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Risque commercial translaté, identification et gestion

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 Displaced commercial risk (DCR) and value of alpha (

α

%) forIslamic banks in Bahrain/GCC

Dr. Mohammad Omar Farooq

Head of Center for Islamic FinanceBahrain Institute of Banking and Finance, Kingdom of BahrainEmail:farooqm59@gmail.com 

Sowmya Vivek

Research Analyst/CoordinatorBahrain Institute of Banking and Finance, Kingdom of Bahrain

Paper accepted for Gulf Research Council, July 11-14, 2012 at University of Cambridge, UK

 

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The phenomenal growth of Islamic Banking and Finance in recent years has highlighted needsfor policies to help integrate Islamic finance in the national and global financial system. Therehas also been an understandable increased interest of researchers into understanding uniqueaspects of Islamic banking and finance and how it can be standardized across the globe. RiskManagement in particular is drawing a lot of interest given the current turmoil in the financialsystem and infrastructure. Few Islamic Bankers believe that Islamic banks overall are lesssusceptible to risk on account of their nature. However an overwhelming majority rightly feelthat in additional to risks which conventional banks follow, Islamic banks face certain risk whichare unique to its nature. These risks include risks like Fiduciary risk and Displaced CommercialRisk (DCR).Displaced commercial risk is a unique risk applicable to an Islamic bank particularly in a dualbanking environment. Displaced Commercial Risk (DCR) is a special risk Islamic banks areexposed to due to the commercial pressure of a having to pay a rate of return equivalent to acompetitive rate of return and absorb a portion of losses which normally would have been borneby investment account holders in order to prevent massive withdrawal of funds.Banks employ a great deal of measures to combat this risk. Profit Equalization Reserves (PER)and Investment Risk Reserve (IRR) play a critical role in the management of DCR in Islamicbanks. The PER is retained from the total income before the profit is allocated betweenshareholders and Investment Account Holders and the calculation of Mudarib Share. IRR isretained only from the profits attributed to Investment Account Holders (After deduction ofMudarib share). The provisioning for these reserves is generally outlined in the contract and isdecided by the management. Islamic banks normally invest these reserves to generate additionalreturns to investment account holders and smooth the returns on PSIA. If the reserves areadequate to avoid the transfer of income from shareholders to Investment Account Holders, thereis no exposure to DCR. However DCR is positive if these reserves are insufficient and there istransfer of some proportion of shareholders returns to depositors.The recognition of DCR requires adjustment to Capital adequacy ratio of Islamic banks. IFSBhas come up with two methods to adjust the capital adequacy ratio of Islamic banks to account

 

for DCR. The first method excludes risk weighted assets funded by PSIA and hence assumes thatthe risks are fully absorbed by investment account holders.The second method requires a proportion

α

% of risk-weighted assets financed by Profit SharingInvestment Accounts to be included in the calculation of capital adequacy ratio. This method ismore aligned with the market reality in that it recognizes that investment account holders don’tfully absorb the risk. ‘

α

%’ which can take any value between 0 and 1 is taken as a proxy of DCRand moves in a positive relationship with DCR. ‘

α

%’ is decided by the central bank and allIslamic banks within its jurisdiction are expected to key in this value while calculating theircapital adequacy ratio.Given this background our paper looks at the issue of DCR and alpha across GCC with particularemphasis on Bahrain. The paper uses the IFSB methodology to calculate DCR and value of alphafor banks in Bahrain.

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Though there has been studies done on DCR and the value of Alpha, not much has been donewith focus on GCC, primarily due to lack of disclosures and data. A number of notable researchworks in this area have been done by Simon Archer and Rifaat Ahmed Abdel Karim (2006;2010) and Vasudevan Sundarajan (2002). Also substantial research in this area has been done bythe Malaysia based Islamic Financial Services Board (IFSB).

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III. Challenges regarding profit-sharing contracts

3.1 Management of PSIA and the mudaraba contractsAs per definition from AAOIFI, Mudaraba contracts essentially are a partnership in profitbetween capital and work. It may be conducted between investment account holders as providersof funds and Islamic bank as a mudarib. The Islamic banks announces its willingness to accept

 

the funds of investment amount holders, the sharing of profits being as agreed between the twoparties and the losses being borne by the provider of funds except if they were due tomisconduct, negligence, or violation of the conditions agreed upon by the Islamic bank. In thelatter cases, such losses would be borne by the Islamic bank.

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 There are two types of Mudharbah contracts that the Islamic banks offer namely the restrictedprofit sharing investment accounts (RPSIA) and unrestricted profit sharing investment accounts(UPSIA).In Restricted PSIA (RPSIA) investment account holders imposes certain restrictions asto where, how and for what purpose his funds are to be invested. Further the Islamic bank maybe restricted from commingling its own funds with the restricted investment account funds forpurpose of investment.

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 In contrast under Unrestricted PSIA (UPSIA),the investment account holder authorizes theIslamic bank to invest the account holder’s funds in a manner which the Islamic bank deemsappropriate without laying any restrictions as to where, how and for what purpose the fundsshould be invested. Under this arrangement the Islamic bank can commingle the investmentaccount holder’s funds with its own funds or with other funds the Islamic bank has the right touse (e.g. current accounts). The investment account holders and the Islamic bank generallyparticipate in the returns of the invested funds.

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