Displaced Commercial Risk

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Displaced commercial risk (DCR) and value of alpha (α%) for Islamic banks in Bahrain/GCC Dr. Mohammad Omar Farooq Head of Center for Islamic Finance Bahrain Institute of Banking and Finance, Kingdom of Bahrain Email: [email protected] Sowmya Vivek Research Analyst/Coordinator Bahrain Institute of Banking and Finance, Kingdom of Bahrain Paper accepted for Gulf Research Council, July 11-14, 2012 at University of Cambridge, UK

Transcript of Displaced Commercial Risk

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Displaced commercial risk (DCR) and value of alpha (α%) for

Islamic banks in Bahrain/GCC

Dr. Mohammad Omar Farooq

Head of Center for Islamic Finance

Bahrain Institute of Banking and Finance, Kingdom of Bahrain

Email: [email protected]

Sowmya Vivek

Research Analyst/Coordinator

Bahrain 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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I. Introduction

The phenomenal growth of Islamic Banking and Finance in recent years has highlighted needs

for policies to help integrate Islamic finance in the national and global financial system. There

has also been an understandable increased interest of researchers into understanding unique

aspects of Islamic banking and finance and how it can be standardized across the globe. Risk

Management in particular is drawing a lot of interest given the current turmoil in the financial

system and infrastructure. Few Islamic Bankers believe that Islamic banks overall are less

susceptible to risk on account of their nature. However an overwhelming majority rightly feel

that in additional to risks which conventional banks follow, Islamic banks face certain risk which

are unique to its nature. These risks include risks like Fiduciary risk and Displaced Commercial

Risk (DCR).

Displaced commercial risk is a unique risk applicable to an Islamic bank particularly in a dual

banking environment. Displaced Commercial Risk (DCR) is a special risk Islamic banks are

exposed to due to the commercial pressure of a having to pay a rate of return equivalent to a

competitive rate of return and absorb a portion of losses which normally would have been borne

by 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 Islamic

banks. The PER is retained from the total income before the profit is allocated between

shareholders and Investment Account Holders and the calculation of Mudarib Share. IRR is

retained only from the profits attributed to Investment Account Holders (After deduction of

Mudarib share). The provisioning for these reserves is generally outlined in the contract and is

decided by the management. Islamic banks normally invest these reserves to generate additional

returns to investment account holders and smooth the returns on PSIA. If the reserves are

adequate to avoid the transfer of income from shareholders to Investment Account Holders, there

is no exposure to DCR. However DCR is positive if these reserves are insufficient and there is

transfer of some proportion of shareholders returns to depositors.

The recognition of DCR requires adjustment to Capital adequacy ratio of Islamic banks. IFSB

has come up with two methods to adjust the capital adequacy ratio of Islamic banks to account

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for DCR. The first method excludes risk weighted assets funded by PSIA and hence assumes that

the risks are fully absorbed by investment account holders.

The second method requires a proportion α% of risk-weighted assets financed by Profit Sharing

Investment Accounts to be included in the calculation of capital adequacy ratio. This method is

more aligned with the market reality in that it recognizes that investment account holders don’t

fully absorb the risk. ‘α%’ which can take any value between 0 and 1 is taken as a proxy of DCR

and moves in a positive relationship with DCR. ‘α%’ is decided by the central bank and all

Islamic banks within its jurisdiction are expected to key in this value while calculating their

capital adequacy ratio.

Given this background our paper looks at the issue of DCR and alpha across GCC with particular

emphasis on Bahrain. The paper uses the IFSB methodology to calculate DCR and value of alpha

for banks in Bahrain.

II. Literature review

Though there has been studies done on DCR and the value of Alpha, not much has been done

with focus on GCC, primarily due to lack of disclosures and data. A number of notable research

works 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 by

the Malaysia based Islamic Financial Services Board (IFSB).1

III. Challenges regarding profit-sharing contracts

3.1 Management of PSIA and the mudaraba contracts

As per definition from AAOIFI, Mudaraba contracts essentially are a partnership in profit

between capital and work. It may be conducted between investment account holders as providers

of funds and Islamic bank as a mudarib. The Islamic banks announces its willingness to accept

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the funds of investment amount holders, the sharing of profits being as agreed between the two

parties and the losses being borne by the provider of funds except if they were due to

misconduct, negligence, or violation of the conditions agreed upon by the Islamic bank. In the

latter cases, such losses would be borne by the Islamic bank.2

There are two types of Mudharbah contracts that the Islamic banks offer namely the restricted

profit sharing investment accounts (RPSIA) and unrestricted profit sharing investment accounts

(UPSIA).In Restricted PSIA (RPSIA) investment account holders imposes certain restrictions as

to where, how and for what purpose his funds are to be invested. Further the Islamic bank may

be restricted from commingling its own funds with the restricted investment account funds for

purpose of investment.3

In contrast under Unrestricted PSIA (UPSIA),the investment account holder authorizes the

Islamic bank to invest the account holder’s funds in a manner which the Islamic bank deems

appropriate without laying any restrictions as to where, how and for what purpose the funds

should be invested. Under this arrangement the Islamic bank can commingle the investment

account holder’s funds with its own funds or with other funds the Islamic bank has the right to

use (e.g. current accounts). The investment account holders and the Islamic bank generally

participate in the returns of the invested funds.4

The management of the comingled fund is as shown in Figure 1, where the commingled funds

are invested in a specified pool of assets reflecting the general business and management strategy

of the Islamic bank.5

From a Shariah perspective, Mudarabah PSIAs are essentially profit-sharing and loss-bearing

investment accounts. However Islamic banks are often forced to smooth the returns on UPSIA

owning mainly due to supervisory and commercial pressure. Hence UPSIAs end up being

shariah compliant alternative to conventional deposit accounts that are ‘capital guaranteed’ and

have a contractually determined rate of return.

