit unit (SDU) [2]. The household, business, and government sectors are part of both the SSUs and SDUs. An Islamic financial system, by definition, provides a linkage between SSUs and SDUs through an array of fi- nancial products and services that do not violate the norms of Islamic ethics [3]. Islamic scholars have not only established the basic principles and norms, but also iden- tified the contractual mechanisms that conform to these norms and do not violate them in any manner [3]. As part of the financial system, the basic principle of Islamic banking is the sharing of profit and loss and the prohibition of riba’ (interest). Amongst the common Is-lamic concepts used in Islamic banking are profit sharing (Mudharabah), safekeeping (Wadiah), joint venture (Mu- sharakah), cost plus sale (Murabahah), and leasing (Ijarah). The two forms of profit and loss sharing modes of fi-nancing, which find frequent mentions in fiqh literature, are Mudharabah and Musharakah. In Musharakah, the bank’s profit on the loan is equal to a certain percentage of the partner’s profits. Once the principal amount of the loan is repaid, the profit-sharing arrangement is con- cluded. Furthermore, Mudharabah is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between *Earlier version of this paper has been written with sis. Rahmatina Kasri from Universitas Indonesia and presented at the 2nd Islamic Economics Conference 2007 (iECONS 2007), Kuala Lumpur: Faculty of Econom-ics and Muamalat , Islamic Science University of Malaysia.Copyright © 2012 SciRes. ME