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The IFSB Issues Working Paper on Risk-Sharing in Islamic Banking

Date posted: 30 May 2019

Kuala Lumpur, 30 May 2019 – The Islamic Financial Services Board (IFSB) today issued its 10th research (WP-10) in the IFSB Working Paper series which explores the risk-sharing practices in the Islamic banking sector. This working paper is basically both exploratory and cross-sectional in nature. It describes the views of both Islamic banks and regulatory and supervisory authorities (RSAs) on the practices of Islamic banks in IFSB member jurisdictions. This is in relation to the governance rights of unrestricted profit-sharing investment account (UPSIA) holders, as well as likely reasons that may account for the limited usage of equity-based contracts (such as muḍārabah and mushārakah) especially on the asset side of the balance sheet of Islamic banks.

The Secretary-General of the IFSB, Dr. Bello Lawal Danbatta stated, “this Paper is the second issuance in the IFSB’s Working Paper series this year. He further added, “this working paper provides some initial exploratory findings on risk-sharing practices in the Islamic banking industry”. “Elicited by the myriads of governance issues and the treatment of UPSIA holders, and the declining use of the risk-sharing contracts (such as muḍārabah and mushārakah) on the asset side, the paper offers the requisite prelude to another IFSB working paper on related issues that is based on empirical cross-country of the Profit Sharing Investment Account (PSIA) practices among Islamic banks in various IFSB member jurisdictions” he further added.

The findings in WP-10 reveal that the capital treatment of the UPSIA in general varies across different jurisdictions and Islamic banking type. In most of the jurisdictions UPSIAs are considered to be ‘investments’ exposed to losses rather than ‘deposits’ with capital certainty. In addition, the UPSIA holders’ lack of governance rights is well-noted by both the RSAs and the Islamic banks. However, neither consider indirect monitoring by the shareholders sufficient to make up for the lack of governance rights of the UPSIA holders.

Furthermore, WP-10 indicates that Islamic banks comply mostly with the disclosure requirements relating to the utilisation of profit equalisation reserve (PER) and/or investment risk reserve (IRR) and consider the basis of allocation of profits between the Islamic banks’ shareholders and UPSIA holders, including the maximum muḍārib percentage share as being very important. Both the PER and IRR are also often used as smoothing techniques.

WP-10 also reveals that high regulatory risk weights required on muḍārabah and mushārakah assets (excluding diminishing mushārakah for home purchase finance) discourage Islamic banks from placing funds in such assets. Other reasons include the agency and transactions costs attaching to such assets. Specifically in this regard, the operational risks reflected in the lack of human resources with the requisite knowledge and understanding of the specificities of risk-sharing contracts is noted.
WP-10 is available for download from the IFSB website: www.ifsb.org

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