On Capital Structure, Risk Sharing and Capital Adequacy in Islamic Banks Oleh Archer

May 9, 2006 16:9 WSPC-104-IJTAF SPI-J071 00362
International Journal of Theoretical and Applied Finance

Vol. 9, No. 3 (2006) 269–280
c World Scientific Publishing Company
ON CAPITAL STRUCTURE, RISK SHARING AND

CAPITAL ADEQUACY IN ISLAMIC BANKS
Int. J. Theor. Appl. Finan. 2006.09:269-280. Downloaded from www.worldscientific.com
SIMON ARCHER
University of Surrey, Guildford, UK
by UNIVERSITY OF WATERLOO on 12/16/14. For personal use only.
RIFAAT AHMED ABDEL KARIM∗

Islamic Financial Services Board, 3rd floor, Block A
Bank Negara Malaysia Building, Jalan Dato’onn
50480 Kuala Lumpur Malaysia
rifaat@ifsb.org
Received 6 December 2004

Accepted 5 July 2005
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 com-
mercial 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
∗ Corresponding author.
269
270 S. Archer & R. A. A. Karim
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.
1. Introduction
A key principle of Islamic banking is the avoidance of interest, whether paid or
received. Hence, when Islamic banks mobilize funds, they normally do so either
in the form of current accounts which are not entitled to any financial return but
which are “capital certain”, or in the form of profit-sharing investment accounts

(PSIA) on the basis of the Mudaraba form of contract. The latter are not “capital
certain”, as they are exposed to losses on the related investments. The Islamic bank
in its capacity as fund manager, or Mudarib according to the Mudaraba form of
contract, is entitled to a contractually specified percentage of profits on the related
investments but does not share in losses. If the Islamic bank has invested its own
(shareholders’) funds and those of current accounts in the same asset pool as the
funds of PSIA, then the bank in its capacity as an investor shares pro rata in both
profits and losses. In this case, the investment of the bank’s own funds is not subject
to the Mudaraba contract between the bank and the PSIA.
In general, PSIA may be divided into unrestricted investment accounts, over
the investment of which the Islamic bank as Mudarib has complete discretion, and
restricted investment accounts, to be invested in a contractually specified category
of assets (although the Mudarib may be left some discretion over this). Normally,
unrestricted PSIA are commingled with the bank’s own funds in a so-called bilateral
Mudaraba; this is not normal in the case of restricted PSIA, except where (subject
to any contractual restrictions on this) the bank invests temporarily to replace the
funds of an investor who withdraws.
The management fees in the form of the Mudarib percentage of profits on PSIA
are a major source of revenue for Islamic banks, and indeed the predominant source
for most of them. Because the fee is calculated on a profit (but not loss) sharing
basis, the use of PSIA by Islamic banks constitutes an interesting form of finan-
cial leverage. On the face of it, since the PSIA are liable for any losses on their
investments (except in case of malfeasance, negligence or breach of contract by the
Mudarib), there is no transfer of asset risk from the PSIA to the bank’s own cap-
ital, as there is in the case of conventional interest-bearing deposits or of debt in
general. Consequently, it would seem that there is no upper limit to the volume of
PSIA that an Islamic bank may take under management so as to enjoy the Mudarib
percentage of profits thereon [4].
However, when these propositions are examined from the perspective of the
capital adequacy of an Islamic bank, some important questions are raised, to which
we turn to in Sec. 2. Section 3 further develops some theoretical propositions on
risk sharing between shareholders and PSIA in Islamic banks put forward in Sec. 2,
and Sec. 4 sets out some conclusions.
Capital Structure, Risk Sharing and Capital Adequacy 271
2. The AAOIFI Capital Adequacy Committee and its Analysis

2.1. AAOIFI and capital adequacy
The Accounting and Auditing Organization of Islamic Financial Institutions
(AAOIFI) is a self-regulatory body set up by a number of Islamic financial
institutions and other interested parties in 1991 [1]. In May 1996, AAOIFI took the
decision to set up a Capital Adequacy Committee. Karim [7] had drawn attention
to the fact that the capital adequacy of Islamic banks was a potentially problematic
issue.
In March 1999 the AAOIFI Capital Adequacy Committee issued a statement:

The Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks [2].
While this statement accepted that, legally speaking, asset risk is not transferred
from PSIA to shareholders of an Islamic bank, it identified two sources of risk to

the bank’s own capital resulting from the management of PSIA.
The first of these sources lies in the nature of the Mudaraba contract, which
places liability for losses on the Mudarib in case of malfeasance, negligence or breach
of contract on the part of the management of the Mudaraba. In such a case, the
capital invested by the PSIA becomes a liability of the bank. The term “fiduciary
risk” was used in the statement to designate this type of risk.
The second source of risk is of a more subtle nature, and raises some fundamental
questions as to the financial economics of Islamic banking. First, we will cite some
empirical evidence regarding the existence of this source of risk, then we will provide
a theoretical explanation which will be developed at greater length in subsequent
sections of the paper. For reasons which will become clear, the Statement used the
term “displaced commercial risk” to designate the risk emanating from this source.
In effect, asset risk is being transferred from PSIA to shareholders in a way that
seems to be at odds with the nature of the Mudaraba contract.
2.2. Displaced commercial risk: Some empirical evidence

There is empirical evidence that it is a common practice among Islamic banks to
“smooth” the financial returns to PSIA by varying the percentage of profit taken as
the Mudarib share, even to the point where the Mudarib share may be negative for
a particular year. Thus, the Mudarib share stated in the contract is a maximum,
while the actual share is liable to vary from year to year.
There are also other mechanisms which the bank can use to vary the allocation
of profit between shareholders and PSIA. One of these concerns the percentage of
the PSIA investment which is deemed to be held for liquidity purposes, and which
has the contractual status of a non-profit sharing (i.e., unremunerated) current
account. The size of this percentage varies according to the original term of the
PSIA investment, with higher percentages for shorter maturities. In fact, banks can
normally invest a significant part of these unremunerated funds in income-producing
short-term assets, and this constitutes an additional return for the shareholders.
But it also provides a “cushion” making it easier for the bank to smooth the returns
to PSIA.
The relative lack of transparency in the financial reporting of Islamic banks
(which several accounting standards issued by AAOIFI are designed to address)
means that this smoothing process is generally not observable from the bank’s
financial statements [5, 6]. But from the responses received during the exposure
period of the AAOIFI Statement on capital adequacy it was clear that such smooth-
ing is widely practiced and indeed acknowledged as a normal feature of Islamic
banking.
2.3. Smoothing within the equity of PSIA

