Presentation slide for Risk Management in Islamic Finance

1. RISK MANAGEMENT
IN
ISLAMIC FINANCE
Mahyuddin Khalid

2. Displaced Commercial Risk
Content
Definition of DCR
Mitigation of DCR
Difference of PER & IRR
Pricing Strategy in DCR
Tools to manage DCR
Impact of DCR mitigation
Impact of risks faced by Islamic
Bank
Learning Outcome
• To explain definition and feature of
Displaced Commercial Risk
• To state Displaced Commercial Risk
and their contract
• To explain ways to manage Displaced
Commercial Risk in Islamic banks
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3. Definition
Unique risk for Islamic Banks
The risk resulting from the volatility of returns generated
by assets financed by investment accounts.
 The bank though may operate in full compliance with the shariah
requirements, yet may not be able to pay competitive rates of
return as compared to its peer group Islamic banks and other
competitors.
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4. Displaced Commercial Risk in Islamic Banks
 This risk is the transfer of the risk associated with deposits to equity
holders.
 This arises when under commercial pressure banks forgo a part of
profit to pay the depositors to prevent withdrawals due to a lower
return (AAOIFI 1999).
 Displaced commercial risk implies that the bank though may operate
in full compliance with the Shariah requirements, yet may not be
able to pay competitive rates of return as compared to its peer
group Islamic banks and other competitors problem an deposit
withdrawal.
 Depositors will again have the incentive to seek withdrawal.
 To prevent withdrawal, the owners of the bank will need to
apportion part of their own share in profits to the investment
depositors
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5. Dual banking environment
 Commercial pressure
Due to GIA/SIA
 Return not guaranteed
Bank’s share of profit
 From equity or reserve
Relationship
 From borrower/lender to partner
Operational Risk
 Fiduciary risk absorbed by Bank
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6. How to manage DCR?
(1) Profit Equalization Reserves
(2) Investment Risk Reserve
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7. Profit Equalization Reserves
The amount appropriated by an Islamic bank or financial
institution out of the mudaraba income before allocating
the share of al-mudarib.
This reserve aims to maintain a specified level of return on
investment (ROI) for investment account holders (IAHs).
It represents a measure of profit stabilization over different
financial periods. The PER is also formed for the purpose of
increasing owners’ equity.
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8. Investment Risk Reserve
The amount appropriated by an Islamic bank or financial
institution out of the income of investment account
holders (IAHs), after the mudarib share is allocated.
This reserve is used as a cushion against future losses that
IAHs may incur.
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9. Differences between the two types of reserve:
PER IRR
Source Mudaraba income IAH income
Stage of
appropriation
Before mudarib share is
allocated
After mudarib share
is allocated
Purpose/use Profit
stabilization/smoothing
Cushion against
future losses
Ultimate
beneficiary
IAHs and al-mudarib IAHs
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10. Pricing Strategy in Displaced Commercial Risk
PRICING
 Provides a higher profit sharing rate for depositors of sharia
banks so that it will affect the competitive level of Islamic banks
for depositors
 However, with the characteristics of Islamic banks operating
under the principle of profit sharing provides a dilemma for
Islamic banks in determining pricing strategy for Islamic banks to
remain sharia but have a high competitive level against
conventional banks.
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11. Tools to Manage Displaced Commercial Risks
Using Hibah
 with this method, the Islamic bank transfer its profit to PSIA
account holders based on a gift contract (hibah).
Floating rentals
 so that increase in benchmark rate is absorbed effectively on both
sides of the balance sheet.
Using Profit Equalization Reserves
 The PER is a mechanism act to mitigate the fluctuation of Rates of
Return arising from the flux of income, provisioning and total
deposits.
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12. Impact of Displace Commercial Risk Mitigation
Islamic banks become more expensive than conventional
banks
Islamic banks want to provide competitive returns for
competitive outcomes with conventional banks to their
depositors when Islamic bank funds are still far from
conventional banks
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13. The Impact Of The Risks Faced By Islamic Bank
Impact on Employees
Impact on Shareholders
Impact on the Customer
Impact on the Economy
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14. Conclusion
 The Islamic banks are encouraged to involve in the profit
and loss sharing type of investment with IAHs. As a result,
the IAHs will be receiving the return based on the
profitability of the investments, rather than fixed amount of
return.
 IAHs as rational decision makers might decide to withdraw
the deposits if rate of return is lower, compared to the
conventional banks.
This will cause Islamic banking unstable and it will affect
the country’s economy as a whole.
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15. Mahyuddin Khalid
End of Chapter
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