The Measurement of the Displaced Commercial Risk in Islamic Banks

Abstract

The 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 α 𝐶 𝐴𝑅 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 α 𝐶 𝐴𝑅 −𝑉 𝑎𝑅 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.

Keywords: Displaced commercial risk, Profit equalisation reserve, Investment risk reserve, Value-at-risk, Extreme value theory

JEL Classification: C22, G01, G21, G28