The way in which the bank creates reserves out of profits attributable to PSIA
can also be used to smooth the returns to the latter without affecting the profit
attributable to shareholders. The bank may include a clause in the Mudaraba con-
tract giving the Mudarib (i.e., the bank) the right to set aside a certain percentage
of the profit attributable to PSIA, as described below. This may be used to mitigate
the bank’s exposure to displaced commercial risk.
The lack of transparency in financial reporting, which was mentioned above, has
permitted Islamic banks to create undisclosed reserves which can be used for income
smoothing purposes. Although the AAOIFI Financial Accounting Standard no. 11
Provisions and Reserves [3], applicable from 1 January 2001, permits such reserves,
it requires disclosure of their amounts and movements. One such reserve (referred to
in [3] as “Profit Equalization Reserve”, hereinafter PER) is created by setting aside
amounts out of the bank’s profit before allocation1 and calculation of the Mudarib
share; the amounts so set aside reduce the profit available to both shareholders
(including the Mudarib share) and PSIA holders. Another reserve (Investment Risk
Reserve, hereinafter IRR) is created by setting aside amounts out of the profit
attributable to PSIA holders, which the bank as Mudarib is typically authorised to
do in the Mudaraba contract. The portion of the PER that is attributable to the
PSIA, and all of the IRR, are invested in assets that produce returns for the PSIA;
however, the bank as Mudarib will receive a percentage of these returns. What is
not clear is whether this percentage is the same as that stated in the Mudaraba
contract with the PSIA holders.
In both cases, reserves are created within the equity of PSIA holders that provide
a means whereby the bank may smooth the reported returns attributable to its PSIA
holders. In the case of the PER, the profit available to shareholders is also affected;
however, this is not so in the case of the IRR, movements on which affect only the
profit available to the PSIA holders.
1 Allocation of profits (and losses) between shareholders and PSIA will be necessary if the bank’s
own funds are commingled with PSIA funds. Even if there is no commingling, the amounts trans-
ferred to the PER will reduce amount of profit on which the bank’s Mudarib share is calculated.
In the absence of the disclosure required by the AAOIFI standards, users of the
financial statements of Islamic banks could not differentiate between two types of
income smoothing: (a) that which involves displaced commercial risk, discussed in
Sec. 2.2 above; and (b) income smoothing within the equity of PSIA, which involves
no displacement of risk onto shareholders. Yet the economic consequences of these
two types of smoothing are crucially different. Displaced commercial risk creates
value for holders of PSIA (as discussed further in Sec. 3 below). However, income
smoothing within the equity of PSIA creates no value for holders of PSIA; but it
does benefit shareholders by reducing their exposure to displaced commercial risk,
and in that sense it creates value for shareholders. As we argue below, this is likely
to be at the expense of the holders of PSIA.
Income smoothing within the equity of PSIA creates no value for holders of
PSIA, as can be seen from the following. Retention of profits creates value for
equity investors only if the ex ante rate of return on such retentions exceeds the
investors’ cost of capital (the expected market rate of return for an investment of
comparable risk). Hence:
(a) Retaining profits to create reserves for income smoothing purposes must be
differentiated from the retention of profits to finance growth opportunities.
The ex ante rate of return on PSIA profits retained for income smoothing
purposes reflects the fact that the purpose of the retention is to increase future
reported profits in periods when the underlying ex post rate of return is below
the PSIA holders’ expected rate. In other words, the ex ante rate of return on
such retentions is below the PSIA holders’ expected rate.
(b) The reduction of the volatility of PSIA cash flows is achieved by reducing
their reported profits and cash distributions in earlier years in order to create
reserves which can be used to increase reported profits and cash distributions in
later years. Decreases in reported profits and cash distributions must precede
increases. Therefore, other things being equal, this type of smoothing could
create value for PSIA holders only if the reduction in the volatility of their
cash flows implied a reduction in their cost of capital (expected rate of return),
such that the present value of their cash flows was increased rather than being
decreased.2 But this could not be the case, since in the absence of this type
of smoothing PSIA holders could perform their own smoothing (by reinvesting
some of the profits in “good” years), and therefore the smoothing could not
reduce their cost of capital.
In effect, then, smoothing within the equity of PSIA is likely to benefit shareholders
at the expense of PSIA holders. Shareholders have an incentive to smooth returns
to PSIA holders, if necessary at the formers’ own expense, for the reasons given
in Sec. 2.2 above. But the use of the types of reserves just mentioned provides a
2 See Tomkins and Karim [10] for a discussion of Islamic banks’ use of the discounting of cash
flows.
means whereby such smoothing may be achieved with no effect (IRR), or only a
very limited effect (PER), on the profit available to shareholders.
2.4. The PSIA holder’s right to withdraw funds

PSIA contracts typically allow investors to withdraw funds before the end of the
contract, subject to the forfeiting of all or part of the investor’s profit share of
any profits earned but not declared for the period up to withdrawal (the length of
this period varies between banks). The investor will not be able to withdraw any
share of the PER or IRR attributable to his investment. Thus, if the PSIA holder
wished to withdraw the entire balance of his account, the amount that could be
withdrawn would be the amount originally invested, plus his share of any declared
but undistributed profit for the period, minus his share of any losses for the periods
prior to withdrawal that are in excess of (i.e., not covered by) reserves. This amount
is equal to the Net Asset Value (NAV) of his investment on a historical cost basis,
less any profit accrued but undeclared, and also excluding the investor’s share of
any reserves within the equity of PSIA.
In effect, the Islamic bank has implicitly issued a “put option” to the PSIA
holder on his investment account, but the exercise price is the NAV on a historical
cost basis, less any share of profit accrued but undeclared and of reserves. Such a
“put option” can never (in options jargon) be “in the money”, since the exercise
price can never exceed NAV, so that exercising the “put” can never yield a profit
or gain.
The question then arises: has this right of withdrawal or put option any value?
It clearly has no value as options normally have, by virtue of the likelihood that it
could be exercised at a profit, for it never could. The value to the PSIA holder may
be determined by considering the cost to the bank. This cost is the opportunity
cost of holding liquid assets in order to meet a possible withdrawal, rather than
illiquid assets with a higher rate of return. In practice, this opportunity cost would
be low or even zero, because the bank treats a proportion of the amount invested
as a zero-return current account (see Sec. 2.2. above), and the shorter the period of
notice required for withdrawal, the larger this proportion is [5].
Since the issuing of the put option is a zero sum game between the Islamic bank
and the PSIA holder, the value of the option to the latter may be considered as equal
to the opportunity cost to the bank (i.e., the shareholders) of the required liquidity.
This, as we have just seen, is zero or close to zero. By comparison, let us consider the
Mudarib share of profits from which the shareholders benefit. This Mudarib share
contributes to covering expenses such as the cost of the bank’s board of directors
and external audit which are considered to exist for the benefit of shareholders and
not PSIA holders [6]. Whether, all things considered, the reduction of the PSIA
holders’ return by the bank’s Mudarib share is compensated by services provided
by the bank to the PSIA is examined further below.
3. Displaced Commercial Risk: Sketch of a Theoretical

