Credit risk management pertaining to profit and loss sharing instruments in Islamic banking

Abstract

PurposeThis paper aims to provide a new approach for the credit risk management process of profit and loss sharing instruments in Islamic banks.Design/methodology/approachThree credit risk management steps are elaborated for profit and loss sharing instruments.FindingsFirst, a new credit risk definition compatible with profit and loss sharing instruments is done. Connected to this definition, possible credit risk factors are identified. Second, in terms of credit risk measurement, a general framework for credit scoring of prospective customer‐agents is drawn. Lastly, three groups of credit risk mitigation tools are suggested.Research limitations/implicationsThe paper can be developed further by empirical analyses and case studies.Originality/valueEven though credit risk is a well‐known and deeply elaborated financial concept in conventional literature, its unique characteristics in terms of profit and loss sharing instruments have not been sufficiently elaborated in Islamic finance literature. This paper is an attempt to fill in this gap.