Displaced commercial risk (DCR) and value of alpha (%) for

Islamic banks in Bahrain/GCC

Dr. Mohammad Omar Farooq
Head of Center for Islamic Finance
Bahrain Institute of Banking and Finance, Kingdom of Bahrain
Email: farooqm59@gmail.com

Sowmya Vivek
Research Analyst/Coordinator
Bahrain Institute of Banking and Finance, Kingdom of Bahrain


Paper accepted for Gulf Research Council, July 11-14, 2012 at University of Cambridge, UK







I. Introduction
The phenomenal growth of Islamic Banking and Finance in recent years has highlighted needs
for policies to help integrate Islamic finance in the national and global financial system. There
has also been an understandable increased interest of researchers into understanding unique
aspects of Islamic banking and finance and how it can be standardized across the globe. Risk
Management in particular is drawing a lot of interest given the current turmoil in the financial
system and infrastructure. Few Islamic Bankers believe that Islamic banks overall are less
susceptible to risk on account of their nature. However an overwhelming majority rightly feel
that in additional to risks which conventional banks follow, Islamic banks face certain risk which
are unique to its nature. These risks include risks like Fiduciary risk and Displaced Commercial
Risk (DCR).
Displaced commercial risk is a unique risk applicable to an Islamic bank particularly in a dual
banking environment. Displaced Commercial Risk (DCR) is a special risk Islamic banks are
exposed to due to the commercial pressure of a having to pay a rate of return equivalent to a
competitive rate of return and absorb a portion of losses which normally would have been borne
by investment account holders in order to prevent massive withdrawal of funds.
Banks employ a great deal of measures to combat this risk. Profit Equalization Reserves (PER)
and Investment Risk Reserve (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 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. Islamic banks normally invest these reserves to generate additional
returns to investment account holders and smooth the returns on PSIA. If the reserves are
adequate to avoid the transfer of income from shareholders to Investment Account Holders, there
is no exposure to DCR. However DCR is positive if these reserves are insufficient and there is
transfer of some proportion of shareholders returns to depositors.
The recognition of DCR requires adjustment to Capital adequacy ratio of Islamic banks. IFSB
has come up with two methods to adjust the capital adequacy ratio of Islamic banks to account
for DCR. The first method excludes risk weighted assets funded by PSIA and hence assumes that
the risks are fully absorbed by investment account holders.
The second method requires a proportion % of risk-weighted assets financed by Profit Sharing
Investment Accounts to be included in the calculation of capital adequacy ratio. This method is
more aligned with the market reality in that it recognizes that investment account holders dont
fully absorb the risk. % which can take any value between 0 and 1 is taken as a proxy of DCR
and moves in a positive relationship with DCR. % is decided by the central bank and all
Islamic banks within its jurisdiction are expected to key in this value while calculating their
capital adequacy ratio.
Given this background our paper looks at the issue of DCR and alpha across GCC with particular
emphasis on Bahrain. The paper uses the IFSB methodology to calculate DCR and value of alpha
for banks in Bahrain.

II. Literature review
Though there has been studies done on DCR and the value of Alpha, not much has been done
with focus on GCC, primarily due to lack of disclosures and data. A number of notable research
works in this area have been done by Simon Archer and Rifaat Ahmed Abdel Karim (2006;
2010) and Vasudevan Sundarajan (2002). Also substantial research in this area has been done by
the Malaysia based Islamic Financial Services Board (IFSB).
1


III. Challenges regarding profit-sharing contracts
3.1 Management of PSIA and the mudaraba contracts
As per definition from AAOIFI, Mudaraba contracts essentially are a partnership in profit
between capital and work. It may be conducted between investment account holders as providers
of funds and Islamic bank as a mudarib. The Islamic banks announces its willingness to accept
the funds of investment amount holders, the sharing of profits being as agreed between the two
parties and the losses being borne by the provider of funds except if they were due to
misconduct, negligence, or violation of the conditions agreed upon by the Islamic bank. In the
latter cases, such losses would be borne by the Islamic bank.
2

There are two types of Mudharbah contracts that the Islamic banks offer namely the restricted
profit sharing investment accounts (RPSIA) and unrestricted profit sharing investment accounts
(UPSIA).In Restricted PSIA (RPSIA) investment account holders imposes certain restrictions as
to where, how and for what purpose his funds are to be invested. Further the Islamic bank may
be restricted from commingling its own funds with the restricted investment account funds for
purpose of investment.
3

In contrast under Unrestricted PSIA (UPSIA),the investment account holder authorizes the
Islamic bank to invest the account holders funds in a manner which the Islamic bank deems
appropriate without laying any restrictions as to where, how and for what purpose the funds
should be invested. Under this arrangement the Islamic bank can commingle the investment
account holders funds with its own funds or with other funds the Islamic bank has the right to
use (e.g. current accounts). The investment account holders and the Islamic bank generally
participate in the returns of the invested funds.
4

The management of the comingled fund is as shown in Figure 1, where the commingled funds
are invested in a specified pool of assets reflecting the general business and management strategy
of the Islamic bank.
5

