Documente Academic
Documente Profesional
Documente Cultură
2 ISSN 2307-227X
International Journal of Research In Social Sciences
© 2013 IJRSS & K.A.J. All rights reserved
www.ijsk.org/ijrss
1
Sheila Nu Nu Htay is an assistant Professor and Ph.D. programme coordinator at IIUM Institute of
Islamic Banking and Finance, Kuala Lumpur Malaysia.
2
Syed Ahmed Salman is a research assistant and PhD candidate at IIUM Institute of Islamic Banking
and Finance, Kuala Lumpur Malaysia.
ABSTRACT
Key Words: Profit Equalization Reserve, Investment Risk Reserve, AAOIFI, IFSB and Bank Negara
Malaysia.
Malaysia (BNM) have recommended and their profit portion to pay the IAHs in order to
allowed the Islamic banks to set aside some prevent the withdrawal of the IAHs. Due to
portion of the profit under two special types of significant experience gained by Islamic banks
reserves, namely, profit equalisation reserve from attempt to mitigate DCR and WR has led
and investment risk reserve. According to to development of standard practices in Islamic
AAOIFI, IFSB and BNM, PER is an amount banking industry regarding PER and IRR.
appropriated by the Islamic bank out of the
mudaraba (profit and loss sharing contract) In the case of Islamic banks in
income, before allocating the mudarib Malaysia, BNM has introduced the guidelines
(entrepreneur) share and its purpose is to for these two reserves in the beginning of
ensure that the market rate of return able to pay 2004. Islamic banks are allowed to save up
to IAHs and increase owner’s equity. It is until 15% from profit gain. However, in certain
mainly intend for protection of a financial firm circumstances, BNM has allowed save up
against the risk of ruin due to existence of amount to be up to 30%. The differences
systematic risk that is prevalent in the industry between PER and IRR is the latter is retention
and issue of adequate capital and cost of only from profits of IAHs and after deduction
raising it to mitigate the risk. Similarly, IRR is of mudarib share. Meanwhile, PER is the
an amount appropriated by the Islamic bank reserve made by bank for certain portion of
after allocating the mudarib share, in order to profits calculated from gross income before
cater against future losses for the IAHs. distribute the profit between the shareholder
It can be said that these reserves are and Investment Account Holder and the
intended to protect the Islamic banks not to calculation of mudarib share. It is a need
lose the IAHs in the case of misfortune. This because it assists to smooth a low rate of return
paper is organized in five sections. The second and reduce the volatility in return of IAHs.
section explains the current practice of Islamic Meanwhile, IRR is use to cover potential
banks regarding PER and IRR. The third losses on assets invested with IAHs’ Funds [6].
section focuses on the guidelines of AAOIFI, In addition, Islamic banks are encouraged to
IFSB and BNM related to these reserves. provide the transparent information relating
Fourth section elaborates on the Shari’ah these reserves.
resolution on them and the last section
concludes. 3.0 RECOMMENDATIONS
FOR PER AND IRR BY AAOIFI,
2.0 CURRENT PRACTICES OF IFSB AND BNM
ISLAMIC BANKS IN PER AND
IRR 3.1 AAOIFI’s Recommendation for
PER and IRR
Since the aim of introducing PER and
IRR in Islamic banks is to compete with AAOIFI is an international not-for-
conventional banking industry, it is a shield profit organization that was founded on 26th
used by the Islamic banks to protect their risks February 1990. It was established solely for
such displaced commercial risk, withdrawal maintaining and promoting Shari’ah standards
risk (WR) and reputational risks [1, 2, 3, 4, 5]. for Islamic financial institutions (IFIs). One of
They further state that the main role of these the objectives of AAOIFI is to define and set
reserves is to mitigate the fluctuation of rates certain acceptable standard for various aspects
of return and to reduce the risk of paying of Islamic finance which are accounting,
profits out of equity in periods when actual governance, ethics, transactions and
profits are lower than expected. investment. These standards must be in
conformity with the principles of Shari’ah.
