Identifying Significant Activities and
Measuring Risks Inherent in IIFS
Risk-based Supervision in Institutions offering
Islamic Financial Services (IIFS)
2-5 February 2015
Kuwait city, Kuwait
Abdullah Haron

Agenda
• Defining Significant Activities in IIFS
• Identifying Types of Risks Inherent in IIFS
• Assessing the Criteria
2

Significant Activities in IIFS
Risk Matrix for IIFS
Inherent Risk
Operational Significant Business or Process Credit Market
Regulatory
Compliance Strategy
Retail financing?
Treasury?
Real estate investment?
AML?

Significant Activities in IIFS
What is the (material) to the achievement of IIFS’ business strategies?
Some questions to consider:
 What is the activities that may result in risk of losses to IIFS where it will not meet its objectives?
 What is the line of business, process or subsidiary’s potential impact on earnings, solvency, liquidity, funding, capital, reputation, internal expertise and capacity of the IIFS, brand value, or system of internal controls?
• Small activities but are profitable may raise flag
• Significant activities can be a subset of all activities
• IIFS’ significant activities may differ from one to another
• Continuous assessments both from macro and micro economic perspective and how they affect the IIFS
4

Significant Activities in IIFS (cont’d)
High
Low
9
10
11
12
13
7
8
5
6
2
3
4
Activities
1
• Real Estate
• AML
• ?
• ?
• Treasury
• Outsourcing recruitment
• What is the expected impact on the IIFS’s customers/depositors/IAH?
• What is the likely impact on the IIFS’s reputation?
• Would it have a material impact on the IIFS’s risk profile?
• How long would it take and what costs would be involved?
5

Significant Activities in IIFS (cont’d)
What are examples of significant activities in IIFS?
 Business line
 Process
 Subsidiary
• What would be the criteria?
6

Significant Activities in IIFS (cont’d)
Various sources:
 Organization chart
 Business plan
 Discussion
• Senior management
• Shari`ah compliant oversight
• Follow lines of accountability and responsibility
• Understand the inherent risks specific to the IIFS and how they are managed
• A lot of judgment is required to agree on “significant activities”
7

Significant Activities in IIFS (cont’d)
Criteria of Significance
 Qualitative
• Strategic importance to the industry or jurisdiction
• Reputation of Shari`ah non-compliance
 Quantitative
• Percentage of assets or capital
• Impacts of tainted income to IAH
• Loss absorbency of PSIA
• What is other potential qualitative and quantitative criteria for IIFS?
• Which criteria signify materiality?
• How many significant activities do you need?
• How detail do you want to go?
8

Types of Risks Inherent in IIFS
Risk Matrix for IIFS
Inherent Risk
Operational Significant Business or Process Credit Market
Regulatory
Compliance Strategy
Rating
High?
Above average?
Moderate?
Low?

Risks Inherent in IIFS
Definition
 Probability of material losses due to exposure to, and uncertainty arising from, current and potential future events
 A material loss is one that could impair the adequacy of capital – potential loss to depositors, investors and other creditors
 Inherent risk is intrinsic to a “Significant Activity” and can change as a result of the developments
• Why shouldn’t we assess risk management when assessing inherent risk?
• What is the purpose of assessing inherent risk?
10

Risks Inherent in IIFS (cont’d)
Risk Identification
Instruments Character Types of Risk
Murabahah and
Murabahah for
Purchase Orderer
Salam and Parallel
Salam
Istisna` and Parallel
Istisna`
Sale or purchase of an asset
Ijarah and Ijarah
Muntahia
Bittamleek
Musharakah and
Diminishing
Musharakah
Mudarabah
Sale of the usufruct
Profit (and /or loss) sharing
Market , Credit and
Operational Risks
Specific Risk –
Displaced Commercial
Market, Credit,
Operational and
Business Risks
Specific Risk –
Fiduciary
PRUDENTIAL REGULATION
• Shari`ah governance: to ensure Shari`ah rules and principles are complied at all times
• Capital and risk management: to ensure the soundness of the institutions
• Transparency and market discipline: to ensure the protection on the rights of the relevant stakeholders
11