Overall the nature and treatment of UPSIA differs from country to country. At one extreme,

UPSIA can be highly protected instruments so that UPSIA tend to be deposit-like products where

the returns are more or less guaranteed by the Islamic bank. At the other extreme, UPSIA are

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investment-like products that fully bear the risk of fluctuations in returns and even losses on the

underlying investments (i.e. typical Mudarabah investments). However in most cases, UPSIA

tend to be a mixture of the two extremes, depending upon the extent of investment risks actually

borne by the URIAH. The resulting challenge to Islamic banks and their supervisory authorities

is to determine the level of risk sharing between the bank and the IAH.

3.2 Concept of Displaced Commercial Risk and the value of alpha (ά)

Displaced commercial risk refers to the extent of additional risk (volatility of returns) borne by

an Islamic Banks shareholders compared to the situation where PSIA assume all commercial

risks as specified in the Mudarabah contract. IFSB Standard defines DCR as:

the risk arising from assets managed on behalf of Investment Account Holders which is

effectively transferred to the Islamic Financial Institutions own capital because the

Institution forgoes part or all of its mudarib’s share (profit) of on such fund, when it

considers this necessary as a result of commercial pressure in order to increase the return

that would otherwise be payable to Investment Account Holder’s.6

As per the Mudarabah contract, an Islamic bank in its capacity as Mudarib does not bear losses if

they are not due to negligence and/or misconduct. Hence, the definition of DCR does not include

covering of losses of IAH, which in principle are covered by IRR.7

As discussed earlier, Islamic banks are under commercial pressure to absorb the losses from the

UPSIA and pay a competitive rate of return on these accounts. Islamic banks worldwide use

smoothing mechanism when determining the rate of return for UPSIA. The smoothing

mechanism includes:

3.2.1 Usage of Prudential Reserves

The most commonly used method to smooth IAH returns is to set aside reserves like Profit

Equalization reserve (PER) and Investment Risk Reserve (IRR). PER is essentially used to

stabilize profit payouts to IAH’s whereas IRR may be used to cushion losses attributable to IAH.

PER is retained from the total income before the profit is allocated between shareholders and

Investment Account Holders and the calculation of Mudarib Share and hence forms part of the

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equities of IAH and shareholders, respectively, which can be drawn down to smooth the profit

payouts to IAH when investment returns decline. The accumulated IRR however entirely

belongs to IAH and can be used only to cushion any losses (negative asset returns) attributable to

IAH that might arise from time to time.

Islamic banks make appropriation to PER when the actual asset returns are higher and these

appropriations may be reversed when actual asset returns are lower than market-related levels. In

addition, appropriations to IRR can be made from the IAH share of profit, to be reversed when

asset returns are negative. As long as Islamic banks can manage the distribution of returns on

PSIA entirely though adjustments in PER without any recourse to income transfer from

shareholders and/or adjusting the Mudarib share of profits, there will be no DCR at the point of

assessing the requirement for additional capital charges.

However there are some limitations on the accumulations of these reserves. In many countries

the central bank put an upper limit on the appropriations to these reserves mainly on account of

intergenerational problems.

3.2.2 Adjusting the Mudarib Share

The second recourse which Islamic banks utilize to smooth the return is by temporarily reducing

its Mudarib share below the contractual share. However, this mechanism can only be used for

income smoothing in the absence of losses, as investment losses on PSIA funds are to be borne

by IAH themselves, while the Islamic banks merely receives no share of profit as Mudarib.

3.2.3 Transfers from Shareholders’ Funds

The last alternative to smooth the returns of IAH (but not to cover losses) is that Islamic banks

management may (with the shareholders’ approval) donate some portion of the shareholders’

income to IAH, so as to offer the latter a level of return close to the market benchmark level,

when the investment returns of the IIFS are lower than the benchmark. The size of the donation

from shareholders required to achieve a desired rate of return to IAH depends upon the available

level of PER, the market benchmark return, and the actual investment return of the IIFS.

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Prior research in this aspect clearly reveal that there is significant absorption of risks by Islamic

banks, since many banks with sharply divergent risk profiles and rates of return on assets seem to

be offering almost identical rates of return to IAH, and these rates are generally in line with the

general rate of return on deposits in conventional institutions. In fact Islamic banks prefer to have

DCR on their books and have a mechanism of transfer of income from shareholders to IAH

instead of facing liquidity and withdrawal risks that may result from IAH being dissatisfied by

the returns they receive. Hence Islamic banks essentially make a trade-off between DCR and

withdrawal risk, with its systemic characteristics.

3.2.4 Definition of alpha

Alpha is the ratio of actual risk transferred to shareholders- that is the DCR in the situation of full

risk transfer to shareholders ( that is the full risk of the actual profit being below the benchmark,

but not the risk of IAH losses) implying the maximum value of DCR. A value of alpha near 0

implies an investment like product with the IAH bearing the risk whereas value of alpha close to

1 implies a deposit like product with the IAH bearing virtually no risk as shown in figure 2.