According to the prevailing standards,
DCR is defined as a risk and a pressure faced The AAOIFI had put together the new
by the Islamic banks to pay its investors- conceptual framework guiding the important
depositors a rate of return higher than what consideration that is relevant to financial
should be payable under the “actual” terms of statement treatment of investment accounts
the investment contract. Therefore, it forces which stem from Shari’ah point view. AAOIFI
the Islamic banks when they underperform and also promotes ability of IFIs to exercise free
are incapable to generate enough profits for authority regarding decisions which affect
distribution to account holders. Therefore, in investment and deployment of 'the investment
reality, most of Islamic banks decide to waive account holders’ fund. This kind of Shari’ah
worldview is related to the “maslaha (public
16
June 2013. Vol. 2, No.2 ISSN 2307-227X
International Journal of Research In Social Sciences
© 2013 IJRSS & K.A.J. All rights reserved
www.ijsk.org/ijrss
interest)’’ which is a secondary source of All of these are in the best interest of
Shari’ah that denotes public interest that all the stakeholders involved such as the
imparts the lives of people. IAHs, the shareholders and the public. It
will help in injecting transparency in the
According to [7] revenue should be system and promote peoples’ trust in the
recognized when realized. Based on the Islamic banks.
professional standard recommended by
AAOIFI, realization of revenue takes place 3.2 IFSB’s Recommendation for PER
when IFI has the right to receive the revenue, and IRR
there is an obligation from the end of another
party to remit and the amount of revenue to be IFSB is one of outstanding
collected should be known with reasonable supervision boards which provide guidelines to
degree of certainty. IFI should recognize the IFIs to manage PER and IRR. As for the board,
investment account in cash as cash equivalent PER is appropriate account created from
value or fair value. If the mudarabah is profit mudarabah contract income. The reserve
sharing based that takes part in the utilization functioned as to support necessary level of
of fund, it is treated as equity of investment return for the investment activities which have
account and as an on-balance sheet item. On been made before apportion the income for
the other hand, if the mudarabah is the type mudarib. This specific account is believed can
that provides no authority in the fund provide security for investment account holder
utilization, it is still treated as equity of (IAH) while increase owner’s equity. In
investment account but as an off-balance sheet comparison, the income will be transfer from
item. AAOIFI FAS 17 provides that at the end investment account holder after proportion
of accounting period, investment held for mudarib share in IRR. The reason of the
trading purposes shall be measured at their fair process is expected to mitigate risk from future
value. The realized profits or losses accrued as losses from investment activities. This will
a result of sale of any investment should be enhance existing and potential investment
measured at the difference between the book account holders’ trust to participate in
value and the net cash proceeds from the sale investment portfolio offered by the Islamic
of investment. banks. These accounting treatment and
disclosure for both reserves should be enforced
upon engaged with investment account
Generally speaking, there are
holders’ consent and Board of Directors’
four objectives of accounting disclosure.
resolution.
Two are Shari’ah based while the other
two are inferred general requirement. The
Shari’ah based is to avoid interest and to The practice of creating the reserves
must include analysis of risk profile of IAH.
pay zakat (religious tax). These two
Based on IFSB no. 12 [9] “Guiding Principles
objectives are social accountability as well
on Liquidity Risk Management for Institutions
as full disclosure. The financial statement
Offering Islamic Financial Services Excluding
should contain all material information
necessary to make them useful to the Islamic Insurance and Islamic Collective
users. The AAOIFI also provided in its Schemes”, Islamic banks must manage IAHs’
liquidity risk. IFSB proposes IFIs to perform
consultation paper [8] certain elements
stress testing including scenario analysis to test
that must be disclosed in the notes to the
and study the possible returns from the
accounts of financial statement regarding
investment activities. By doing that, Islamic
the IAHs as follows:
banks can forecast the expected return from
investment. IFSB also sets guideline to
i) Accounting policy being under perform additional cash flow analysis
practice and basis for charging periodically. By carefully managing IRR,
provision management should alert on its ability to share
ii) Total administrative expenses the profit with investors.
charged to investment accounts
with a brief description 3.3 BNM’s Recommendation for PER
iii) Percentage of profit allocation and IRR
between owner’s equity and
various investment account The supervision provided for PER and
holders IRR can be attained from BNM guideline. The
iv) Percentage earmarked to be guideline has assisted Islamic banking to
deducted for PER and IRR.