Risks Inherent in IIFS (cont’d)
Risks in Banking Industry
Credit Risk
Market Risk
Liquidity
Operational
Risk
Specific Risks in IIFS
Equity
Investment
Risk
Rate of Return
Risk
Displaced
Commercial
Risk
Sharī`ah non-
Compliance
Risk
Fiduciary
Risk
12

Risks Inherent in IIFS (cont’d)
Category
 Credit (including equity investment)
 Market
 Operational
 Rate of return (displaced commercial risk)
 Liquidity
• Why shouldn’t we include reputational risk?
• Depending on the jurisdiction, the list of risks can be made granular for a more comprehensive understanding of risks (e.g. credit risks can be sub-divided into credit and equity investment)
 Clear and precise definition is important
• Only relevant and significant risks should be identified.
 Will the assessment of “net risk” change?
13

Risks Inherent in IIFS (cont’d)
Criteria to assign rating
 Obtain a sound understanding of the activity as undertaken by IIFS
 Assess the activity before and without considering the quality of the risk management process and control
• Size does not matter
• Probability does not change
Factors that could increase or decrease the rating
 Nature of market segment, extent of concentration, distribution channel, operational complexity, regulations
• Size of the significant activity do not have any impact in inherent risk ratings
• Inherent risk of a particular activity (e.g. real estate investment) is the same for all IIFS in the same jurisdiction
14

Risks Inherent in IIFS (cont’d)
Discussion
 What is the primary inherent risks of these products?
• Mortgage financing
• Commodity Murabahah
 Is the credit risk inherent in the following example the same?
• Mortgage financing of USD1 million
• Mortgage financing of USD50 million
 Is the liquidity risk inherent in the following example the same?
• PSIA of USD1 million
• Commodity Murabahah of USD1 million
• The assessment of risks inherent in IIFS should be dynamic, forward looking, continuous and systematic due to the nature of PSIA
• Challenges: definitions of each inherent risk, mixing inherent risk and oversight assessment, consistency in the starting point of different asset class
15

Credit Risk
IFSB: Credit Risk Management Principles
Definition:
Credit risk is defined as the exposure to the likelihood that a counterparty will fail to meet
Its obligations in accordance with agreed terms
Sources:
Exposure to potential loss in:
1. Receivables and leases
(e.g. Mur a bahah, Diminishing Mush a rakah and Ij a rah )
2. Working capital financing transactions
(e.g.
Salam, Istisn a `or Mudarabah )
3. Non-traded equity instruments ,
(such as those based on Mudarabah and Mush a rakah contracts, which are held for investment purposes and not for trading)
Credit risk principles also applicable to
Credit risks associated with securitisation and investment activities
(e.g. Investment certificate or sukuk)
Principle 2.1: IIFS shall have in place a strategy for financing, using various instruments in compliance with Sharī`ah , whereby it recognises the potential credit Exposures that may arise at different stages of the various financing agreements .
Principle 2.2: IIFS shall carry out a due diligence review in respect of counterparties prior to deciding on the choice of an appropriate Islamic financing instrument.
Principle 2.3: IIFS shall have in place appropriate methodologies for measuring and reporting the credit risk exposures arising under each Islamic financing instrument.
Principle 2.4: IIFS shall have in place
Sharī`ah -compliant credit risk mitigating techniques appropriate for each Islamic financing instrument.

Equity Investment Risk
Definition:
Equity investment risk broadly defined as the risk arising from entering into a partnership for the purpose of undertaking or participating in a particular financing or general business activity as described in the contract, and in which the provider of finance shares in the business risk .
Profile:
• Distinct difference between Muḍārabah and Mushārakah financings is in terms of
IIFSs’ involvement in investment
• Due diligence for fiduciary responsibility
• Legal and regulatory environment (Tariffs, quotas, taxation or subsidies etc)
• Lack of reliable information
Sources:
Risks associated with Muḍārabah or
Mushārakah partner , business activity and operations
IFSB: Equity Investment Risk Principles
Principle 3.1: IIFS shall have in place appropriate strategies, risk management and reporting processes in respect of the risk characteristics of equity investments, including Mu ḍārabah and
Mushārakah investments .
Principle 3.2: IIFS shall ensure that their valuation methodologies are appropriate and consistent, and shall assess the potential impacts of their methods on profit calculations and allocations. The methods shall be mutually agreed between the IIFS and the Mu ḍ ārib and/or
Mushārakah partners.
Principle 3.3: IIFS shall define and establish the exit strategies in respect of their equity investment activities, including extension and redemption conditions for Mu ḍ ārabah and
Mushārakah investments, subject to the approval of the institution’s Sharī`ah Board.

