Stress Testing and Reverse Stress Testing: An Approach for a Resilient Islamic Financial Industry

Abstract

Stress testing is an important tool for risk management in the operation of Islamic financial and capital markets. Islamic financial market’s (IFM) instruments use different stress testing and liquidity risk approaches due to considerations relating to their regional, regulatory, legal, product and operational requirements that may dictate a certain approach and stress scenarios to manage the associated risks and test their ability to absorb market shocks. This chapter provides in-depth insights into the best market practices for stress testing framework for the survival of Islamic financial markets and institutions in the face of possible market shocks, within a sophisticated financial market in Europe. This subject is important for two reasons: firstly, the survival of an Islamic financial market and its institutions is hugely dependent on its risk factors and stress testing management approaches. Secondly, the ability of managing such market shocks without compromising Shari’ah requirements is a very important component for Islamic financial institutions (IFIs). The study collects its data by using the method of a case study to obtain in-depth knowledge from the Bank of England and IFIs in the UK. The findings of the study identify key stress testing steps and assessment in addition to risks that are crucial for the survival of the IFM and its institutions. It also suggests a stress testing approach that could reduce the impact of financial shocks to the IFM and ensure its resilience.