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A A
A A
A A
A A
A A
A A
A
A
A
R p x k i
R p x k i
R p x k
R p x k
R p x
R p x
R p
R p
R
~
1 1 1
~
1 1
~
1 1
~
1
~
1
~
1 1
~
1
~
~
With:
A
R
~
: Revenue on Asset jointly financed by PSIA funds and shareholders funds.
p : Proportion of Profit Equalization reserve retained for the year.
A
x : Percentage of IAHs profits share.
k : Proportion of Mudarib Share taken by the bank.
i : Proportion of Investment Risk Reserve taken for the year.
The Investment Account Holder compares his return with the return of a benchmark
B
R
~
, this
return is not necessarily known at the date of the investment.
We want to know the bank equity amount necessary to absorb the displaced commercial risk.
In spite of the existing reserve level, the return on investment can fall below the benchmark
level. The equity level uncovered by the reserve amount will be obtained by the Value at
Risk, VaR, for a given probability level, , and a given horizon of time.
( )
( )
=
= +
E VaR R R p
VaR R E R p
B I
B I
~ ~
~ ~
(5)
15
E: the part of accumulated amount of reserve attributed to Investment Account Holders.
From equation (5), by subtracting the mean and dividing by the standard deviation of the
deviation between the profit on investment and in benchmark we obtain:
( ) ( ) ( )
( )
( ) ( ) ( )
( )
=
|
|
\
|
B I
B I
B I
B I B I
R R
R E R E E VaR
R R
R E R E R R
p
~ ~
~ ~
~ ~
~ ~ ~ ~
If investment and benchmark profits follow the standard normal law, and by isolating the VaR
it comes:
( ) ( ) ( ) ( )
B I B I
R E R E E R R z VaR
~ ~ ~ ~
+ + =
The Islamic bank invests the amount of investment accounts in well diversified portfolio. The
benchmark is also a well diversified portfolio. Betas of investment and benchmark portfolios
are respectively
B A
, with
B A
f > .
16
Using the CAPM equation, we can write:
( ) ( ) ( ) [ ] [ ]
( ) ( ) [ ]
F M B F B
F M A F A I
r R E r r E
r R E r f r fE r E
+ =
+ = =
~
~
~
~ ~
Without taking into account the specific risk, we have the following relations:
( ) ( )
( ) ( )
( ) ( )
M B A B I
M B B
M A I
R V f r r Cov
R V r V
R V f r V
~
~
,
~
~
~
~
~
2
2 2
=
=
=
VaR is: ( ) ( ) ( ) ( ) [ ] ( )
F F M M B A
r f e r R E R z f
DI
VaR
1
~ ~
+ + + =
(6)
In the simplest case were the benchmark portfolio is the risk free asset and the invested
portfolio is equal to the market portfolio, the VaR becomes:
( ) ( ) ( ) [ ] ( )
F F M M
r f e r R E R z f
DI
VaR
1
~ ~
+ + + =
For instance, if:
- The risk premium is 4 %,
- The market volatility is 20 %,
- The risk free rate is 4 %,
- The reserves are 25 %,
- f is equal to 0,9
- the probability level 99 % (investment accounts are highly protected)
VaR is equal to: ( ) % 74 , 13 % 4 1 , 0 % 25 % 4 % 20 33 , 2 9 , 0 = + + =
DI
VaR
In this case, equity used to protect the displaced commercial risk are 13,74% of the amount of
investment accounts.
17
3. CASE STUDY: BAHRAIN ISLAMIC BANK
We consider Bahrain Islamic Bank as a case study and we attempt to measure potential losses
resulting from the displaced commercial risk from the Bahrain Islamic Bank annual report of
31-12-2008. The methodology applied is based on the Value at risk model presented in
section 2.2.
The invested portfolio is equal to a Shariah-Compliant market portfolio. In fact, Islamic
finance laws require assigning capital in socially responsible investments and Shariah-
approved activities. Several Islamic Market Indexes
17
are introduced in Markets in the world
to represent Islamic-compliant portfolios. We suppose that Bahrain Islamic bank invest in
S&P Bahrain Shariah Index. We consider also Bahrain all Share index as a market portfolio.
The following table represents the main data we need from the balance sheet and the income
statement (of 31/12/2008) of Bahrain Islamic Bank in order to assess the displaced
commercial risk.
Accumulated PER
2368
Accumulated IRR
167
Profit Sharing Investment Deposits (DI)
624119
Market Portfolio
Bahrein all Share index
Shariah Compliant Portfolio
S&P Bahrain Shariah index
rf
18
4,5%
The historical data concerning Bahrain all Share index and S&P Bahrain Shariah index are
exported from the financial database Datastream.
Table 2 presents the various parameters of formula (6) we calculated using the data described
above.
k
19
0,426841509
i
20
0,009433962
f
21
0,567751336
17
Dow Jones Islamic Market indexes, S&P Islamic Index, FTSE Islamic Global Index, etc.
18
Annual rate, http://www.bahrainstock.com/bahrainstock/index.asp
19
Mudarib Share/ Profit Attribuable to IAHs net of PER before Mudarib share
20
Investment Risk reserve IRR retained in 2008/ Profit Attribuable to IAHs (net of PER and Mudarib share)
18
e
0,003794148
E(R
m
)
22
0,00035183
Standard deviation
m
0,00605432
Beta
A
23
1,12672218
Applying the formula (6) for different holding period and confidence level, we obtain these
results of VaR:
0,99 0,95
10 -0,02022227 -0,01187581
90 -0,04367345 -0,01863406
1 anne -0,13048509 -0,08858617
For Example, the capital required by Bahrain Islamic Bank to cover the displaced commercial
risk: DCR
VaR
= 13,05% of the total of investment accounts with 99% confidence and a
holding period 1 year.