Market Risk
Definition:
Market risk normally refer to the potential impact of adverse price movements such as benchmark rates, foreign exchange (FX) rates, equity prices and commodity prices , on the economic value of an asset
IFSB: Market Risk Principle
Principle 4.1: an appropriate in respect of
IIFS shall have in place framework for market risk management (including reporting) all assets held , including those that do not have a ready market and/or are exposed to high price volatility.
Sources:
1. Fluctuations in values in: Tradable and marketable instruments (including Suk u k )
Investments in lease assets, Off balance sheet individual portfolios (for example, restricted investment accounts).
2. The risk arise from the current and future Volatility of market values of:
Specific assets ( e.g. commodity price of Salam asset, market value of a sukūk, and market value of Murābahah assets purchased to be delivered over a specific period) and Foreign exchange rates

Market Risk (cont’d)
Principles 4.1: Market Risk Management
Develop a market risk strategy
Quantify market risk exposures and assess
Exposure to the probability of future losses
Valuation of assets where no direct prices are not available
Risk appetite for tradable assets and
Adequately supported by capital
Sound and comprehensive market risk management Process & information system
Where available valuation methodologies are deficient: a) assess the need to allocate funds to cover risks resulting from illiquidity; b) establish a contractual agreement with
Counterparty specifying the methods to be used in valuing the assets
Same risk management policies and
Procedures to assets held as RIAH
•
Level of acceptable market risk appetite
• Types of risk taking activities
•
Target markets
• Reviewed periodically and disclosed to fund providers
• Conceptual framework for MR
• Guidelines governing risk taking in different portfolios of RIAH and their market risk limits
•
Appropriate frameworks for pricing, valuation and income recognition
• Strong MIS for controlling, monitoring and reporting market risk exposure and performance to appropriate levels of senior management

Operational Risk
Definition:
Risk of loss resulting from inadequate or failed internal process, people and systems or from external events. IIFS shall also incorporate possible causes of loss resulting from Sharī`ah non-compliance and the failure in their fiduciary responsibilities.
Sharī`ah non-compliance
These risks expose IIFS
Fiduciary responsibilities
Fund providers’ withdrawals, loss of income,
Voiding of contracts etc
IFSB: Operational Risk Principles
Principle 7.1: IIFS shall have in place adequate systems and controls, including
Sharī`ah
Board/ Advisor, to ensure compliance with Sharī`ah rules and principles .
Principle 7.2: IIFS shall have in place appropriate mechanisms to safeguard the interests of all fund providers .
Where IAH funds are comingled with
IIFSs’ own funds, IIFS shall ensure that the bases for asset, revenue, expense and profit allocations are established, applied and reported in a manner consistent with IIFSs’ fiduciary responsibilities.
Leading to diminished
Reputation or the limitation of business opportunities

Risk Matrix of an IIFS
Governance and Oversight Function
Significant Business or Process
Inherent Risk
Net Risk Direction of Risk Importance
Rating Direction Time Frame
Earning
Capital
Liquidity
Composite Risk
When assigning composite rating,
- It is not simply a numerical average
- Need to reflect inter-relationship and impact of components for example, potential of loss absorbency of PSIA dan DCR
- Need to ensure comparability and relative strength

Earning
In assessing earnings of an IIFS
 Identification of earning components
• Net profit income
• Other income
• Provisions of expense
• Trading (e.g. real estate, commodity murabahah)
• Overhead, Zakat and tax
• Tainted income
 Quality of those earnings
 Earning analysis
• Trend, peer review (within the Islamic financial services industry and overall banking industry), growth
 Rating earnings

Earning (cont’d)
In assessing earnings of an IIFS
 Is the quantity and quality of earnings adequate or inadequate?
 How much is the tainted income? WHY?
 Did the IIFS achieve return-on-asset above peer performance? WHY?
 Did the IIFS meet or exceed the budget for the year?
WHY?
 Did the IIFS achieve a higher or lower performance from the previous year? WHY?
 Did the IIFS use PER or IRR in boosting its earnings?