From a Shariah perspective, Mudarabah PSIAs are essentially profit-sharing and loss-bearing
investment accounts. However Islamic banks are often forced to smooth the returns on UPSIA
owning mainly due to supervisory and commercial pressure. Hence UPSIAs end up being
shariah compliant alternative to conventional deposit accounts that are capital guaranteed and
have a contractually determined rate of return.
Overall the nature and treatment of UPSIA differs from country to country. At one extreme,
UPSIA can be highly protected instruments so that UPSIA tend to be deposit-like products where
the returns are more or less guaranteed by the Islamic bank. At the other extreme, UPSIA are
investment-like products that fully bear the risk of fluctuations in returns and even losses on the
underlying investments (i.e. typical Mudarabah investments). However in most cases, UPSIA
tend to be a mixture of the two extremes, depending upon the extent of investment risks actually
borne by the URIAH. The resulting challenge to Islamic banks and their supervisory authorities
is to determine the level of risk sharing between the bank and the IAH.
3.2 Concept of Displaced Commercial Risk and the value of alpha ()
Displaced commercial risk refers to the extent of additional risk (volatility of returns) borne by
an Islamic Banks shareholders compared to the situation where PSIA assume all commercial
risks as specified in the Mudarabah contract. IFSB Standard defines DCR as:
the risk arising from assets managed on behalf of Investment Account Holders which is
effectively transferred to the Islamic Financial Institutions own capital because the
Institution forgoes part or all of its mudaribs share (profit) of on such fund, when it
considers this necessary as a result of commercial pressure in order to increase the return
that would otherwise be payable to Investment Account Holders.
6

As per the Mudarabah contract, an Islamic bank in its capacity as Mudarib does not bear losses if
they are not due to negligence and/or misconduct. Hence, the definition of DCR does not include
covering of losses of IAH, which in principle are covered by IRR.
7

As discussed earlier, Islamic banks are under commercial pressure to absorb the losses from the
UPSIA and pay a competitive rate of return on these accounts. Islamic banks worldwide use
smoothing mechanism when determining the rate of return for UPSIA. The smoothing
mechanism includes:
3.2.1 Usage of Prudential Reserves
The most commonly used method to smooth IAH returns is to set aside reserves like Profit
Equalization reserve (PER) and Investment Risk Reserve (IRR). PER is essentially used to
stabilize profit payouts to IAHs whereas IRR may be used to cushion losses attributable to IAH.
PER is retained from the total income before the profit is allocated between shareholders and
Investment Account Holders and the calculation of Mudarib Share and hence forms part of the
equities of IAH and shareholders, respectively, which can be drawn down to smooth the profit
payouts to IAH when investment returns decline. The accumulated IRR however entirely
belongs to IAH and can be used only to cushion any losses (negative asset returns) attributable to
IAH that might arise from time to time.
Islamic banks make appropriation to PER when the actual asset returns are higher and these
appropriations may be reversed when actual asset returns are lower than market-related levels. In
addition, appropriations to IRR can be made from the IAH share of profit, to be reversed when
asset returns are negative. As long as Islamic banks can manage the distribution of returns on
PSIA entirely though adjustments in PER without any recourse to income transfer from
shareholders and/or adjusting the Mudarib share of profits, there will be no DCR at the point of
assessing the requirement for additional capital charges.
However there are some limitations on the accumulations of these reserves. In many countries
the central bank put an upper limit on the appropriations to these reserves mainly on account of
intergenerational problems.
3.2.2 Adjusting the Mudarib Share
The second recourse which Islamic banks utilize to smooth the return is by temporarily reducing
its Mudarib share below the contractual share. However, this mechanism can only be used for
income smoothing in the absence of losses, as investment losses on PSIA funds are to be borne
by IAH themselves, while the Islamic banks merely receives no share of profit as Mudarib.
3.2.3 Transfers from Shareholders Funds
The last alternative to smooth the returns of IAH (but not to cover losses) is that Islamic banks
management may (with the shareholders approval) donate some portion of the shareholders
income to IAH, so as to offer the latter a level of return close to the market benchmark level,
when the investment returns of the IIFS are lower than the benchmark. The size of the donation
from shareholders required to achieve a desired rate of return to IAH depends upon the available
level of PER, the market benchmark return, and the actual investment return of the IIFS.
Prior research in this aspect clearly reveal that there is significant absorption of risks by Islamic
banks, since many banks with sharply divergent risk profiles and rates of return on assets seem to
be offering almost identical rates of return to IAH, and these rates are generally in line with the
general rate of return on deposits in conventional institutions. In fact Islamic banks prefer to have
DCR on their books and have a mechanism of transfer of income from shareholders to IAH
instead of facing liquidity and withdrawal risks that may result from IAH being dissatisfied by
the returns they receive. Hence Islamic banks essentially make a trade-off between DCR and
withdrawal risk, with its systemic characteristics.
3.2.4 Definition of alpha
Alpha is the ratio of actual risk transferred to shareholders- that is the DCR in the situation of full
risk transfer to shareholders ( that is the full risk of the actual profit being below the benchmark,
but not the risk of IAH losses) implying the maximum value of DCR. A value of alpha near 0
implies an investment like product with the IAH bearing the risk whereas value of alpha close to
1 implies a deposit like product with the IAH bearing virtually no risk as shown in figure 2.
IV. Capital adequacy and supervisory implications
The recognition of DCR makes it necessary for Islamic Banks to provide capital for the same,
subject to any risk mitigation including appropriation to PER and IRR accounts. There are
essentially two methods advocated by IFSB to adjust the capital adequacy ratio to account for
DCR. The first method is called the standard formula whereby risk weighted assets funded by
PSIA are excluded and hence it assumes that the risks are fully absorbed by investment account
holders. In this case UPSIA are treated like pure investment products wherein IAH bears 100%
of credit and market risk of assets funded by them. The CAR in this case will be
Eligible capital
Total RWA (Credit + market risks) + Operational risk
Less
RWA funded by PSIA (credit + market risks)
The second method also called the supervisory discretion formula requires a proportion % of
risk-weighted assets financed by Profit Sharing Investment Accounts to be included in the
calculation of capital adequacy ratio. This method is more aligned with the market reality in that
it recognizes that investment account holders dont fully absorb the risk. % which can take
any value between 0 and 1 is taken as a proxy of DCR and moves in a positive relationship with
DCR. % is decided by the central bank and all Islamic banks within its jurisdiction are
expected to key in this value while calculating their capital adequacy ratio.
Hence under this method, UPSIA are treated as a mix of both deposit and investment products.
Under this, Islamic banks bear a proportion of credit and market risk of assets funded by IAH.
Alpha is the corresponding proportion of assets funded by unrestricted PSIA, as determined by
national supervisors. The CAR in this case will be
Eligible capital
Total RWA (Credit + market risks) + Operational risk
Less
RWA funded by Restricted PSIA (credit + market risks)
Less
(1- ) (RWA funded by unrestricted PISA (credit + market risk)
Less
(RWA funded by PER and IRR of unrestricted PSIA (credit +market risks)
4.1 CAR based on IFSB methodology: An Example
The example below indicates the computation of CAR for a hypothetical Islamic Bank. The
example also highlights how a change in alpha will impact the capital adequacy ratio.