Explanation
Sections 2.2 and 2.3 above imply that it is important to distinguish between:
(a) smoothing of returns to PSIA by making offsetting adjustments to profits
attributable to shareholders (displaced commercial risk), and (b) smoothing of
returns to PSIA by using reserves within the equity of PSIA. The former cre-
ates value for PSIA holders, at the expense of shareholders, while the latter has
the opposite effect and is evidently intended to mitigate shareholders’ exposure to
displaced commercial risk.
However, while type (b) smoothing is clearly a zero sum game at the PSIA hold-
ers’ expense, type (a) smoothing may be a positive sum game in which PSIA holders
gain more than shareholders lose. This proposition is examined in this Section.
There is empirical evidence that smoothing of PSIA returns is the reflection of
competitive pressures in the marketplace. Although PSIA funds are invested on a
profit-sharing basis, PSIA investors typically seek a less volatile return than they
would receive in the absence of such smoothing. While this may appear anomalous
from the standpoint of the Mudaraba contract, it is quite consistent with what
financial economics would lead us to expect. From the latter standpoint, it would
be anomalous if, in a competitive capital market, the bank as Mudarib were able to
transfer a percentage share of the return on the underlying assets to shareholders
without transferring a corresponding share of the asset risk. We have particularly
in mind unrestricted PSIA, the funds of which are invested in the same pool of
assets as the shareholders’ funds. The issue here is to explain how the equilibrium
rate of return to holders of PSIA could be less than the equilibrium rate of return
to shareholders. The following discussion thus focusses on unrestricted PSIA, but
also has implications for restricted PSIA which are not explored further in this
paper.
On this point, our analysis extends that given by Al-Deehani, Karim and
Murinde (AKM) [4], who assumed that no risk is transferred to shareholders. In the
AKM model, the Mudarib share is a reward to the bank (i.e., to its shareholders)
for its asset management activities. However, AKM (see their Proposition 4) do not
explain the apparent discrepancy between the investment account holders’ ex ante
expectation of receiving a rate of return which reflects the riskiness of the assets
in which their funds are invested, and their ex post realisation of a rate of return
reduced by the Mudarib share but without any concomitant reduction in risk.
This follows from the fact that the AKM paper does not distinguish between
(a) the market value of the Islamic bank (shareholders’ equity plus unrestricted
PSIA) and (b) the market value of the shareholders’ equity alone. Hence, the
increase in the value of the shareholders’ equity that is attributable to the Mudarib
share (i.e., the capitalised value of that income stream), is treated as an increase in
the value of the bank (in the sense of shareholders’ equity plus unrestricted PSIA).
The AKM paper is able to follow this reasoning because PSIA are treated on a
book value basis (since they are not securitized and have no market price). Hence
any impact, on the value of PSIA, of the deduction of the Mudarib share from the
PSIA share of the returns on the pool of assets is not apparent.
Conceptually, however, if the rate of return received by the PSIA holders is less
than the equilibrium rate of return applicable given the riskiness of the assets in
which their funds are invested, then the value of their investment is impaired (the
accounting recognition of that impairment is another matter). In other words, any
value created for shareholders by the Mudarib share would, other things equal (i.e.,
in a zero sum game), be reflected in a decreased value of PSIA which would be
apparent if they were shown at their market value, as would be the case if they
were securitized.3 Such a reduction in value would be avoided only in a positive
sum game, in which the bank as fund manager created sufficient value for the PSIA
holders to compensate them for having to pay the Mudarib share. (In Sec. 2.4 above,
we examined the implications of the PSIA holders’ right of withdrawal, which may
be considered as a kind of “put” option, but one which is nearly or completely
valueless.)
However, the game may have a positive sum, as follows. From the perspective of
the Capital Asset Pricing Model (CAPM), a corresponding share of the systematic
(non-diversifiable) risk, as given by the Security Market Line (SML), would be
transferred from PSIA holders to shareholders in compensation for the Mudarib
share. However, given that in general the capital market environment of Islamic
banks is emerging markets, in which investors may have limited opportunities for
diversification, it is significant that the risk transferred is not confined to systematic
risk. With displaced commercial risk, it is a share of total risk or volatility (as given
by the Capital Market Line (CML) in Portfolio Theory [9]) that is transferred.
We may now address the question of why the leverage provided by PSIA to
Islamic banks may be attractive to the latter (even in the absence of smoothing
within the equity of PSIA), if the share of asset risk transferred to shareholders is
a function (as given by the CML) of the share of return so transferred. The prin-
cipal reasons put forward in the finance literature to explain the attractiveness of
conventional leverage using interest-bearing instruments, in a context of efficient
capital markets, are: (a) the tax shield on interest; and (b) the reduction in agency
costs achieved by signalling the firm’s ability to meet debt obligations and hence
the reliability of its future returns [8], i.e., a form of “bonding”. Neither of these
seems applicable to PSIA in the case of Islamic banks. The returns paid to PSIA
do not in general give rise to a tax shield, nor do PSIA give rise to debt obliga-
tions [4]. On the other hand, the practices that give rise to displaced commercial
risk might result in PSIA having some of the signalling and bonding properties
of debt.
3 Inthis case, the price of the PSIA would be at a discount to their net asset value. It is not the
assets as such, but the PSIA claim over those assets, that would have lost value. This would be
apparent from their market price, or if they were accounted for at fair value.
Another possibility arises, as suggested above, based on the following