IV. Capital adequacy and supervisory implications

The recognition of DCR makes it necessary for Islamic Banks to provide capital for the same,

subject to any risk mitigation including appropriation to PER and IRR accounts. There are

essentially two methods advocated by IFSB to adjust the capital adequacy ratio to account for

DCR. The first method is called the standard formula whereby risk weighted assets funded by

PSIA are excluded and hence it assumes that the risks are fully absorbed by investment account

holders. In this case UPSIA are treated like pure investment products wherein IAH bears 100%

of credit and market risk of assets funded by them. The CAR in this case will be

Eligible capital

Total RWA (Credit + market risks) + Operational risk

Less

RWA funded by PSIA (credit + market risks)

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The second method also called the supervisory discretion formula requires a proportion α% of

risk-weighted assets financed by Profit Sharing Investment Accounts to be included in the

calculation of capital adequacy ratio. This method is more aligned with the market reality in that

it recognizes that investment account holders don’t fully absorb the risk. ‘α%’ which can take

any value between 0 and 1 is taken as a proxy of DCR and moves in a positive relationship with

DCR. ‘α%’ is decided by the central bank and all Islamic banks within its jurisdiction are

expected to key in this value while calculating their capital adequacy ratio.

Hence under this method, UPSIA are treated as a mix of both deposit and investment products.

Under this, Islamic banks bear a proportion of credit and market risk of assets funded by IAH.

Alpha is the corresponding proportion of assets funded by unrestricted PSIA, as determined by

national supervisors. The CAR in this case will be

Eligible capital

Total RWA (Credit + market risks) + Operational risk

Less

RWA funded by Restricted PSIA (credit + market risks)

Less

(1- ά) (RWA funded by unrestricted PISA (credit + market risk)

Less

ά (RWA funded by PER and IRR of unrestricted PSIA (credit +market risks)

4.1 CAR based on IFSB methodology: An Example

The example below indicates the computation of CAR for a hypothetical Islamic Bank. The

example also highlights how a change in alpha will impact the capital adequacy ratio.

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Table 1: CAR computation of a hypothetical Islamic Bank

Liabilities

Demand Deposits 200

URIAH 500

RIAH 250

PER and IRR 50

Shareholder's capital 20

Assets

Trade financing (Murabaha) 550

Salaam/Ijarah/Istisnah 250

Mudarabah and Musharakah investments 220

Total Risk Weighted assets 250

Risk-adjusted assets financed by IAH 100

Risk adjusted assets financed by PER and IRR 10

Alpha 30%

Adjustment for market and operational risk 62.5

CAR according to the standard Formula

20 = 9.88%

(250+62.5)-(100+10)

CAR according to the supervisory discretion formula

20 = 8.15%

(250+62.5)-(0.7X100-0.3X10)

If Alpha is changed to 60%

CAR according to the supervisory discretion formula would

be

20 = 7.18%

(250+62.5)-(0.4X100-0.6X10)

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The above example illustrates how a change in alpha can impact the Capital adequacy ratio. This

highlights the importance of setting a value for alpha that fairly reflects the amount of DCR,

taking account of the risk mitigating effects of the PER and IRR.

Setting up of the right value of alpha is very important and has very important supervisory

implications. If supervisory authorities set alpha at 0 when in fact it should be set close to 1, the

result is likely to be Islamic banks that are significantly undercapitalized, with consequent threats

to financial stability. Conversely, setting alpha close to 1 when in fact it should be set much

lower, will result in Islamic banks being required to carry excess amounts of capital, which will

impair their ability to compete. Thus, accurate supervisory assessments of alpha is very

important to fostering stability without undermining the competitive position of Islamic banks,

and to providing adequate incentives for Islamic Banks to manage the DCR in respect of their

PSIA.

This paper, therefore, sets out to provide a method whereby an appropriate value for alpha can be

approximated using a set of relevant data. The model uses basic accounting definitions in

defining the value of DCR and alpha. The data for this model has been taken from Bank’s annual

reports and disclosures.8

It is very important for Islamic banks to know about the appropriate levels of PER and IRR,

given their exposure to DCR. The purpose of setting aside these reserves is not just to improve

the CAR as calculated formulaically. Rather, the appropriate value of alpha needs to be

determined taking into account the incidence of DCR and the actual mitigating effects of these

reserves. The following section addresses these issues.

4.2 The model and the overall accounting framework9

We will start with developing the basic accounting framework for defining the DCR and alpha.

The model outlined below is based on the model developed by IFSB to measure DCR and alpha

and uses the same accounting framework as developed by IFSB.

Risk in this model is modeled using variability of asset returns. Unexpectedly, low returns that

fall below a threshold value or unexpectedly high losses that exceed a threshold level at a

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specified probability level, serve as the measures of risks that Islamic banks shareholders will

face under various scenarios.

In order to assess the returns to PSIA, and the associated risks measured by the variability of

these returns, a basic framework is needed for measuring the ‘mudarabah profits,’ defined as

profits that are available for distribution between IAH as capital provider and the IIFS as

mudarib. This framework is shown in Figure 1.

Below are the definitions and accounting equations of variables we will use in the model.

4.2.1 Mudarabah Profits

The existing applicable accounting standards, as per IFSB Guidance Note, state that when an

Islamic bank commingles its own funds and the Mudarabah funds of unrestricted IAH (UIAH),

profits are first allocated between Mudarib’s own funds (shareholders’ funds) and UIAH funds

according to the capital contribution of each of the two parties. The share of an Islamic bank as a

Mudarib for its role as fund manager is then deducted from the share of profits allocated to

UIAH. Based on this, Mudarabah profits (before allocating Mudarib share) attributable (i.e. after

appropriations to or releases from PER) between UIAH and the IIFS as a Mudarib can be defined

as investment income from balance sheet assets (the latter may include other assets in the

investment pool, based on other sources of funds, including current accounts) plus trading

income minus provisions, minus appropriations to PER, minus income attributable to sources not

included in the investment pool.