Table 1: CAR computation of a hypothetical Islamic Bank
Liabilities
Demand Deposits 200
URIAH 500
RIAH 250
PER and IRR 50
Shareholder's capital 20

Assets
Trade financing (Murabaha) 550
Salaam/Ijarah/Istisnah 250
Mudarabah and Musharakah investments 220

Total Risk Weighted assets 250

Risk-adjusted assets financed by IAH 100
Risk adjusted assets financed by PER and IRR 10
Alpha 30%
Adjustment for market and operational risk 62.5

CAR according to the standard Formula

20 = 9.88%
(250+62.5)-(100+10)

CAR according to the supervisory discretion formula

20 = 8.15%
(250+62.5)-(0.7X100-0.3X10)

If Alpha is changed to 60%

CAR according to the supervisory discretion formula would
be

20 = 7.18%
(250+62.5)-(0.4X100-0.6X10)



The above example illustrates how a change in alpha can impact the Capital adequacy ratio. This
highlights the importance of setting a value for alpha that fairly reflects the amount of DCR,
taking account of the risk mitigating effects of the PER and IRR.
Setting up of the right value of alpha is very important and has very important supervisory
implications. If supervisory authorities set alpha at 0 when in fact it should be set close to 1, the
result is likely to be Islamic banks that are significantly undercapitalized, with consequent threats
to financial stability. Conversely, setting alpha close to 1 when in fact it should be set much
lower, will result in Islamic banks being required to carry excess amounts of capital, which will
impair their ability to compete. Thus, accurate supervisory assessments of alpha is very
important to fostering stability without undermining the competitive position of Islamic banks,
and to providing adequate incentives for Islamic Banks to manage the DCR in respect of their
PSIA.
This paper, therefore, sets out to provide a method whereby an appropriate value for alpha can be
approximated using a set of relevant data. The model uses basic accounting definitions in
defining the value of DCR and alpha. The data for this model has been taken from Banks annual
reports and disclosures.
8

It is very important for Islamic banks to know about the appropriate levels of PER and IRR,
given their exposure to DCR. The purpose of setting aside these reserves is not just to improve
the CAR as calculated formulaically. Rather, the appropriate value of alpha needs to be
determined taking into account the incidence of DCR and the actual mitigating effects of these
reserves. The following section addresses these issues.
4.2 The model and the overall accounting framework
9

We will start with developing the basic accounting framework for defining the DCR and alpha.
The model outlined below is based on the model developed by IFSB to measure DCR and alpha
and uses the same accounting framework as developed by IFSB.
Risk in this model is modeled using variability of asset returns. Unexpectedly, low returns that
fall below a threshold value or unexpectedly high losses that exceed a threshold level at a
specified probability level, serve as the measures of risks that Islamic banks shareholders will
face under various scenarios.
In order to assess the returns to PSIA, and the associated risks measured by the variability of
these returns, a basic framework is needed for measuring the mudarabah profits, defined as
profits that are available for distribution between IAH as capital provider and the IIFS as
mudarib. This framework is shown in Figure 1.
Below are the definitions and accounting equations of variables we will use in the model.
4.2.1 Mudarabah Profits
The existing applicable accounting standards, as per IFSB Guidance Note, state that when an
Islamic bank commingles its own funds and the Mudarabah funds of unrestricted IAH (UIAH),
profits are first allocated between Mudaribs own funds (shareholders funds) and UIAH funds
according to the capital contribution of each of the two parties. The share of an Islamic bank as a
Mudarib for its role as fund manager is then deducted from the share of profits allocated to
UIAH. Based on this, Mudarabah profits (before allocating Mudarib share) attributable (i.e. after
appropriations to or releases from PER) between UIAH and the IIFS as a Mudarib can be defined
as investment income from balance sheet assets (the latter may include other assets in the
investment pool, based on other sources of funds, including current accounts) plus trading
income minus provisions, minus appropriations to PER, minus income attributable to sources not
included in the investment pool.
Mudarabah income before allocating the Mudarib share can therefore be written as follows:
RM = A.(R
A
S
P
) A.R
P
KR
K