17
June 2013. Vol. 2, No.2 ISSN 2307-227X
International Journal of Research In Social Sciences
© 2013 IJRSS & K.A.J. All rights reserved
www.ijsk.org/ijrss
and reasonable in a situation of lower return [11] Amir Shaharuddin. (2010). Maslahah-
faced by Islamic Institution. Mafsadah Approach in Assessing the
Shari’ah Compliance of Islamic Banking
This is also in line with waiving of Products. International Journal of
Business and Social Science.
right concepts (Mubara’ah) which is allowed [3] Archer, Simon, Rifaat Ahmed Abdel
by Shari’ah which means “waiving a portion Karim. (2007). Islamic Finance: The
of right to receive profits for the purpose of Regulatory Challenge. John Wiley &
achieving market stability in the future” [10]. Sons, Business & Economics.
In certain research stated that ruling for the [10] Bank Negara Malaysia. Syariah
PER and IRR are under the basis of maslahah Resolution in Islamic Finance by Bank
mafsadah [11] and the profit portion save by Negara 2nd Edition, 29.
Islamic institution is based on Hibah [12]. It [9] IFSB- 12. (2012.) Guiding Principles on
has being agreed by the contemporary Liquidity Risk Management for
Institutions Offering Islamic Financial
scholars. Services (excluding Islamic Insurance
Takaful Institutions and Islamic
Collective Investment Schemes).
[12] Ismail Aminuddin, Discussed in blog
5.0 CONCLUSION “Islamic Banking way.
[5] Khan, Tariqullah, Ahmed Habib. (2001).
Islamic banks have emerged as an alternating Risk Management an Analysis of Issues in
banking system to conventional one. Islamic Financial Industry. Jeddah - Saudi
Unfortunately, since the conventional banking Arabia.
has been well established and dominating the [4] Romzie Rosman. (2009). Risk
banking sector a few decades ago, it is difficult Management Practices and Risk
for the Islamic banks to compete and penetrate Management Processes of Islamic Banks:
A Proposed Framework International
the market. The situation becomes more
Review of Business Research Papers Vol.5
difficult for the Islamic banks in the case of No. 1.
profit and loss sharing with the IAHs. During [1] Sundararajan, V. (2007). Risk
the booming period, there is no issue since measurement and disclosure in Islamic
Islamic banks will be able to pay the finance and implication of profit sharing
competitive rate of return to the investors. investment accounts. Retrieved September
However, in the case of loss from investing, if 24, 2012.
the Islamic banks cannot pay same rate given http://islamiccenter.kau.sa/7iecon/Ahdath/
by the conventional banks, IAHs might Con06/_pdf/Vol1/8%20V%20Sundararaja
n%20Risk%20Measurement.pdf.
withdraw their deposits and it will
[2] Sundararajan, V. (2010). Issues in
consequently lead to DCR. In order to protect Managing Profit Equalization Reserves
the Islamic banks from WR and DCR, and Investment Risk Reserves in Islamic
international organizations such as AAOIFI Bank. Journal of Islamic Economic,
and IFSB as well as some countries like Banking and Finance.
Malaysia have provided the guidelines. These [6] Toumi, K. & Vivini J.L. (n.d.). Islamic
guidelines are regarding how to appropriate banks’ exposure to displaced commercial
PER and IRR as well as what should be risk: Identification and measure.
accounting recognition and disclosure. It is Retrieved September 24,
2012.http://cermat.iae.univtours.fr/IMG/p
expected that this paper will be the interests of
df/Islamic_banks_exposure_to_displaced_
investors, bankers and the society. In addition, commercial_risk_Identification_and_Mea
Shari’ah scholars and researchers will be able surement.pdf.
to further investigate how these reserves can be
fair to all the involved parties.
REFERENCES