Mudarabah income before allocating the Mudarib share can therefore be written as follows:

RM = A.(RA – SP) – A.RP – KRK

Where:

RM: Mudarabah income

A: Total assets, equal to the sum of shareholders’ funds (K), and UPSIA funds (DI) and other

funds (OF)

RA: The gross rate of return on assets

SP: Provisions made out of current income as a percentage of assets

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RP: Appropriation to PER as a percentage of total assets

KRK: Income attributable to the shareholders outside of the Mudarabah, such as income from

assets funded by current accounts, and before the attribution of the Mudarib share, expressed in

terms of a rate of return on shareholders’ funds, RK.

4.2.2 Rate of Return to IAH

The IAH get their returns only from the specified profit-sharing ratio applied to Mudarabah

profits. The amount of profit distributed to IAH is, therefore, the agreed share of Mudarabah

profit net of appropriations to (or plus releases from) PER and, where applicable, IRR plus any

income transfer from shareholders’ funds. This is not the same as the income attributable to

PSIA – that is, the amount of the agreed Mudarabah profit share of PSIA before any transfers in

or out of the PER and/or IRR.

RI = β.RM/DI – RIR

Where:

β: % of IAH share

RM: Mudarabah income

DI: UPSIA funds

RIR: Appropriation to IRR as a percentage of total assets

4.2.3 Rate of Return to Shareholders’ Equity

The returns to shareholders are derived from both their share of returns in the pool of investment

assets acquired using the commingled IAH/shareholders’ funds, plus their share of Mudarabah

profits for the services as a Mudarib, and the net earnings from other funds – for example,

income from other banking services and other non-PSIA assets that are funded from other

sources. Accordingly, the rate of return on shareholders’ equity (RE)10

can be written as follows:

RE = (1 – β). {RM/K + A. RP/K} + RK

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Where:

(1 –B): Mudarib’s share

RM: Mudarabah income

K: Shareholders’ funds

A: Total assets, equal to the sum of shareholders’ funds (K), and UPSIA funds (DI) and other

funds (OF)

RP: Appropriation to PER as a percentage of total assets

RK: The rate of return on shareholders’ funds that is invested in other assets.

4.2.4 Net Profits, and Return on Assets

As a measure of profitability, return on assets is defined as the sum of net profits to shareholders

plus income attributable to PSIA (i.e. total net profits of the year before distribution to IAH)

expressed as a percentage of total assets. (Total assets are defined as the sum of shareholders’

and UPSIA funds.) The gross rate of return on assets is equal to the rate of return on assets after

adding back provisions expressed as a percentage of assets. The conventional measure of the rate

of return on assets defined as total net profits before any distribution to IAH as a percentage of

average total assets can also be used for estimation purposes.

4.2.5 Other Data

Estimation of DCR and alpha also requires other data including the amounts of transfers made

from and/or to PER and IRR, Mudarib share as a percentage, amounts of transfers made from

shareholders' funds, total assets, average UPSIA, a market benchmark for the rate of return to be

paid to IAH, the amount of provisions appropriated from the gross income, gross income for the

financial year, gross income to shareholders, and gross income available for IAH.

4.3 The model

The model we are using to calculate DCR and alpha is based on the model developed by IFSB.

The IFSB model relies on basic accounting equations to define DCR and deduce the value. The

IFSB model assumes that rate of return to be paid to IAH (Ri) can be modelled as a function of

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two variables: the rate of return on assets (RA), which represents the income available for

distribution between IAH and IIFS shareholders; and the market benchmark rate (Rm), which

represents alternative returns available to depositors generally, including IAH, in the market.11

The section below outlines the methodology developed by IFSB in measuring DCR and Alpha.

4.3.1 Estimation of DCR and Alpha

The method developed by IFSB for calculating DCR and alpha involves the following steps:

Step 1: Estimate ‘w’.

Step 2: Estimate return to shareholders under alternative scenarios.

Step 3: Compute unexpected losses to shareholders under alternative scenarios.

Step 4: Estimate DCR and alpha.

The procedures required for each step are further detailed in the following paragraphs.

Step 1: Estimation of ‘w’

The relationship between the co-movement of rate of return on assets and market benchmark,

and rate of return to IAH can be modeled as :

Ri = w. (Rm) + (1 – w). RA

Where

Rm: Market benchmark rate

Step 2: Estimation of return to shareholders under alternative scenarios

Scenario 1: PSIA are treated as pure investment products

Under this scenario, all commercial risks arising from assets funded by IAH are borne by the

IAH themselves. In other words, there is no ‘smoothing’ of payouts to IAH. Therefore, there will

not be DCR and, accordingly, values of ‘alpha’ and ‘w’ will be zero. Other risk determinants –

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PER and IRR, transfer of income from shareholders to IAH will also be zero, and Mudarib's

share will be fixed (i.e. under this scenario, alpha = 0, w = 0, RI = RA – SP, IRR/PER = 0).

Therefore, the rate of return to shareholders will depend strictly on investment return (i.e. return

on assets and Mudarib's share):

RE0 = RA – SP

The standard deviation of RE0 will give an estimate of unexpected losses under this scenario.