Where:
RM: Mudarabah income
A: Total assets, equal to the sum of shareholders funds (K), and UPSIA funds (DI) and other
funds (OF)
R
A
: The gross rate of return on assets
S
P
: Provisions made out of current income as a percentage of assets
R
P
: Appropriation to PER as a percentage of total assets
KR
K
: Income attributable to the shareholders outside of the Mudarabah, such as income from
assets funded by current accounts, and before the attribution of the Mudarib share, expressed in
terms of a rate of return on shareholders funds, RK.

4.2.2 Rate of Return to IAH
The IAH get their returns only from the specified profit-sharing ratio applied to Mudarabah
profits. The amount of profit distributed to IAH is, therefore, the agreed share of Mudarabah
profit net of appropriations to (or plus releases from) PER and, where applicable, IRR plus any
income transfer from shareholders funds. This is not the same as the income attributable to
PSIA that is, the amount of the agreed Mudarabah profit share of PSIA before any transfers in
or out of the PER and/or IRR.
RI = .RM/DI R
IR

Where:
: % of IAH share
RM: Mudarabah income
DI: UPSIA funds
R
IR
: Appropriation to IRR as a percentage of total assets

4.2.3 Rate of Return to Shareholders Equity
The returns to shareholders are derived from both their share of returns in the pool of investment
assets acquired using the commingled IAH/shareholders funds, plus their share of Mudarabah
profits for the services as a Mudarib, and the net earnings from other funds for example,
income from other banking services and other non-PSIA assets that are funded from other
sources. Accordingly, the rate of return on shareholders equity (R
E
)
10
can be written as follows:
R
E
= (1 ). {RM/K + A. R
P
/K} + R
K

Where:
(1 B): Mudaribs share
RM: Mudarabah income
K: Shareholders funds
A: Total assets, equal to the sum of shareholders funds (K), and UPSIA funds (DI) and other
funds (OF)
R
P
: Appropriation to PER as a percentage of total assets
R
K
: The rate of return on shareholders funds that is invested in other assets.

4.2.4 Net Profits, and Return on Assets
As a measure of profitability, return on assets is defined as the sum of net profits to shareholders
plus income attributable to PSIA (i.e. total net profits of the year before distribution to IAH)
expressed as a percentage of total assets. (Total assets are defined as the sum of shareholders
and UPSIA funds.) The gross rate of return on assets is equal to the rate of return on assets after
adding back provisions expressed as a percentage of assets. The conventional measure of the rate
of return on assets defined as total net profits before any distribution to IAH as a percentage of
average total assets can also be used for estimation purposes.
4.2.5 Other Data
Estimation of DCR and alpha also requires other data including the amounts of transfers made
from and/or to PER and IRR, Mudarib share as a percentage, amounts of transfers made from
shareholders' funds, total assets, average UPSIA, a market benchmark for the rate of return to be
paid to IAH, the amount of provisions appropriated from the gross income, gross income for the
financial year, gross income to shareholders, and gross income available for IAH.
4.3 The model
The model we are using to calculate DCR and alpha is based on the model developed by IFSB.
The IFSB model relies on basic accounting equations to define DCR and deduce the value. The
IFSB model assumes that rate of return to be paid to IAH (Ri) can be modelled as a function of
two variables: the rate of return on assets (RA), which represents the income available for
distribution between IAH and IIFS shareholders; and the market benchmark rate (Rm), which
represents alternative returns available to depositors generally, including IAH, in the market.
11

The section below outlines the methodology developed by IFSB in measuring DCR and Alpha.
4.3.1 Estimation of DCR and Alpha
The method developed by IFSB for calculating DCR and alpha involves the following steps:
Step 1: Estimate w.
Step 2: Estimate return to shareholders under alternative scenarios.
Step 3: Compute unexpected losses to shareholders under alternative scenarios.
Step 4: Estimate DCR and alpha.
The procedures required for each step are further detailed in the following paragraphs.
Step 1: Estimation of w
The relationship between the co-movement of rate of return on assets and market benchmark,
and rate of return to IAH can be modeled as :
R
i
= w. (R
m
) + (1 w). R
A

Where
R
m
: Market benchmark rate
Step 2: Estimation of return to shareholders under alternative scenarios
Scenario 1: PSIA are treated as pure investment products
Under this scenario, all commercial risks arising from assets funded by IAH are borne by the
IAH themselves. In other words, there is no smoothing of payouts to IAH. Therefore, there will
not be DCR and, accordingly, values of alpha and w will be zero. Other risk determinants
PER and IRR, transfer of income from shareholders to IAH will also be zero, and Mudarib's
share will be fixed (i.e. under this scenario, alpha = 0, w = 0, R
I
= R
A
S
P
, IRR/PER = 0).
Therefore, the rate of return to shareholders will depend strictly on investment return (i.e. return
on assets and Mudarib's share):
R
E0
= R
A
S
P

