Measurement of the displaced commercial risk in Islamic Banks

Abstract

HighlightsWe identify the displaced commercial risk DCR exposure of Islamic banks. We identify the scenarios of displaced commercial risk exposure to compute the DCR Profits and Losses to Islamic banks shareholders. Scenarios of risk depend on the actual rate of return on investment accounts, the benchmark rate of return and level of existing reserves to mitigate the DCR. We assess the capital charge needed to cover the displaced commercial risk using the Value-at-risk measure of risk, DCR-VaR. We assess the coefficient alpha α CAR-VaR for the capital adequacy ratio for Islamic banks.We consider three methods, the Historical non-parametric VaR, the parametric-VaR and the Extreme Value Theory-VaR. AbstractThe objective of the research is to quantify the displaced commercial risk (DCR) based on quantitative finance techniques. We develop an internal model based on the Value-at-risk (VaR) measure of risk to assess the DCR-VaR and the alpha coefficient in the capital adequacy ratio of Islamic banks. We identify first the scenarios of exposure of Islamic banks to DCR that depend on the actual return on unrestricted profit sharing investment accounts (PSIA U ), the benchmark return as well as the level of the existing profit equalization reserve (PER) and investment risk reserve (IRR). Second, we quantify the DCR-VaR and the alpha coefficient for a given holding period and for given confidence level. We illustrate the DCR-VaR model on selected Islamic banks from Bahrain. Our model helps to better assess the needed equity to cover the DCR and an accurate capital adequacy ratio for Islamic banks. The model has also policy implications for regulators and the IFSB to develop better guidance on good practices in managing this risk.

A structural model of “alpha” for the capital adequacy ratios of Islamic banks

“…However, the actual returns generated by IAH assets (net of the bank's profit share and provision for IAH assets, hereafter "contractual" returns) may be less than the benchmark rate, causing Islamic banks to subsidise cash returns paid to IAHs (AAOIFI, 1999). The ongoing practice of smoothing cash returns to IAHs using subsidies (as well as reserves) is confirmed by recent literature examining this practice across different jurisdictions (see Hamza, 2016;Suandi, 2017;Lassoued et al, 2018;Zainuldin and Lui, 2018;Toumi et al, 2018). As a result of DCR, the rate of return risk manifesting in IAH assets, which should vest with IAHs, is displaced to bank shareholders, giving rise to a potentially deleterious impact on bank capital if shareholders subsidise the returns paid to IAHs using their own capital.…”

“…Secondly, decisions concerning IAH cash returns are a matter of bank policy, being fundamental to the retail appeal and commercial success of Islamic banks in dual-banking systems 5 . However, for the IFSB methodology (and its enhancement using value-at-risk, instead of standard deviation, see Toumi et al, 2018) there is no available mapping from return subsidisation policy 6 to resulting quantitative impact on capital adequacy. This because reserves-based investment account returnsmoothing practices mask the true extent to which banks are exposed to DCR (Boulila et al, 2010 confirmed the income smoothing practices of Islamic banks using a sample of 66 Islamic banks in 19 countries, a result also confirmed by Farook et al, 2012).…”

Profit- and loss-sharing impact on Islamic bank liquidity in GCC countries

“…Moreover, not only the share of PSIA as a source of funds is relevant for liquidity risk but also, as argued by Sundararajan and Errico (2002), the PSIA’s depositors’ sensitivity to changes in returns occurs in the exposition to liquidity risk. Consequently, managing the displaced commercial risk is important to avoid liquidity and withdrawal risk (Toumi et al , 2019). The solution is to convince PSIA accounts holders to use their deposits for medium- and long-run investments.…”

Integration of Islamic bank specific risks and their impact on the portfolios of Islamic Banks

“…The Islamic Financial Services Board (IFSB) documents IFSB-2 (2005) and IFSB-GN4 (2011) deal with the occurrence of displaced commercial risk and measure it with a function labeled alpha. Alpha represents that portion of risk weighted assets that is funded by funds that will be displaced to shareholders to smooth out the payouts to investment account holders (Toumi et al , 2019; Touri et al , 2020). In this way, displaced commercial risk affects the capital of Islamic banks requiring an additional charge to capital (Toumi et al , 2019).…”