Earning (cont’d)
A strong rating on earnings indicates that earnings are more than sufficient to support operations, maintain adequate capital and allowance levels after consideration is given to asset quality, growth and other factors affecting quality, quantity and trend of earnings.
Given that IAHs share the profit and bear the loss of the
IIFS, supervisors need to assess the profit payouts to
IAHs in relation to displaced commercial risk.

Capital
In assessing capital of an IIFS
 Sources of capital
 Tier 1 and Tier 2 capital components
 Evaluation of capital
• Risks
• Additional ratios
• Capital planning
• Rating

Capital (cont’d)
Ability to maintain satisfactory source of capital
 Earnings retention
• The first line of defense against losses
• Good earnings are a critical factor in IIFS’s ability to raise capital from external sources
 Asset redistribution/reallocation
• Trading higher risk assets for lower risk ones (e.g., swapping financing for government securities)
 Issuance
• Ability to raise capital (access to capital markets/ investors) especially under stress

Capital (cont’d)
Components of Tier 1 Capital
 Common Stock
• Par value, or face value, of stock
 Surplus
• Price over par value when the stock is sold
 Undivided Profits/Retained Earnings
• Past period earnings that have not paid out in dividends
 Less: Intangible assets (e.g. goodwill, patents, copyrights), certain investments, tax assets etc.

Capital (cont’d)
Components of Tier 2 Capital
 Loan Loss Reserves
• limited to 1.25% of risk-weighted assets
 Term Subordinated Debt
• Debt that is junior to other debt
 Limit: Tier 2 capital may not exceed 100% of Tier 1 capital

Capital (cont’d)
Evaluation of Capital: Capital Ratios
 Risk Based:
• Tier 1 Capital to Risk Weighted Assets
• Total Capital to Risk Weighted Assets
• Tier 1 Common Capital to Risk Weighted Assets
 Leverage:
• Tier 1 Capital to Average Total Assets
• Tier 1 Common Capital to Average Total Assets
 Accounting:
• Stockholders’ Equity to Total Assets
• Stockholders’ Equity to Average Total Assets

Capital (cont’d)
Minimum Requirement for Capital Ratio
 Tier 1 Risk Based Capital Ratio = 6%
 Total Risk Based Capital Ratio = 8%
 Tier 1 Leverage Ratio = 4%

Capital (cont’d)
Evaluating Capital in IIFS
 Asset Quality: Credit and Market Risks
 Earnings: Market, Operational, and Credit Risks
 Liquidity: Liquidity Risk (including withdrawal risk)
 Other Risks: Legal and Reputational Risk
 Capital Planning
• Capital sufficient in relation to current risk and strategic initiatives; All business lines identified; Contingent liabilities reasonable; Capital requirements integrated into dividend policy; Internal qualitative and quantitative assessments of capital

Capital (cont’d)
A strong rating on capital indicates a strong capital level relative to the IIFS’s risk profile (RBC ratios significantly above minimum requirements)
Although PSIA is considered as quasi-equity in IIFS, it cannot be considered as capital because PSIA can withdraw its investment anytime with certain conditions.
Hence, it is not considered as a stable equity.