Scenario 2: PSIA are treated as pure deposit-like products

Under this hypothetical scenario, IAH bear no losses and all commercial risks arising from assets

funded by IAH are borne by shareholders. Therefore, DCR will be at its maximum and,

accordingly, values of ‘alpha’ and ‘w’ will also be at their maximum – that is, 1. Other risk

determinants – PER and IRR, Mudarib’s share and income transfer from shareholders to IAH

will vary according to the payout policy adopted by the Islamic bank (i.e. under this scenario,

alpha = 1, w = 1, RI = Rm). The rate of return to equity will be as follows:

RE1 = (RA – SP) + DI/K.(RA – SP – Rm)

The standard deviation of RE1 will give an estimate of unexpected losses under this scenario.

Scenario 3: PSIA are treated as being in-between pure investment and deposit-like products

Under this scenario, which represents an intermediate situation between the two extreme cases

(scenarios 1 and 2), the payout to IAH is a weighted average of market return and investment

return. Accordingly, there is risk-return sharing between IAH and shareholders of the IIFS

resulting in some DCR. The values of ‘alpha’ and ‘w’ will, therefore, fall between zero and 1.

Other risk determinants: PER and IRR, Mudarib’s share, and transfer of income from

shareholders to IAH will depend on the Islamic Bank’s payout policy and sufficiency of reserves

held by IAH. The rate of return to equity is expressed as follows:

RE2 = (RA – SP) + DI/K.w.(RA – SP – Rm)

The standard deviation of RE2 will give an estimate of unexpected losses under this scenario.

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Step 3: Computation of unexpected losses to shareholders under alternative scenarios

Assuming a normal probability distribution, and using the standard deviations of rate of return on

equity (RE) that are obtained in step 2, the corresponding unexpected loss to shareholders under

the three above-mentioned scenarios of PSIA can be calculated as follows:

• Scenario 1: Unexpected loss to shareholders when PSIA are treated as pure investment

products:

UL0 = a multiple of the standard deviation of RE0

• Scenario 2: Unexpected loss to shareholders when PSIA are treated as pure deposit like

products:

UL1 = a multiple of the standard deviation of RE1

• Scenario 3: Unexpected loss to shareholders when PSIA are treated as being in between pure

investment and deposit-like products:

UL2 = a multiple of the standard deviation of RE2

Step 4: Estimation of DCR and alpha

From the unexpected losses to shareholders that were obtained in step 3, DCR and alpha can be

obtained using the following equations:

DCR = UL2 – UL0

Maximum DCR = UL1 – UL0

‘Alpha’ = (UL2 – UL0) / (UL1 – UL0)

We follow the same model as developed by IFSB however we have calculated scenario 3 as

simulated returns of scenario 1 and 2.12

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V. Treatment of URIAH accounts in Bahrain and other GCC countries

Bahrain is undoubtedly the most established financial center in the Gulf and a global hub for

Islamic Finance with a growing number of Islamic banks and financial institutions. The country

was amongst the first few to recognize the potential and demand for Islamic banking and

developed the industry at a time when it was not drawing the international interest and attention.

As of 2010, the country has 24 Islamic banks operating (of which 23 are locally incorporated)

with a total asset base of USD 36 billion. In the last five Bahrain's Islamic financial assets has

more than doubled from being worth 16 billion dollars in 2006 to 36 billion dollars in 2010.13

Besides Bahrain UAE and Qatar are also emerging centers for Islamic finance accounting for

approximately 20% and 10% respectively of the global Islamic asset base. As of 2010, UAE has

10 Islamic banks operating in the country whereas Qatar has 5 Islamic banks within its

territory.14

Table 2. Alpha levels in Practice

Country

Level of

alpha

Bahrain 0.3

Dubai 0.35

Indonesia 1

Malaysia 1

Qatar 0.35

Sudan 0.5

5.1 Treatment of URIAH accounts in Bahrain

Under URIAH contracts, banks are authorized by the IAH to invest the account holder’s funds

on the basis of Mudaraba contract in a manner which the bank deems appropriate without laying

down any restrictions as to where, how and for what purpose the funds should be invested.

Islamic banks in Bahrain comingle the equity of the IAHs’ investment funds with its own funds

or with other funds like the current accounts. The bank and IAH generally participate in the

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returns on the invested funds. The banks do not take liability for any losses incurred on the joint

pool other than the loss resulting from gross negligence or willful misconduct on the part of the

bank or due to the bank’s violation of the terms and condition as agreed between the bank and

the IAH.

The banks normally invest the amount received from the customer on account of equity if

investment account holder in a portfolio of investments. The banks are required to maintain a

cash reserve from this account with the CBB.

The income allocated to the IAH is in accordance with the utilization of such deposits. The

utilization rate is determined by the ALCO with the approval of the Shariah supervisory board.

The URIAH accounts include different maturity range starting from 1 month, 3 month, 6 month,

9 month, 12 month and 36 month. The customer signs written contract covering all terms and

conditions of the investment, including tenor, basis of profit allocation and early withdrawal.

URIAH accounts are significant source of funds for Banks in Bahrain and account for

approximately 50% of the total asset base.15

Hence banks are very sensitive to maintain these

deposits and regularly monitor rate of return offered by competitive banks to evaluate the

expectation of its IAH.

Profits from URIAH accounts are allocated between the bank and URIAH based on the

contribution of each of the group. Operating expenses incurred by the banks are not charged to

investment account.

