Profit Sharing Investment Accounts -- Measurement and Control of Displaced Commercial Risk (DCR) in Islamic Finance

Abstract

The paper highlights some of the key issues and gaps in the supervision of Islamic Banks, and in particular, addresses the supervisory implications of the role of investment account management. One of the key issues in Islamic banking is how to measure and manage the sharing of returns and risks between shareholders and investment account holders (IAH), so that such risk sharing can become an effective tool of risk management in Islamic finance. A methodology for estimating such risk sharing is developed so that the extent of risks shifted (“displaced”) from IAH to shareholders, also referred to as “Displaced Commercial Risk” (DCR), can be measured. Drawing on the recent work on linking the DCR with the “Alpha”, which is the share of risk weighted assets funded by IAH that should be included in the denominator of Capital Adequacy formula for Islamic banks( as recommended in the new IFSB Capital Adequacy standard), the paper presents and illustrates an empirical approach for the supervisory assessment of “Alpha”.