The standard deviation of R
E0
will give an estimate of unexpected losses under this scenario.
Scenario 2: PSIA are treated as pure deposit-like products
Under this hypothetical scenario, IAH bear no losses and all commercial risks arising from assets
funded by IAH are borne by shareholders. Therefore, DCR will be at its maximum and,
accordingly, values of alpha and w will also be at their maximum that is, 1. Other risk
determinants PER and IRR, Mudaribs share and income transfer from shareholders to IAH
will vary according to the payout policy adopted by the Islamic bank (i.e. under this scenario,
alpha = 1, w = 1, R
I
= R
m
). The rate of return to equity will be as follows:
R
E1
= (R
A
S
P
) + DI/K.(R
A
S
P
R
m
)
The standard deviation of R
E1
will give an estimate of unexpected losses under this scenario.
Scenario 3: PSIA are treated as being in-between pure investment and deposit-like products
Under this scenario, which represents an intermediate situation between the two extreme cases
(scenarios 1 and 2), the payout to IAH is a weighted average of market return and investment
return. Accordingly, there is risk-return sharing between IAH and shareholders of the IIFS
resulting in some DCR. The values of alpha and w will, therefore, fall between zero and 1.
Other risk determinants: PER and IRR, Mudaribs share, and transfer of income from
shareholders to IAH will depend on the Islamic Banks payout policy and sufficiency of reserves
held by IAH. The rate of return to equity is expressed as follows:
R
E2
= (R
A
S
P
) + DI/K.w.(R
A
S
P
R
m
)
The standard deviation of R
E2
will give an estimate of unexpected losses under this scenario.
Step 3: Computation of unexpected losses to shareholders under alternative scenarios
Assuming a normal probability distribution, and using the standard deviations of rate of return on
equity (RE) that are obtained in step 2, the corresponding unexpected loss to shareholders under
the three above-mentioned scenarios of PSIA can be calculated as follows:
Scenario 1: Unexpected loss to shareholders when PSIA are treated as pure investment
products:
UL
0
= a multiple of the standard deviation of R
E0

Scenario 2: Unexpected loss to shareholders when PSIA are treated as pure deposit like
products:
UL
1
= a multiple of the standard deviation of R
E1

Scenario 3: Unexpected loss to shareholders when PSIA are treated as being in between pure
investment and deposit-like products:
UL
2
= a multiple of the standard deviation of R
E2

Step 4: Estimation of DCR and alpha
From the unexpected losses to shareholders that were obtained in step 3, DCR and alpha can be
obtained using the following equations:
DCR = UL
2
UL
0

Maximum DCR = UL
1
UL
0

Alpha = (UL
2
UL
0
) / (UL
1
UL
0
)
We follow the same model as developed by IFSB however we have calculated scenario 3 as
simulated returns of scenario 1 and 2.
12

V. Treatment of URIAH accounts in Bahrain and other GCC countries
Bahrain is undoubtedly the most established financial center in the Gulf and a global hub for
Islamic Finance with a growing number of Islamic banks and financial institutions. The country
was amongst the first few to recognize the potential and demand for Islamic banking and
developed the industry at a time when it was not drawing the international interest and attention.
As of 2010, the country has 24 Islamic banks operating (of which 23 are locally incorporated)
with a total asset base of USD 36 billion. In the last five Bahrain's Islamic financial assets has
more than doubled from being worth 16 billion dollars in 2006 to 36 billion dollars in 2010.
13

Besides Bahrain UAE and Qatar are also emerging centers for Islamic finance accounting for
approximately 20% and 10% respectively of the global Islamic asset base. As of 2010, UAE has
10 Islamic banks operating in the country whereas Qatar has 5 Islamic banks within its
territory.
14

Table 2. Alpha levels in Practice
Country
Level of
alpha
Bahrain 0.3
Dubai 0.35
Indonesia 1
Malaysia 1
Qatar 0.35
Sudan 0.5

5.1 Treatment of URIAH accounts in Bahrain
Under URIAH contracts, banks are authorized by the IAH to invest the account holders funds
on the basis of Mudaraba contract in a manner which the bank deems appropriate without laying
down any restrictions as to where, how and for what purpose the funds should be invested.
Islamic banks in Bahrain comingle the equity of the IAHs investment funds with its own funds
or with other funds like the current accounts. The bank and IAH generally participate in the
returns on the invested funds. The banks do not take liability for any losses incurred on the joint
pool other than the loss resulting from gross negligence or willful misconduct on the part of the
bank or due to the banks violation of the terms and condition as agreed between the bank and
the IAH.
The banks normally invest the amount received from the customer on account of equity if
investment account holder in a portfolio of investments. The banks are required to maintain a
cash reserve from this account with the CBB.
The income allocated to the IAH is in accordance with the utilization of such deposits. The
utilization rate is determined by the ALCO with the approval of the Shariah supervisory board.
The URIAH accounts include different maturity range starting from 1 month, 3 month, 6 month,
9 month, 12 month and 36 month. The customer signs written contract covering all terms and
conditions of the investment, including tenor, basis of profit allocation and early withdrawal.
URIAH accounts are significant source of funds for Banks in Bahrain and account for
approximately 50% of the total asset base.
15
Hence banks are very sensitive to maintain these
deposits and regularly monitor rate of return offered by competitive banks to evaluate the
expectation of its IAH.
Profits from URIAH accounts are allocated between the bank and URIAH based on the
contribution of each of the group. Operating expenses incurred by the banks are not charged to
investment account.
Banks in Bahrain recognize the concept of DCR and provide for the same. Though banks set
aside PER and IRR, foregoing mudarib share is the preferred method for adjusting DCR. Also
there is no upper limit on appropriation to PER and IRR accounts imposed by the central Bank.
Banks in Bahrain typically invest URIA funds in short and medium term Murabaha, Sukuks and
Ijarah Muntahia Bittamleek. Funds are normally invested after deductions of mandatory reserve
and sufficient operational cash requirements. The rate of return payable to URIA holders is
decided by ALCO, keeping in view the rate of return earned from the portfolio financed by
URIA.
The central bank of Bahrain recognizes the concept of DCR and requires banks to have a policy
in place for the management of DCR. Also all Islamic banks are required to make detailed
disclosures in their annual report on URIAH accounts. The disclosure requirements for Islamic
Banks in Bahrain are detailed in Appendix A.
5.2 Measurement of DCR and alpha for banks in Bahrain
As discussed earlier the central bank of Bahrain requires Islamic banks to make detailed
disclosure regarding URIAH accounts in their annual reports. However while evaluating annual
reports of banks in Bahrain we found that not all banks make disclosures as required by Central
bank. Hence we have restricted our analysis to three Islamic banks in Bahrain For the sake of
sensitivity of data we choose not to name the banks and refer to them as Bank A, B and C.
16

