How Islamic Banks Manage Their Risks and Returns with PER and IRR

If you are interested in Islamic finance, you may have heard of the terms PER and IRR.

But do you know what they mean and how they affect the performance of Islamic banks?

PER stands for Profit Equalization Reserve, and IRR stands for Investment Risk Reserve. These are two types of reserves that Islamic banks use to manage the risks and returns of their Profit Sharing Investment Accounts (PSIA).

PSIA are the main source of funding for Islamic banks, and they are based on the Mudarabah contract, which is a profit-sharing agreement between the bank and the investors. Under this contract, the bank acts as the manager (Mudarib) of the funds, and the investors are the owners (Investment Account Holders, or IAH).

The bank and the IAH agree on a profit-sharing ratio, which determines how the profits from the investments are distributed between them. However, if there are losses, the IAH bear them entirely, unless they are caused by the bank’s misconduct or negligence.

This sounds fair and simple, right?

Well, not quite. There are some challenges and complexities that arise from this arrangement, and they have to do with the risk-return profile of the PSIA.

Read my other posts here: Conventional Finance - FinFormed, Islamic Finance - FinFormed, Takaful - FinFormed, Career - FinFormed and Randow Writings - FinFormed

The Risk-Return Mismatch Between PSIA and Assets

One of the main challenges that Islamic banks face is how to match the risk-return profile of the PSIA with the risk-return profile of the assets that they invest in.

You see, the PSIA are not guaranteed by the bank, and they are exposed to the fluctuations of the asset returns. This means that the IAH may receive different returns in different periods, depending on how well the investments perform.

However, the IAH are not necessarily willing or able to accept this variability. They may have certain expectations and preferences about the returns that they want to receive, and they may compare them with the returns offered by other banks or financial products.

For example, suppose that you are an IAH who has invested in a PSIA with an Islamic bank. You expect to receive a return that is competitive with the market benchmark, say 10% per year. However, the bank invests your funds in assets that have a higher risk and a higher potential return, say 15% per year.

Now, if the assets perform well, you may receive a higher return than you expected, say 12%.

You would be happy with this outcome, right?

But what if the assets perform poorly, and you receive a lower return than you expected, say 8%? You would be unhappy with this outcome, right?

This is the problem of the risk-return mismatch between the PSIA and the assets. The bank has to balance the risk and return of the assets with the expectations and preferences of the IAH, and this is not an easy task.

The Negative Consequences of the Risk-Return Mismatch

If the bank fails to manage the risk-return mismatch between the PSIA and the assets, it may face some negative consequences, such as:

• Displaced Commercial Risk: This is the risk that the bank has to transfer some of its income or reserves to the IAH in order to maintain a certain level of return for them, and thus reduce its own profitability and capital adequacy. This may happen when the asset returns are lower than the market benchmark, and the bank has to cushion the impact on the IAH by sacrificing its own share of profits or by using other sources of funds. This risk is also known as the “alpha risk”, and it affects the capital requirements of the bank.
• Withdrawal Risk: This is the risk that the IAH withdraw their funds from the bank if they are dissatisfied with the returns that they receive, and thus reduce the liquidity and solvency of the bank. This may happen when the asset returns are lower than the market benchmark, and the bank is unable to cushion the impact on the IAH by sacrificing its own share of profits or by using other sources of funds. This risk is also known as the “beta risk”, and it affects the stability of the bank.
• Reputational Risk: This is the risk that the bank loses its credibility and trustworthiness among the IAH and other stakeholders if it fails to deliver the expected returns or to comply with the Shariah principles. This may happen when the bank engages in practices that are inconsistent with the Mudarabah contract, such as guaranteeing the principal or the returns of the PSIA, or using the reserves inappropriately. This risk is also known as the “gamma risk”, and it affects the image and growth of the bank.

As you can see, the risk-return mismatch between the PSIA and the assets can have serious implications for the performance and sustainability of the Islamic bank. Therefore, the bank needs to find a way to overcome this challenge and manage the risks and returns of the PSIA effectively.

The Use of PER and IRR to Manage the Risks and Returns of PSIA

One of the ways that Islamic banks use to manage the risks and returns of the PSIA is the use of PER and IRR. These are two types of reserves that the bank can set aside and draw down in order to smooth the returns paid to the IAH and to protect their funds against losses.