conjecture.4 If shareholders in Islamic banks are typically able to be well-diversified
investors (because of access to international capital markets), while PSIA investors
do not have this possibility, then it would be efficient for shareholders to take on
diversifiable risk from PSIA, since PSIA investors, but not shareholders, would be
averse to diversifiable risk. However, it is unlikely that an Islamic bank could trans-
fer only diversifiable risk from PSIA to its shareholders; rather, as illustrated above,
it would transfer total risk (volatility) from PSIA to shareholders by smoothing the
returns paid on PSIA (what we have termed “displaced commercial risk”).
The asset beta of the PSIA portfolio, betaA , is equal to:
[std devA /std devM ] ∗ corr(A, M ),

where std devA and std devM are the standard deviations of expected returns of
the PSIA portfolio and the market portfolio, respectively, and corr(A, M ) is the
correlation coefficient between them.
The total risk of the PSIA portfolio, relative to the market portfolio, is equal to:
std devA /std devM .
If the proportion of total risk absorbed by the shareholders through “displaced

commercial risk” is p, then the systematic risk faced by the shareholders and the
total risk faced by the PSIA holders become, respectively:
[(1 + p)std devA /std devM ] corr(A, M ), an increase of
[ p ∗ std devA /std devM ] corr(A, M )
and
(1 − p) std devA /std devM , a decrease of p ∗ std devA /std devM .