Liquidity Risk
Definition:
Liquidity risk is the potential loss to IIFS arising from their inability either to meet their obligations or to fund increases in assets as they fall due without incurring unacceptable costs or losses
Sources:
Major type of funds:
1. Current account holders
• Guaranteed
• Repayment at any time
2. Unrestricted Investment account holders (UIAH)
• Share profit and bear losses from
• Investment on their behalf
UIAH may also Withdraw their fund
• if return lower than expected rate of return,
• concern about financial condition of the IIFS, and if IIFS do not comply with Shari’ah rule
IFSB: Liquidity Risk Principles
Principle 5.1: IIFS shall have in place a liquidity management framework
(including reporting) taking into account separately and on an overall basis their liquidity exposures in respect of each category of current accounts, unrestricted and restricted investment accounts.
Principle 5.2: IIFS shall assume liquidity risk commensurate with their ability to have sufficient recourse to Sharī`ah-compliant funds to mitigate such risk.

Liquidity Risk (cont’d)
In assessing liquidity of an IIFS, check if any
 Deterioration in asset quality
 Excessive borrowings
 Changes in fund providers
 Decreased size of individual transactions
 Difficulty obtaining long-term funding
 Increased Loan to Deposit ratios
 Rapid decrease in deposits or withdrawal of PSIA
 Large rise in asset sales
 Negative press
 Concentrations

Liquidity Risk (cont’d)
General components of liquidity risk management
 Risk Measurement & Controls
• Limit Structure
• Gap Analysis
 Contingency Funding Plan
• Scenario Analysis
 Management Process
 Management Information Systems (MIS)

Liquidity Risk (cont’d)
Principles 5.1: Liquidity Management Framework
Operational Considerations
Qualitative Factors
BOD/ SM
Oversight general ability of the management skills in treasury management and Public Relations
Quality of MIS
IIFSs’ reputation in the market willingness and ability of shareholders to provide additional capital willingness and ability of the head office/ parent to provide liquidity in the case of a branch or subsidiary:
Contingency
Crisis
Management
LMP
Shariah
Support
Monitoring
Reporting
Liquidity Management Policy (LMP)
Liquidity Management Policies should incorporate both Qualitative and
Quantitative factors:
Quantitative Factors
Extent of diversity and sources of funds concentration of the funding base reliance on marketable assets availability of standby lines of external funding

Liquidity Risk (cont’d)
Principles 5.1: Liquidity Management Framework
Known
Cash flows
Measuring and Monitoring Liquidity
• Maturities and the amounts known in advance.
• Receivables from
Murabahah , Ijarah , IMB receivables and
Diminishing Musharakah
Conditional but predictable
Cash flows
•
(Salam and Istisna )
–conditionality based on the agreed terms and conditions over an agreed period
Conditional and unpredictable
Cash flows
• Investment in
Musharakah for open-ended period with exit strategy may be assessed periodically.
• The redemption of invested capital and possible level of
ROI is conditional upon the performance of the activities.
Nature
Of IIFS’
Balance
Sheet
Mostly, IIFS depend on Short Term funding, which can “disappear” too rapidly in case of liquidity crunch. IIFS…Assume funds repaid at maturity and No rollover.
Conventional banks usually like to raise Long Term debt, but IIFS face hurdles.
Result: Asset-Liability mismatch and resulting liquidity problem

Liquidity Risk (cont’d)
Principles 5.2: Liquidity Risk Mitigation-Liquidity Contingency Plan (LCP)
In case all previous measures fail to meet the liquidity gap adequately
LCP- Stage-3
Emergency
Measures or Investments in an orderly manner to meet such a liquidity gap or situation
LCP- Stage-2
Liquidate Assets
Liquidation procedures
LCP- Stage-I
Identification of liquidity gap
Or Situation acting as a Triggering Event,
Withdrawals don’t follow predictable pattern e.g.
Institutional Rating
Downgrade
LCP- Inclusion of Following factors and Defining Possible action points at each stage:
•
Holdings of tradable high quality liquid assets
• Profile and the degree of liquidity of other assets
• Assessment of Shariah -compliant and available funding products in the market;
• Possible agreements with other IIFS or conventional
•
•
• institutions on an interest-free basis - for accessing temporary funding or arrangements sale and leaseback for longer term funding
•
Possible liquidity arrangements with the central bank (on an interest-free basis)
• Establishment of a crisis management team or personnel responsible for taking actions at different stages of the liquidity crisis
• Notification procedures for communication with
IIFS’s head office and/or supervisory authorities

