ON CAPITAL STRUCTURE, RISK SHARING AND CAPITAL ADEQUACY IN ISLAMIC BANKS

Simon Archer and Rifaat Ahmed Abdel Karim ()
Additional contact information
Simon Archer: University of Surrey, Guildford, UK
Rifaat Ahmed Abdel Karim: Islamic Financial Services Board, 3rd floor, Block A, Bank Negara Malaysia Building, Jalan Dato'onn, 50480 Kuala Lumpur, Malaysia

International Journal of Theoretical and Applied Finance (IJTAF), 2006, vol. 09, issue 03, 269-280

Abstract: Islamic banks do not pay interest on customers' deposit accounts. Instead, customers' funds are placed in profit-sharing investment accounts (PSIA). Under this arrangement, the returns to the bank's customers are their pro-rata shares of the returns on the assets in which their funds are invested, and if these returns are negative so are the returns to the customers. The bank is entitled to a contractually agreed share of positive returns (profits) as remuneration for its work as asset manager; however, if the returns are zero or negative, the bank receives no remuneration but does not share in any loss.In the case of Unrestricted PSIA, the investment account holders' funds are invested (i.e., commingled) in the bank's asset pool together with the bank's shareholders' own funds and the funds of current account holders. In that case, the bank's own funds that are invested in the asset pool are treated the same as those of Unrestricted PSIA holders for profit and loss sharing purposes; however, the shareholders also receive as part of their profit the remuneration earned by the bank as asset manager (less certain expenses not chargeable to the PSIA holders). This remuneration (management fees) represents an important source of revenue and profits for Islamic banks.From a capital market perspective, this arrangement presents an apparent anomaly, as follows: shareholders and Unrestricted PSIA holders share the same asset risk on the commingled funds, but shareholders enjoy higher returns because of the management fees. On the other hand, competitive pressure may induce the bank to forgo some of its management fees in order to pay a competitive return to its PSIA holders. In this way, some of the PSIA holders' asset risk is absorbed by the shareholders. This phenomenon has been termed "displaced commercial risk" [2].This paper analyzes this phenomenon. We argue that, in principle, displaced commercial risk is potentially an efficient and value-creating means of sharing risks between two classes of investor with different risk diversification capabilities and preferences: wealthy shareholders who are potentially well diversified, and less wealthy PSIA holders who are not. In practice, however, Islamic banks set up reserves with the intention of minimizing any need to forgo management fees.

Keywords: Capital structure; risk sharing; capital adequacy; Islamic banks; investment accounts; displaced commercial risk (search for similar items in EconPapers)
Date: 2006
References: View complete reference list from CitEc
Citations: View citations in EconPapers (13)

Downloads: (external link)
http://www.worldscientific.com/doi/abs/10.1142/S0219024906003627
Access to full text is restricted to subscribers

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wsi:ijtafx:v:09:y:2006:i:03:n:s0219024906003627

Ordering information: This journal article can be ordered from

DOI: 10.1142/S0219024906003627

Access Statistics for this article

International Journal of Theoretical and Applied Finance (IJTAF) is currently edited by L P Hughston

More articles in International Journal of Theoretical and Applied Finance (IJTAF) from World Scientific Publishing Co. Pte. Ltd.
Bibliographic data for series maintained by Tai Tone Lim ().