Data collected and calculations are shown in the tables below.
Table 3a. Measurement of DCR and alpha for banks in Bahrain
Name Year
Average
UPSIA (DI)
Average
Equity (K) DI+K
Total
end of
period
assets
Gross
return on
UPSIA
before
funding
cost
Return
on
UPSIA
% (RA)
Bank A
2010 192439 123775 316214 419216 8254 4.29%
2009 184394 130530 314924 473604 11103 6.02%
2008 128814 136486 265300 464993 8953 6.95%
2007 38405 88782 127187 269511 3012 7.84%
Bank B
2010 480308 357000 837308 1446700 19104 3.98%
2009 503207 350000 853207 1373400 25045 4.98%
2008 211917 256600 468517 1284700 10862 5.13%
Bank C
2010 741382 128600 869982 935700 33083 4.46%
2009 680293 158300 838593 912000 35694 5.25%
2008 624119 176800 800919 874000 36934 5.92%

Table 3b. Measurement of DCR and alpha for banks in Bahrain
Name Year PER
Total
PER as
% of
average
UPSIA
(RP) IRR
Total
IRR as a
% of
UPSIA
(RIR)
Mudaraba
income
Mudaraba
income for
distribution
(RM)
Benchmark
rate
Bank A
2010 0 0 0 0 8254 8254 3.41%
2009 560 0.30% 452 0.25% 11103 10543 3.65%
2008 443 0.34% 339 0.26% 8953 8510 3.78%
2007 146 0.38% 91 0.24% 3012 2866 3.91%
Bank B
2010 0 0.00% 0 0.00% 19104 19104 3.41%
2009 0 0.00% 0 0.00% 25045 25045 3.65%
2008 0 0.00% 0 0.00% 10862 10862 3.78%
Bank C
2010 0 0.00% 0 0.00% 33083 33083 3.41%
2009 0 0.00% 167 0.02% 35694 35694 3.65%
2008 0 0.00% 0 0.00% 36934 36934 3.78%

Table 3c. Measurement of DCR and alpha for banks in Bahrain
Name Year
Mudarib
share in
absolute
amount
% of
Mudarib
share (1-
B)
Implied
share of
IAH
% of
IAH
implied
share
(B)
Rate of
return
attributable
to IAH
(RI)
Rate of
return
paid to
IAH (Ri)
Bank A
2010 2469 30% 5785 70% 3.01% 4.04%
2009 1772 17% 8771 83% 4.76% 4.58%
2008 1903 22% 6607 78% 5.13% 4.87%
2007 566 20% 2300 80% 5.99% 5.75%
Bank B
2010 5300 28% 13804 72% 2.87% 2.87%
2009 4228 17% 20817 83% 4.14% 4.14%
2008 997 9% 9865 91% 4.66% 4.66%
Bank C
2010 10467 32% 22616 68% 3.05% 2.39%
2009 11517 32% 24177 68% 3.55% 2.61%
2008 13183 36% 23751 64% 3.81% 2.81%

5.3 Measuring Rate of Return to Shareholders under Three Scenarios
Scenario 1
The first scenario is the profit sharing investment account (PSIA) is treated as pure investment
product. Therefore, rate of return to shareholders (R
e0
) is measured as follow:
R
e0
= R
A
S
p

Scenario 2
The second scenario is the PSIA is treated as pure deposit-like product. Here, the R
e1
is measured
as follow:
R
e1
= (R
A
S
P
) + DI/K. (R
A
S
p
R
m
)
Scenario 3 (R
e2
)
The third scenario is the PSIA is treated as being in between pure investment and deposit-like
products. We have calculated this by simulating returns obtained under scenario 1 and 2.
17

