A Value at Risk Based Model for the Measurement of Displaced Commercial Risk in Islamic Banks

Islamic banks differ significantly in that they typically mobilise funds in the form of Profit Sharing Investments Accounts that are remunerated on the basis of sharing the actual returns on assets financed by the investment funds, with the Investment Account Holders. In theory, the profits are shared in pre-agreed ratio and all losses on assets financed by the investment funds are to be borne by Investment Account Holders, except in the case of misconduct, negligence or breach of contracted terms by the Islamic bank. In practice, the concept of sharing the actual profits with Investment Account Holders is not the common practice of Islamic banks. In fact, under commercial pressure or regulatory pressure, the majority of Islamic banks are obliged to absorb a proportion of losses normally borne by Investment Account Holders in order to mitigate potential massive withdrawal of funds. This practice exposes Islamic banks to a specific risk, called displaced commercial risk which requires allocating adequate capital to smooth returns on Unrestricted Profit Sharing Investment Accounts and/or to cover losses. The paper identifies the Displaced Commercial Risk and proposes a methodology to measure this risk based on Value at Risk model. The measurement of the actual risks sharing depends on returns smoothing policies of the Islamic bank. It illustrates this approach with a case study of an Islamic Bank.