Banks in Bahrain recognize the concept of DCR and provide for the same. Though banks set

aside PER and IRR, foregoing mudarib share is the preferred method for adjusting DCR. Also

there is no upper limit on appropriation to PER and IRR accounts imposed by the central Bank.

Banks in Bahrain typically invest URIA funds in short and medium term Murabaha, Sukuks and

Ijarah Muntahia Bittamleek. Funds are normally invested after deductions of mandatory reserve

and sufficient operational cash requirements. The rate of return payable to URIA holders is

decided by ALCO, keeping in view the rate of return earned from the portfolio financed by

URIA.

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The central bank of Bahrain recognizes the concept of DCR and requires banks to have a policy

in place for the management of DCR. Also all Islamic banks are required to make detailed

disclosures in their annual report on URIAH accounts. The disclosure requirements for Islamic

Banks in Bahrain are detailed in Appendix A.

5.2 Measurement of DCR and alpha for banks in Bahrain

As discussed earlier the central bank of Bahrain requires Islamic banks to make detailed

disclosure regarding URIAH accounts in their annual reports. However while evaluating annual

reports of banks in Bahrain we found that not all banks make disclosures as required by Central

bank. Hence we have restricted our analysis to three Islamic banks in Bahrain For the sake of

sensitivity of data we choose not to name the banks and refer to them as Bank A, B and C.16

Data collected and calculations are shown in the tables below.

Table 3a. Measurement of DCR and alpha for banks in Bahrain

Name Year

Average

UPSIA (DI)

Average

Equity (K) DI+K

Total

end of

period

assets

Gross

return on

UPSIA

before

funding

cost

Return

on

UPSIA

% (RA)

Bank A

2010 192439 123775 316214 419216 8254 4.29%

2009 184394 130530 314924 473604 11103 6.02%

2008 128814 136486 265300 464993 8953 6.95%

2007 38405 88782 127187 269511 3012 7.84%

Bank B

2010 480308 357000 837308 1446700 19104 3.98%

2009 503207 350000 853207 1373400 25045 4.98%

2008 211917 256600 468517 1284700 10862 5.13%

Bank C

2010 741382 128600 869982 935700 33083 4.46%

2009 680293 158300 838593 912000 35694 5.25%

2008 624119 176800 800919 874000 36934 5.92%

Table 3b. Measurement of DCR and alpha for banks in Bahrain

Page 20: Displaced Commercial Risk

Name Year PER

Total

PER as

% of

average

UPSIA

(RP) IRR

Total

IRR as a

% of

UPSIA

(RIR)

Mudaraba

income

Mudaraba

income for

distribution

(RM)

Benchmark

rate

Bank A

2010 0 0 0 0 8254 8254 3.41%

2009 560 0.30% 452 0.25% 11103 10543 3.65%

2008 443 0.34% 339 0.26% 8953 8510 3.78%

2007 146 0.38% 91 0.24% 3012 2866 3.91%

Bank B

2010 0 0.00% 0 0.00% 19104 19104 3.41%

2009 0 0.00% 0 0.00% 25045 25045 3.65%

2008 0 0.00% 0 0.00% 10862 10862 3.78%

Bank C

2010 0 0.00% 0 0.00% 33083 33083 3.41%

2009 0 0.00% 167 0.02% 35694 35694 3.65%

2008 0 0.00% 0 0.00% 36934 36934 3.78%

Table 3c. Measurement of DCR and alpha for banks in Bahrain

Name Year

Mudarib

share in

absolute

amount

% of

Mudarib

share (1-

B)

Implied

share of

IAH

% of

IAH

implied

share

(B)

Rate of

return

attributable

to IAH

(RI)

Rate of

return

paid to

IAH (Ri)

Bank A

2010 2469 30% 5785 70% 3.01% 4.04%

2009 1772 17% 8771 83% 4.76% 4.58%

2008 1903 22% 6607 78% 5.13% 4.87%

2007 566 20% 2300 80% 5.99% 5.75%

Bank B

2010 5300 28% 13804 72% 2.87% 2.87%

2009 4228 17% 20817 83% 4.14% 4.14%

2008 997 9% 9865 91% 4.66% 4.66%

Bank C

2010 10467 32% 22616 68% 3.05% 2.39%

2009 11517 32% 24177 68% 3.55% 2.61%

2008 13183 36% 23751 64% 3.81% 2.81%

5.3 Measuring Rate of Return to Shareholders under Three Scenarios

Scenario 1

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The first scenario is the profit sharing investment account (PSIA) is treated as pure investment

product. Therefore, rate of return to shareholders (Re0) is measured as follow:

Re0 = RA – Sp

Scenario 2

The second scenario is the PSIA is treated as pure deposit-like product. Here, the Re1 is measured

as follow:

Re1 = (RA – SP) + DI/K. (RA – Sp – Rm)

Scenario 3 (Re2)

The third scenario is the PSIA is treated as being in between pure investment and deposit-like

products. We have calculated this by simulating returns obtained under scenario 1 and 2.17

5. 4 Measuring Unexpected Losses under Three Scenarios

After getting the results for the Re under these three scenarios, unexpected losses (UL) for each

Re then need to be calculated, in order to determine the displaced commercial risk (DCR) and

Alpha.