5. 4 Measuring Unexpected Losses under Three Scenarios
After getting the results for the Re under these three scenarios, unexpected losses (UL) for each
R
e
then need to be calculated, in order to determine the displaced commercial risk (DCR) and
Alpha.
The UL0 is standard deviation of Re0 while UL 1 and UL 2 are standard deviations of Re1 and
Re2 respectively. The results are shown in the table below:
Table 4. Unexpected losses (UL) under alternative scenarios
Name Year
Return to
shareholders
if UPSIA are
treated like
investment
(Re0)
Return to
shareholder if
UPSIA are
treated like
deposits
(Re1)
Simulated
return to
shareholders
(Re2)
Standard
Deviation
of Re0
Standard
Deviation
of Re1
Standard
Deviation
of Re2
Bank A
2010 2.25% 0.44% 1.31%
2.24% 3.90% 3.10%
2009 4.07% 4.66% 4.38%
2008 6.95% 9.94% 8.61%
2007 7.84% 9.54% 8.70%
Bank B
2010 3.98% 4.74% 4.37%
0.51% 0.90% 0.69%
2009 4.98% 6.89% 5.95%
2008 5.13% 6.24% 5.66%
Bank C
2010 4.46% 10.53% 7.50%
0.59% 1.20% 0.90%
2009 5.25% 12.11% 8.59%
2008 5.92% 13.46% 9.71%

5.5 The Determination of DCR and Alpha
The DCR and Alpha can be determined based on the following formulas:
DCR = UL
2
UL
0

Maximum DCR = UL
1
UL
0

Alpha = UL
2
UL
0
/ UL
1
UL
0

The calculations are shown in the table below:
Table 5. Calculated values of DCR and Alpha
Name DCR
Maximum
DCR Alpha
Bank A 0.86% 1.66% 52.05%
Bank B 0.18% 0.39% 45.59%
Bank C 0.31% 0.60% 50.85%

VI. Conclusion
The paper attempts to understand DCR calculation and treatment of URIAH accounts in Bahrain.
As illustrated in the paper the capital adequacy ratio of an Islamic bank is highly sensitive to the
value of alpha. Also choosing the right value of alpha is very important to maintain the
competitiveness of Islamic banks particularly in a dual banking environment. The estimation of
alpha requires historical data which in turn requires banks to make periodic disclosures in their
annual reports. Our study was constrained to a significant extent due to lack of disclosures in
other GCC countries. Even in Bahrain where the disclosures are mandatory as per central banks
guidelines we found that banks are not making the necessary disclosures regarding URIAH
accounts.
In the absence of historical data it is impossible to fit in a statistical/econometric model to
calculate alpha as some researchers have developed. Also it is much more practical for banks to
use the IFSB model which uses the basic accounting information and definitions. Hence the
paper illustrates the calculation of DCR using the IFSB method. We find that using the
methodology as described for the banks in Bahrain the alpha should be in the range of 50-60%
which is significantly higher than the alpha required by the central bank of Bahrain. This also
ties in with our survey of Islamic bankers who feel that URIAHs are more or less shariah
compliant alternative of conventional deposit accounts and hence alpha should be much higher
than the central bank requirement of 30%.
As a concluding remark we would like to highlight the importance of public disclosures on part
of Islamic Banks. The central banks need to be more aggressive in getting Islamic banks to make
disclosures in their annual reports. Also the Islamic banks must realize that they need to produce
the necessary data for their own purposes as part of their risk management procedures with
respect to DCR and capital adequacy.

1
The Islamic Financial Services Board (IFSB) is an international standard-setting organisation that promotes and
enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards
and guiding principles for the industry, broadly defined to include banking, capital markets and insurance sectors.
2
AAOIFI standards, Appendix D: glossary.

3
AAOIFI standards, Appendix E: definitions.

4
AAOIFI standards, Appendix E: definitions.
5
Archer, et. al. 2010.

6
IFSB 2005-Standard 7610.

7
IFSB guidance note in connection with the IFSB capital adequacy standard: the determination of alpha in the
capital adequacy ratio for institutions offering only Islamic Financial services- March 2011

8
In order for the necessary data to be available, Islamic banks need to make the necessary disclosures. Public
disclosure would, however, have the substantial-added advantage that information intermediaries such as rating
agencies and research analysts would have ready access to it, thus contributing to market discipline. Moreover,
retail-oriented disclosures of relevant data can help manage the risk-return expectations of IAH. Islamic banks

should of course produce the necessary data for their own purposes as part of their risk management procedures with
respect to DCR and capital adequacy.

9
IFSB guidance note in connection with the IFSB capital adequacy standard: the determination of alpha in the
capital adequacy ratio for institutions offering only Islamic Financial services- March 2011

10
IFSB. Guidance Note in Connection with the IFSB Capital Adequacy Standard: The Determination of Alpha in
the Capital Adequacy Ratio for Institutions (Other than Insurance Institutions) Offering only Islamic Financial
Services, March 2011, Available at: <URL: http://www.ifsb.org/standard/eng-GN-4%20Guidance%20Note.pdf>,
Access Date: March 16, 2012.

11
IFSB conducted a survey on DCR in 2009 to evaluate the treatment of UPSIA and DCR in different countries.
The survey showed that in many countries unrestricted PSIA are treated like semi-deposits owing to market
considerations and/or regulatory requirements and DCR exists at different levels in all surveyed countries. The
rationale for the treatment of PSIA varies from one country to another, in part due to the prevailing regulatory
requirements in each country. While regulations in all countries tend to protect the principal capital of PSIA (not the
returns), for market considerations IIFS are inclined to pay smoothed rates of return that are competitive with those
paid by their peers and conventional counterparts. The survey results also revealed that IIFS determine rate of return
to be paid to IAH based on two factors, actual rates of return and market benchmarks.