The amount of capital Charge required thus to cover the displaced commercial risk for
different holding period and confidence level are presented in the table below:
0,99 0,95
10 -12621,1052 -7411,91865
90 -27257,4307 -11629,8711
1 year -81438,2223 -55288,3135
For example, the capital required by Bahrain Islamic Bank to cover the displaced commercial
risk: DCR
VaR
= 81438 BD
24
with 99% confidence and a holding period of 1 year.
The result obtained by the model we proposed will be compared to the capital charge needed
for displaced commercial risk calculated based on Central Bank of Bahrain capital adequacy
guidelines. The Central Bank of Bahrain has examined its prudential regime for Islamic
21
( )( )( ) i k p 1 1 1
22
We calculated the daily returns using times series of the market index prices for a period of 2 years (30-03-
2007 to 31-12-2008) to assess the daily volatility of returns
m
and the daily expected returns ) (
m
R E .
23
The same period for S&P Bahrain Shariah index related data.
A
= Cov (R
Shariah index
, R
m
)/V(R
m
).
24
13,075%* Investment Deposits
19
finance in order to ensure its regime is in line with international standards, including the
standards produced by the Islamic Financial Services Board (IFSB). Central Bank of Bahrain
fixed the ratio of 30% for displaced commercial risk (equivalent to the value of Alpha). In
other words, Islamic banks in Bahrain must bear 30 % of the credit and market risk-weighted
assets financed by investment accounts to mitigate the displaced commercial risk. The rest (70
%) is to be borne by Investment Account Holders. As the Bahrain Islamic bank funds are
comingled, we suppose that the risk-weighted assets financed by the Investment Accounts are
calculated based on their prorata share of the relevant assets.
From the annual report, we note:
Total credit weighted assets 390344
Market risk weighted asset 54733
Total risk weighted assets (credit risk + Market risk)
445077
Total liabilities, Investment Account and Equity
873967
Investment Account
624119
We calculate the charge of capital required to displaced commercial risk using the
methodology described above, the result is:
% Investment Account of Total (liabilities, Investment account and Equity)
71,41%
Total risk weighted assets (credit risk + Market risk) funded by investment
Account
317839,2458
Alpha
30%
The charge of capital required to displaced commercial risk: DCR
alpha
95351,77375
The comparison between the DCR
VaR
et DCR
alpha
reveals that the Bahrain Islamic Bank
charge of capital needed to displaced commercial risk as proposed under the simple risk
weight supervisory discretion approach of IFSB (2005) is different than capital charge
requirement calculated based on the Value at risk model we proposed.
4. CONCLUSION AND IMPLICATIONS:
20
Displaced Commercial risk is a new risk in banking risks literature. The paper has attempted
to identify the displaced commercial risk, a specific risk faced by Islamic banks arising from
the management of Profit Sharing investment accounts. The majority of Islamic banks absorb
a proportion of losses normally borne by investment account holders under commercial
pressure and this practice exposes them to the displaced commercial risk. We have proposed
an internal model based on Value at Risk to measure the displaced commercial risk based on
returns smoothing policies of the Islamic bank. The measurement of the actual risks sharing
depends on returns smoothing policies of the Islamic bank within the retention of different
Reserves. The model depends on various parameters: the proportion of Profit Equalisation
Reserve that the Islamic bank retains from the total revenue on asset, the ratio of profits and
losses sharing between the Islamic bank and Investment Account Holders, the proportion of
Mudarib Share of the bank as a fund manager and finally the proportion of the Investment
Risk Reserve. We studied a case of Bahrain Islamic Bank and we attempted to apply the
Value at risk model we proposed on this Islamic bank. We find that the capital requirement to
displaced commercial risk as proposed under the simple risk weight supervisory discretion
approach of IFSB(2005) is higher than the capital requirement that result from the Value at
Risk model. The supervisory discretion approach proposed by IFSB (2005) is subject to many
criticisms since the IFSB recommend to all Islamic banks in the same jurisdiction, the same
proportion of risk weighted asset funded by Investment Accounts without taking into account
the actual returns smoothing peculiar to each Islamic bank. The Value at Risk model we
proposed would be an alternative method to measure the additional capital charge required to
cover the displaced commercial risk especially that the IFSB (2005) capital framework and
the capital requirements directive allow for an internal model approach. As we proposed, the
assessment of the displaced commercial risk should be based on actual returns smoothing
policies of each Islamic Bank. The comparison we have conducted should be made on a large
panel of Islamic banks to confirm our funding. Applying the model on only one Islamic bank
is considered as a limit of our study. However, its an original study since in our knowledge;
no study so far focuses on the measurement of this new specific risk associated to Islamic
Banks.
21
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Archer & Rifaat Ahmed Abdel Rifaat Islamic finance: the regulatory challenge Edition John
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18. Erna Rachmawati, Ekki Syamsulhakim, 2004. "Factors Affecting Mudaraba Deposits in Indonesia,"
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23
APPENDIX A
1. STANDARD APPROACH
( )
( )
PSIA by finnaced
market credit assets weighted risk
l operationa market credit asset weighted risk total
capital
ratio
+
+ +
=
2. SUPERVISORY DISCRETION FORMULA
( )
( )
( )
PSIA ed unrestrict by financed
PSIA restricted by financed
market credit asset weighted risk
market credit asset weighted risk
l operationa market credit asset weighted risk total
capital
ratio
+
+
+ +
=
) 1 (
The proportion % quantifies the risk to be absorbed by shareholders of Islamic banks, with
the remainder (1- %) absorbed by Profit Sharing Investment Account holders. The
national supervision authority determine in arbitrary manner the value of % and impose the
same value to all Islamic banks operating under its jurisdiction.