Liquidity Risk (cont’d)
Basel III: Liquidity Coverage Ratio
 The objective is to promote the short-term resilience of the liquidity risk profile of IIFS by ensuring that they have sufficient high-quality liquid assets to survive a significant stress scenario lasting 30 calendar days
Stock of High Quality Unencumbered Liquid Assets > 100%
Net cash outflows over 30 days under a Stress Scenario

Liquidity Risk (cont’d)
Basel III: Liquidity Coverage Ratio

Liquidity Risk (cont’d)
Basel III: Net Stable Funding Ratio (NSFR)
 The objective is to promote resilience over a longer time horizon by creating additional incentives for banks to fund their activities with more stable sources of funding on an ongoing basis. The NSFR has a time horizon of one year and has been developed to capture structural issues to provide a sustainable maturity structure of assets and liabilities
Available Amount of One-Year Stable Funding (Sources)>100%
Required Amount of One-Year Stable Funding (Uses)

Liquidity Risk (cont’d)
Basel III: Net Stable Funding Ratio

Liquidity Risk (cont’d)
Other potential ratios that maybe applicable to IIFS
 Illiquidity asset - long-term assets (defined as maturing beyond a specified time period) as a percent of total assets
• To better gauge the potential for assets to be used as sources of liquidity to meet uncertain future cash needs
 Relative stability or volatility of sources of funding
 To assess the relative stability or volatility of liabilities or PSIA as sources of funds through an assessment of the maturity of liabilities and their ability to be ‘‘rolled-over’’ or renewed under both normal business and adverse circumstances

Liquidity Risk (cont’d)
A strong rating on liquidity indicates a sufficient volume of liquid assets and/or ready and easy access to external sources of liquidity, on favorable terms.
The challenge to IIFS is readily available short-term
Shari`ah compliant assets. Insufficient volume may result in IIFS maybe at disadvantage compared to their peers in conventional institutions.

Rate of Return Risk
IFSB: Rate of Return Risk Principles
Definition:
The possible impact on the net income of the IIFS arising from the impact of changes in the market rates and relevant benchmark rates on the return on assets and on the returns payable on funding.
Rate of return risk differs from interest rate risk in that
IIFS are concerned with the returns on their investment activities at the end of the investment holding period and with the impact on net income after the sharing of returns with IAH.
Rate of return risk lead to Displaced Commercial Risk refers to the magnitude of risks that are transferred to shareholders in order to cushion the IAH from bearing some or all of the risks to which they are contractually exposed in Mu ḍa rabah funding contracts
Principle 6.1: IIFS shall establish a comprehensive risk management and reporting process to assess the potential impacts of market factors affecting rates of return on assets in comparison with the expected rates of return for investment account holders (IAH) .
Principle 6.2: IIFS shall have in place an appropriate framework for managing displaced commercial risk , where applicable.

Rate of Return Risk (cont’d)
Principles 6.1: Rate of Return Risk Management Process
 Appropriate systems for identifying and measuring the factors which give rise to rate of return risk (RRR)
 Employ gapping method while calculating rate of return
 The measurement of RRR highlights the importance of cash flow forecasting
 Take into account non-contractual behavioral maturity of the transactions
• Early settlement and rebates
 Balance sheet techniques to minimize exposures
• Varying future profit ratios
• Developing new Shariah compliant instrument
• Issuing securitization tranches of Shariah permissible assets

Rate of Return Risk (cont’d)
Principles 6.2: Displaced Commercial Risk Management
 Pressure of payment of competitive rates to IAH when return on underlying assets is underperforming e.g. financing provided on Murabaha basis for long term (on fixed rate) but market profit rates go up forcing IIFS to give better return to its IAH.
• linking to Benchmark
 Displaced commercial risk is the consequence of the rate of return risk
• To cover under-performing return on assets financed by IAH compared with competitors’ rates: o Forfeiting bank’s Mudarib fee