12
We conducted a survey on DCR and treatment of URIAH accounts in banks in Bahrain. The survey focused on
areas like how banks decide on the adjustment factor (defined as w in IFSB model) while benchmarking their rates
to the market rate. The decision on the w factor is essentially taken by the ALCO committee based on the liquidity
requirement of the bank. Hence we feel that there cannot be a uniform w which can be applied to all banks. Also
lack of prior time series data makes it difficult to put in a statistical model to calculate as recommended by the IFSB.
13
Data as per Bankscope

14
Data as per Bankscope

15
Based on data in annual report

16
For bank B and C data for 2007 is not available

17
For doing simulations we have used the Monte Carlo simulation method wherein a random value is selected for
each of the tasks, based on the range of the estimates. Given that R
e2
lies between R
e0
and R
e1
we have simulated the
returns within this range. The simulations are done in excel and the average simulated return is taken as a proxy of
R
e2
.














Appendix A
Central bank of Bahrain Disclosure requirements with respect to URIAH accounts


The central bank of Bahrain has a detailed disclosure requirement with respect to DCR and
URIAH accounts . All banks in Bahrain are required to make the following disclosures with
respect to DCR:
1. The bank's policy on DCR, including the framework for managing the expectations of its
shareholders and unrestricted IAH, the sharing of risks among the various stakeholders,
and the range and measures of risk facing unrestricted IAH based on the bank's general
business strategies and investment policies.

2. The historical data over the past five years for the following:
Total Mudaraba profits available for sharing between unrestricted IAH and
shareholders as Mudarib (as a percentage of Mudaraba assets)
Mudaraba profits earned for unrestricted IAH (as a percentage of assets) before
any smoothing
Mudaraba profits paid out to unrestricted IAH (as a percentage of assets) after any
smoothing
Balances of PER and IRR, and movement of these in determining unrestricted
IAH payout
Variations in Mudarib's agreed profit-sharing ratio from the contractually agreed
ratio
Market benchmark rates selected by the bank

3. Five year comparison of historical rate of return of unrestricted IAH in relation to the
market benchmark rate selected by the bank

4. Five year comparison between the percentage rate of returns to IAH and the percentage
returns to shareholders from Mudaraba profits

5. Amount and percentage of profits appropriated to PER and IRR

6. Analysis of the difference between aggregate Mudaraba-earned profit and profit
distributed to IAH as a function of movement in PER, IRR and the Mudarib's share

7. Analysis of the proportion of the RWA funded by IAH that should be considered in
arriving at the total RWA together with an explanation of the underlying rationale.


The following quantitative disclosures should be made when the concerned Islamic bank has
unrestricted investment accounts:
Amount of IAH funds
The ratio of Profit Equalization Reserves (PER) to the total amount of PSIA by type of
IAH
The ratio of Investment Risk Reserves (IRR) to the total of PSIA by type of IAH
ROAA and ROAE
Ratio of profit distributed to PSIA by type of IAH. The bank must disclose the profit
sharing formula used for the calculation and distribution of profits
The management fee (Mudarib share) as a percentage of the total investment profit, and
the extent to which it is subject to partial or total waiver in order to pay a competitive rate
of return to IAH
Ratio of financing to PSIA by type of IAH
Percentage of financing for each type of Shariah-compliant contract to total financing
Share of profits earned by IAH, before transfers to or from reserves (amount and as a
percentage of funds invested)
Share of profits paid out to IAH, after transfers to or from reserves (amount and as a
percentage of funds invested);
Share of profits paid out to the bank as Mudarib;
Movement on PER and IRR during the year;
The utilization and computation of PER and/or IRR during the period;
Average declared rate of return or profit rate on PSIA by maturity (3-month, 6-month,
12-month, 36-month);
Types of assets in which the funds are invested and the actual allocation among various
types of assets;
Changes in asset allocation in the last six months;
Off-balance sheet exposures arising from investment decisions, such as commitment and
contingencies;
Limits imposed on the amount that can be invested in any one asset;
The treatment of assets financed by IAH in the calculation of RWA for capital adequacy
purposes;
Profits earned and profits paid out over the past five years (amount and as a percentage of
funds invested); and
Amount of total administrative expenses charged to unrestricted IAH.




Figure 1: A Framework to compute Mudaraba income and returns to IAH

Source: Islamic Financial Services Board. Exposure Draft: Guidance Note in Connection with the IFSB Capital
Adequacy Standard: The Determination of Alpha in the Capital Adequacy Ratio, November 2010, p. 16.

Other funds
such as current
accounts
Funding
Shareholders
funds
IAH Funds from
PSIA
Portion
commingled
with other
funds
Portion
commingled
with IAH
funds
Invested
Portion
Reserves
Financing
Other assets
Pool of assets held by commingling
IAH funds with shareholder funds
Returns
Earnings on other
assets and reserves
Unsmoothed profits on commingled
funds
Profits assigned
to share holders
PER
Smoothed profits after
subtracting PER. This is
Mudarabah income
Retain to IAH, based on a profit
share applied to Mudarabah
income the share of PER is held
as equity of IAH and not
distributed; and hence not
included in IAH return
Mudaribs share, 1
of Mudarabah
income
Returns to Shareholders Includes
a share 1 of PER


Figure 2- Understanding the concept of DCR and alpha













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