By:

Faisal Hassan
Hafiz Muhammad Umar Farooq
Muhammad Waqas Rafiq
Rabiya Asif
Salman Ejaz
Tazeen Rashid

MBA 2k13 | [Company address]

Islamic financial institutions dont provide fixed returns in exchange for their customers
deposits or investments. Instead, people who provide funds expect to share profits and losses
with the firm. This shared-risk-and-reward scenario is nice in theory, but in practice, investors
expect returns at least equal to the market. If they dont get them, they may move their money to
other financial institutions. This becomes more likely as more Islamic banks and other firms
enter the marketplace and sharia-compliant customers options increase.
Displaced commercial risk is simply the risk that Islamic bank bears or absorbs in order to pay
returns, competitive to that of conventional banks, to PSIA fund providers even if the underlying
assets dont earn profits. If Islamic bank does not yield to market pressure, they may lose their
fund providers. Thus, they have to do income smoothing by saving extraordinary returns for
cases of loss and thus even if they get positive or negative returns, theyll give market return to
its depositors. They use PER (Profit Equalization Reserve) for saving these extra returns.
So, lets suppose you opens a PSIA (Mudarabah) account with an Islamic bank to raise fund of
$100 where Bank is 20% partner and you are 80% partner. After some time, this account earns
$10 (i.e. 10%) but the AMR (average market Return) is 12%. You would expect $9.6 (i.e. 12% of
$80) but bank could only give you $8 (i.e. 10% of $80) as its underlying assets have earned only
10% return. The bank will have to give you $9.6 to match conventional banks return (to avoid
making it unattractive investment for you), so it has paid $1.6 extra which gives displaced
commercial risk represented by alpha (a)= 2% (i.e. $1.6/80).
However, Islamic institution can deal with this risk by:
It gives up a portion of its own profit and/or waives its fee from an investment, project, or
asset so it can funnel that money into customer returns.
It creates a fund called a profit equalization reserve (PER) by setting aside a percentage
of previous years profits to use when investment returns dip too low.
It creates another fund called an investment risk reserve (IRR) (again, funded by a portion
of previous years profits) that allows the firm to recover investment losses in a given
year.
Adjust PSR
Alternative deposit instruments like Islamic Negotiable Instrument of Deposits (INIDs)
and Commodity Murabahah.
PER and 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 (i.e. Bank) 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. If these reserves were sufficient to manage the payouts to PSIA holders, there
would be no need to sacrifice shareholder profits in order to maintain PSIAs return. Hence, if

PER/IRR were sufficient, there would be no DCR. But if DCR is positive, Islamic banks are
required to allocate adequate capital to cover the credit and market risks exposures arising from
the assets funded by the PSIA, which would otherwise be absorbed by the IAH.