Let’s see how they work:

• PER: This is a reserve that the bank can set aside from the gross income of the investments, before distributing the profits between the bank and the IAH. The purpose of this reserve is to maintain a certain level of return for the PSIA, and to make it competitive with the market benchmark. The bank can draw down this reserve when the asset returns are lower than the market benchmark, and use it to supplement the returns paid to the IAH. The PER belongs to both the bank and the IAH, in the same proportion as their profit-sharing ratio.
• IRR: This is a reserve that the bank can set aside from the net income of the investments, after paying the bank’s share of profits as the manager. The purpose of this reserve is to cover any potential losses on the assets invested with the IAH funds and to preserve the value of their principal. The bank can use this reserve to offset any losses that may arise from time to time and to bring the IAH return to zero or positive. The IRR belongs entirely to the IAH, and it can be treated as part of their equity.

By using PER and IRR, the bank can achieve the following benefits:

• Reduce the Displaced Commercial Risk: By using PER and IRR, the bank can reduce the need to transfer its own income or reserves to the IAH in order to maintain a certain level of return for them. This means that the bank can retain more of its profits and capital, and thus improve its profitability and capital adequacy. This also means that the bank can treat the PSIA as pure investment products, and not as deposits, and thus reduce its capital requirements for them.
• Reduce the Withdrawal Risk: By using PER and IRR, the bank can reduce the volatility of the returns paid to the IAH, and make them more stable and predictable. This means that the IAH can have more confidence and satisfaction with the returns that they receive, and thus be more loyal and committed to the bank. This also means that the bank can have more stable and reliable sources of funding, and thus improve its liquidity and solvency.
• Reduce the Reputational Risk: By using PER and IRR, the bank can comply with the Shariah principles and the Mudarabah contract, and avoid any practices that are inconsistent with them. This means that the bank can uphold its credibility and trustworthiness among the IAH and other stakeholders, and thus enhance its image and growth.

As you can see, the use of PER and IRR can help the Islamic bank to manage the risks and returns of the PSIA effectively, and to overcome the challenge of the risk-return mismatch between the PSIA and the assets. However, the use of PER and IRR also involves some challenges and complexities, such as:

• How to determine the adequate level of PER and IRR: The bank has to decide how much PER and IRR to set aside and draw down in order to achieve the desired return for the IAH, and to balance the risk and return of the assets. This depends on various factors, such as the volatility of the asset returns, the market benchmark, the expectations and preferences of the IAH, and the policies and regulations of the bank and the supervisor. The bank has to use some analytical methods and models to estimate the optimal level of PER and IRR, and to monitor and adjust them periodically.
• How to disclose and report the use of PER and IRR: The bank has to disclose and report the use of PER and IRR to the IAH and other stakeholders, such as the shareholders, the auditors, and the supervisors. This is to ensure the transparency and accountability of the bank, and to provide the relevant information for the decision-making and supervision of the stakeholders. The bank has to follow some accounting and prudential standards and guidelines to disclose and report the use of PER and IRR, and to ensure their consistency and comparability across banks and jurisdictions.

These are some of the issues that the bank has to address when it comes to the use of PER and IRR. However, with the right knowledge and skills, the bank can overcome these challenges and complexities, and make the most of the benefits of PER and IRR.

In conclusion, PER and IRR are two powerful tools that Islamic banks can use to manage the risks and returns of their PSIA. They can help the bank to balance the risk-return profile of the PSIA with the risk-return profile of the assets, meet the expectations and preferences of the IAH, and comply with the Shariah principles and the Mudarabah contract. However, the use of PER and IRR also involves some challenges and complexities that the bank has to address, such as how to determine the adequate level of PER and IRR, and how to disclose and report their use.

By understanding and applying the concepts of PER and IRR, you can gain a deeper insight into the workings of Islamic finance, and you can make more informed decisions about your investments in PSIA. So, keep learning and exploring, and be proud of your progress!

Key Takeaways

1. PER and IRR: Profit Equalization Reserve (PER) and Investment Risk Reserve (IRR) are two types of reserves that Islamic banks use to manage the risks and returns of their Profit Sharing Investment Accounts (PSIA).
2. Risk-Return Mismatch: One of the main challenges that Islamic banks face is how to match the risk-return profile of the PSIA with the risk-return profile of the assets that they invest in.
3. Negative Consequences: If the bank fails to manage the risk-return mismatch between the PSIA and the assets, it may face some negative consequences, such as Displaced Commercial Risk, Withdrawal Risk, and Reputational Risk.
4. Use of PER and IRR: By using PER and IRR, the bank can reduce the Displaced Commercial Risk, the Withdrawal Risk, and the Reputational Risk, and thus improve its performance and sustainability.
5. Challenges and Complexities: The use of PER and IRR involves some challenges and complexities, such as how to determine the adequate level of PER and IRR, and how to disclose and report their use.

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

Subscribe on LinkedIn

Follow us on social media @Linkedin