Pressure on IIFS to attract and retain investors ( IIFS may waive their rights to part or entire Mu d arib share of profits) o Profit equalization reserves (PER)
• To cover future investment losses of manageable magnitude: o Investment risk reserves (IRR)
• To absorb unexpected losses with a higher net impact: o Third Party Funds- Other than Shareholders funds

Rate of Return Risk (cont’d)
Reducing Mudarib fees to protect returns to IAH
 To cover under-performing return on assets financed by
IAH compared with competitors’ rates
 Remains a management decision
 IIFS is eligible, under the Mudarabah contract, for a
Mudarib (management) fee, which typically constitutes 20-
40% of asset yields net of PERs.
 In case asset yields deteriorate, the IIFS could reduce management fees ex post
 although unilateral increases of Mudarib fees are strictly forbidden
 This is viewed as a gift of the bank to IAH to earn their loyalty across the relationship

Rate of Return Risk (cont’d)
Forfeiting the Mudarib Fee

Rate of Return Risk (cont’d)
Profit Equalization Reserve (PER)
 Amount appropriated out of the gross income, before allocating the Mudarib share to maintain a certain level of Return on
Investment for IAH and increase owners’ equity .
• Simply, refers to reserves set aside from Mu ḍa rabah profits before applying the profit-sharing distribution ; hence, part of the PER is a component of shareholders’ equity and the remainder is a component of the equity of IAH
 Their purpose is to provide an excess return to IAH in periods where assets have performed worse than expected, and therefore when yields on IAH might be lower for a given
IIFS than for its Islamic and conventional peers.
 Basis for computing the amounts so appropriated should be pre-defined and agreed with IAH (for disclosures relating to
PER and IRR see IFSB-4 ).

Rate of Return Risk (cont’d)
Investment Risk Reserve (IRR)
Is the amount appropriated by IIFS out of income of unrestricted
IAH, after allocating the Mu da rib share, in order to cushion the effects of the risk of future investment losses on IAH.
Terms and conditions whereby IRR can be set aside and utilised should be determined and approved by the BOD.
Third Party FundsOther than Shareholders’ Funds
Constitute the ultimate line of defense against DCR
Should Mudarib fee cuts, IRR and PER are insufficient to protect
IAH from excessive volatility regarding returns, third parties like govt. can use their funds to compensate for possible losses of IAH
Most of the Shariah scholars do not allow shareholders bailing out IAHs, because one party in the Mudarabah contract can not guarantee funds of other party

Rate of Return Risk (cont’d)
Shareholders’
Funds
Transfer from
Shareholders’ profits
Techniques of Smoothing Payout to
Investment Account Holders (IAH)
 Based on Hibah

The shareholders accept the risks attached to the UIAH funds
Profit from
Investments
Forgoing
Mudarib’s
Share
 Appropriation before distribution of profit to shareholders and IAH
 The % taken from Mudarib share is varying
 Based on management decisions in line with the approval from BOD
Profit
Equalisation
Reserves (PER)
Profit Before
Distributions
 Setting aside from profit attributable to IAH after deducting Mudarib’s share
Investment
Risk Reserves
(IRR)
Shareholders
IAH’s
Funds
PER
IAH
IRR
Distribution of profit
Distribution of reserves

Rate of Return Risk (cont’d)
Issues in Smoothing Practices
 IAHs have no control over usage of these reserves and even in some cases they are not informed of their IIFS maintaining any such reserves.
 An IAH with a long-term investment perspective may find it useful to delegate the inter-temporal allocation of his income to IIFS. However, an IAH with a short-term investment perspective may be negatively affected by the building of reserves which most likely will be used for benefit of someone else.
 The IRR may give rise to moral hazard problems similar to those arising from deposit insurance schemes, since the existence of IRR in IIFS is likely to encourage management to engage in excessive risk taking.
 Harmonization/ Standardization issues
• What type of reserves
• Minimum or Maximum deduction/ Maximum sixe of reserves
• Whether to transfer all the profit to shareholders after reaching the max.

abdullahharon@gmail.com
Reference: a) IFSB FIS workshops and standards c) Naimi Shuib, FSI-AMF Liquidity Risk presentations 2014