The UL0 is standard deviation of Re0 while UL 1 and UL 2 are standard deviations of Re1 and

Re2 respectively. The results are shown in the table below:

Table 4. Unexpected losses (UL) under alternative scenarios

Name Year

Return to

shareholders

if UPSIA are

treated like

investment

(Re0)

Return to

shareholder if

UPSIA are

treated like

deposits

(Re1)

Simulated

return to

shareholders

(Re2)

Standard

Deviation

of Re0

Standard

Deviation

of Re1

Standard

Deviation

of Re2

Bank A

2010 2.25% 0.44% 1.31%

2.24% 3.90% 3.10%

2009 4.07% 4.66% 4.38%

2008 6.95% 9.94% 8.61%

2007 7.84% 9.54% 8.70%

Page 22: Displaced Commercial Risk

Bank B

2010 3.98% 4.74% 4.37%

0.51% 0.90% 0.69%

2009 4.98% 6.89% 5.95%

2008 5.13% 6.24% 5.66%

Bank C

2010 4.46% 10.53% 7.50%

0.59% 1.20% 0.90%

2009 5.25% 12.11% 8.59%

2008 5.92% 13.46% 9.71%

5.5 The Determination of DCR and Alpha

The DCR and Alpha can be determined based on the following formulas:

DCR = UL2 – UL0

Maximum DCR = UL1 – UL0

Alpha = UL2 – UL0 / UL1 – UL0

The calculations are shown in the table below:

Table 5. Calculated values of DCR and Alpha

Name DCR

Maximum

DCR Alpha

Bank A 0.86% 1.66% 52.05%

Bank B 0.18% 0.39% 45.59%

Bank C 0.31% 0.60% 50.85%

VI. Conclusion

The paper attempts to understand DCR calculation and treatment of URIAH accounts in Bahrain.

As illustrated in the paper the capital adequacy ratio of an Islamic bank is highly sensitive to the

value of alpha. Also choosing the right value of alpha is very important to maintain the

competitiveness of Islamic banks particularly in a dual banking environment. The estimation of

alpha requires historical data which in turn requires banks to make periodic disclosures in their

annual reports. Our study was constrained to a significant extent due to lack of disclosures in

other GCC countries. Even in Bahrain where the disclosures are mandatory as per central bank’s

Page 23: Displaced Commercial Risk

guidelines we found that banks are not making the necessary disclosures regarding URIAH

accounts.

In the absence of historical data it is impossible to fit in a statistical/econometric model to

calculate alpha as some researchers have developed. Also it is much more practical for banks to

use the IFSB model which uses the basic accounting information and definitions. Hence the

paper illustrates the calculation of DCR using the IFSB method. We find that using the

methodology as described for the banks in Bahrain the alpha should be in the range of 50-60%

which is significantly higher than the alpha required by the central bank of Bahrain. This also

ties in with our survey of Islamic bankers who feel that URIAHs are more or less shariah

compliant alternative of conventional deposit accounts and hence alpha should be much higher

than the central bank requirement of 30%.

As a concluding remark we would like to highlight the importance of public disclosures on part

of Islamic Banks. The central banks need to be more aggressive in getting Islamic banks to make

disclosures in their annual reports. Also the Islamic banks must realize that they need to produce

the necessary data for their own purposes as part of their risk management procedures with

respect to DCR and capital adequacy.

1 The Islamic Financial Services Board (IFSB) is an international standard-setting organisation that promotes and

enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards

and guiding principles for the industry, broadly defined to include banking, capital markets and insurance sectors.

2 AAOIFI standards, Appendix D: glossary.

3 AAOIFI standards, Appendix E: definitions.

4 AAOIFI standards, Appendix E: definitions.

5 Archer, et. al. 2010.

6 IFSB 2005-Standard 7610.

7 IFSB guidance note in connection with the IFSB capital adequacy standard: the determination of alpha in the

capital adequacy ratio for institutions offering only Islamic Financial services- March 2011

8 In order for the necessary data to be available, Islamic banks need to make the necessary disclosures. Public

disclosure would, however, have the substantial-added advantage that information intermediaries such as rating

agencies and research analysts would have ready access to it, thus contributing to market discipline. Moreover,

retail-oriented disclosures of relevant data can help manage the risk-return expectations of IAH. Islamic banks

Page 24: Displaced Commercial Risk

should of course produce the necessary data for their own purposes as part of their risk management procedures with

respect to DCR and capital adequacy.

9 IFSB guidance note in connection with the IFSB capital adequacy standard: the determination of alpha in the

capital adequacy ratio for institutions offering only Islamic Financial services- March 2011

10

IFSB. Guidance Note in Connection with the IFSB Capital Adequacy Standard: The Determination of Alpha in

the Capital Adequacy Ratio for Institutions (Other than Insurance Institutions) Offering only Islamic Financial

Services, March 2011, Available at: <URL: http://www.ifsb.org/standard/eng-GN-4%20Guidance%20Note.pdf>,

Access Date: March 16, 2012.

11

IFSB conducted a survey on DCR in 2009 to evaluate the treatment of UPSIA and DCR in different countries.

The survey showed that in many countries unrestricted PSIA are treated like semi-deposits owing to market

considerations and/or regulatory requirements and DCR exists at different levels in all surveyed countries. The

rationale for the treatment of PSIA varies from one country to another, in part due to the prevailing regulatory

requirements in each country. While regulations in all countries tend to protect the principal capital of PSIA (not the

returns), for market considerations IIFS are inclined to pay smoothed rates of return that are competitive with those

paid by their peers and conventional counterparts. The survey results also revealed that IIFS determine rate of return

to be paid to IAH based on two factors, actual rates of return and market benchmarks.

12

We conducted a survey on DCR and treatment of URIAH accounts in banks in Bahrain. The survey focused on

areas like how banks decide on the adjustment factor (defined as w in IFSB model) while benchmarking their rates

to the market rate. The decision on the w factor is essentially taken by the ALCO committee based on the liquidity

requirement of the bank. Hence we feel that there cannot be a uniform w which can be applied to all banks. Also

lack of prior time series data makes it difficult to put in a statistical model to calculate as recommended by the IFSB.

13 Data as per Bankscope

14

Data as per Bankscope

15

Based on data in annual report

16

For bank B and C data for 2007 is not available

17

For doing simulations we have used the Monte Carlo simulation method wherein a random value is selected for

each of the tasks, based on the range of the estimates. Given that Re2 lies between Re0 and Re1 we have simulated the

returns within this range. The simulations are done in excel and the average simulated return is taken as a proxy of

Re2.

Page 25: Displaced Commercial Risk

Appendix A

Central bank of Bahrain Disclosure requirements with respect to URIAH accounts

The central bank of Bahrain has a detailed disclosure requirement with respect to DCR and

URIAH accounts . All banks in Bahrain are required to make the following disclosures with

respect to DCR:

1. The bank's policy on DCR, including the framework for managing the expectations of its

shareholders and unrestricted IAH, the sharing of risks among the various stakeholders,

and the range and measures of risk facing unrestricted IAH based on the bank's general

business strategies and investment policies.

2. The historical data over the past five years for the following:

• Total Mudaraba profits available for sharing between unrestricted IAH and

shareholders as Mudarib (as a percentage of Mudaraba assets)

• Mudaraba profits earned for unrestricted IAH (as a percentage of assets) before

any smoothing

• Mudaraba profits paid out to unrestricted IAH (as a percentage of assets) after any

smoothing

• Balances of PER and IRR, and movement of these in determining unrestricted

IAH payout

• Variations in Mudarib's agreed profit-sharing ratio from the contractually agreed

ratio

• Market benchmark rates selected by the bank

3. Five year comparison of historical rate of return of unrestricted IAH in relation to the

market benchmark rate selected by the bank

4. Five year comparison between the percentage rate of returns to IAH and the percentage

returns to shareholders from Mudaraba profits

5. Amount and percentage of profits appropriated to PER and IRR

6. Analysis of the difference between aggregate Mudaraba-earned profit and profit

distributed to IAH as a function of movement in PER, IRR and the Mudarib's share

7. Analysis of the proportion of the RWA funded by IAH that should be considered in

arriving at the total RWA together with an explanation of the underlying rationale.

Page 26: Displaced Commercial Risk

The following quantitative disclosures should be made when the concerned Islamic bank has

unrestricted investment accounts:

• Amount of IAH funds

• The ratio of Profit Equalization Reserves (PER) to the total amount of PSIA by type of

IAH

• The ratio of Investment Risk Reserves (IRR) to the total of PSIA by type of IAH

• ROAA and ROAE

• Ratio of profit distributed to PSIA by type of IAH. The bank must disclose the profit

sharing formula used for the calculation and distribution of profits

• The management fee (Mudarib share) as a percentage of the total investment profit, and

the extent to which it is subject to partial or total waiver in order to pay a competitive rate

of return to IAH

• Ratio of financing to PSIA by type of IAH

• Percentage of financing for each type of Shariah-compliant contract to total financing

• Share of profits earned by IAH, before transfers to or from reserves (amount and as a

percentage of funds invested)

• Share of profits paid out to IAH, after transfers to or from reserves (amount and as a

percentage of funds invested);

• Share of profits paid out to the bank as Mudarib;

• Movement on PER and IRR during the year;

• The utilization and computation of PER and/or IRR during the period;

• Average declared rate of return or profit rate on PSIA by maturity (3-month, 6-month,

12-month, 36-month);

• Types of assets in which the funds are invested and the actual allocation among various

types of assets;

• Changes in asset allocation in the last six months;

• Off-balance sheet exposures arising from investment decisions, such as commitment and

contingencies;

• Limits imposed on the amount that can be invested in any one asset;

• The treatment of assets financed by IAH in the calculation of RWA for capital adequacy

purposes;

• Profits earned and profits paid out over the past five years (amount and as a percentage of

funds invested); and

• Amount of total administrative expenses charged to unrestricted IAH.

Page 27: Displaced Commercial Risk

Figure 1: A Framework to compute Mudaraba income and returns to IAH

Source: Islamic Financial Services Board. Exposure Draft: Guidance Note in Connection with the IFSB Capital

Adequacy Standard: The Determination of Alpha in the Capital Adequacy Ratio, November 2010, p. 16.

Other funds

such as current

accounts

Funding Shareholders’

funds IAH Funds from

PSIA

Portion

commingled

with other

funds

Portion

commingled

with IAH

funds

Invested

Portion Reserves

Financing Other assets Pool of assets held by commingling

IAH funds with shareholder funds

Returns Earnings on other

assets and reserves

Unsmoothed profits on commingled

funds

Profits assigned

to share holders PER

Smoothed profits after

subtracting PER. This is

Mudarabah income

Retain to IAH, based on a profit

share β applied to Mudarabah

income the share β of PER is held

as equity of IAH and not

distributed; and hence not

included in IAH return

Mudarib’s share, 1 –

β of Mudarabah

income

Returns to Shareholders – Includes

a share 1 – β of PER

Page 28: Displaced Commercial Risk

Figure 2- Understanding the concept of DCR and alpha

Page 29: Displaced Commercial Risk

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