Hence, provided corr(A, M ) < 1, the amount of total risk removed from the PSIA
will be greater than the amount of systematic risk shifted to the shareholders; and
the smaller is corr(A, M ), the greater is the gain from the displacement.
The propositions just put forward imply that PSIA, as a form of financial lever-
age, may involve some transfer of asset risk from PSIA investors to shareholders.
While in the case of conventional debt instruments such as interest-bearing deposits,
the transfer follows from the nature of the contract, this is not so for PSIA. Instead,
the transfer (displaced commercial risk) results from market pressures or economic
forces regarding the relationship between risk and return.
This “displacement” would result in a net gain (i.e., would create value) inso-
far as the reduction in total risk to PSIA investors had greater utility than the
4 Our observations suggest that shareholders in Islamic banks consist predominantly of institutions
and extremely wealthy individuals able to diversify their risk, while PSIA holders are mainly
individuals who are well-off but not extremely wealthy and with limited diversification possibilities.
However, pending further research, this remains a conjecture.
corresponding increase in total risk to shareholders had disutility. The reason for
supposing that such a net gain would be obtained is that the diversifiable or
non-systematic element of that total risk would have disutility to PSIA investors
who are not potentially well-diversified, but not to potentially well-diversified share-
holders. Thus, displaced commercial risk would be a positive sum game that con-
tributes to the efficiency of the financial intermediation performed by Islamic banks.
From the shareholders’ point of view, their stream of expected cash flows is
increased by the expected Mudarib share of profits. As against that, their cost of
capital is increased by the proportion of systematic risk taken over. The overall
asset beta, betaA , is the weighted average of the betas of PSIA assets and assets
financed by shareholders’ funds. If the proportion of systematic risk shifted from
PSIA to shareholders’ funds is p, then the effect on the beta of shareholders’ funds
will be to increase it by the proportion:
p × PSIA/(PSIA + shareholders’ funds).
Let the expected annual value of the Mudarib share be M , and the expected value
of the bank’s other operating cash flows E. Moreover, let the bank’s cost of equity
capital before and after the “displaced commercial risk” be ke and kc , respectively.
The findings of AKM suggest that, for their sample at least, the present value of
E + M capitalized at rate kc exceeds that of E capitalized at rate ke .
4. Conclusions
The propositions put forward in Sec. 3 above provide an explanation of how financial
leverage from PSIA could create value for the shareholders of Islamic banks which
differs in part from that suggested by AKM. They do not take into consideration
“displaced commercial risk” (their work was published at the same time the AAOIFI
Statement on Capital Adequacy which first drew attention to this phenomenon).
Their finding, that increases in PSIA financing increase the value of an Islamic
bank’s common shares, might appear to imply that investment account financing is
a kind of “free lunch” for Islamic banks, in the sense that a proportion of the return
on assets is transferred from investment account holders to shareholders without
any concomitant transfer of risk. Such “free lunches” would constitute a significant
market imperfection. In particular, it is not clear why holders of unrestricted PSIA
would not shift their investment from PSIA into common shares in order to enjoy
superior returns for (apparently) the same level of risk.5 In the absence of trans-
parent financial reporting, however, the practice of smoothing returns to PSIA by
the use of undisclosed reserves within the equity of PSIA provides exactly such a
“free lunch”.
5 Shareholders face the systematic risk of the stock market, which holders of PSIA appear to
avoid because their investments are unsecuritized and unquoted. But the economic value of their
investment is exposed to the same asset risk, and their valueless or almost valueless “put option”
does not affect this situation.
However, as we argued in Sec. 3, the picture is not complete without an expla-

nation which takes account of the phenomenon of “displaced commercial risk”.
On this point, our theoretical proposition is that the increase in the value of the
bank’s common shares from taking on PSIA (as per AKM) includes the effect of the
shareholders’ ability (because of superior access to international capital markets) to
diversify away unsystematic risk transferred from investment account holders which
the latter are less able to diversify away.
“Displaced commercial risk”, far from reflecting an aberration on the part of
the managers of Islamic banks, thus appears as potentially an efficient and value-
creating means of sharing risks between two classes of investor with differing risk
diversification capabilities and hence different risk preferences. It would be a mat-
ter of efficient risk-sharing between a class of investors who are potentially well-
diversified (shareholders) and another class who are not (PSIA investors).
But just as financial distress costs set an upper limit to the use of debt, so dis-
placed commercial risk has implications in terms of possible financial distress costs
to an Islamic bank which imply an upper limit to its use of PSIA. This was the
conclusion that the AAOIFI Capital Adequacy Committee reached in arriving at
a proposed formula for calculating a capital adequacy ratio (CAR) for an Islamic
bank. Use of PSIA by Islamic banks thus has some of the characteristics of con-
ventional leverage, including the danger of being used to excess; a danger that the
AAOIFI Capital Adequacy Committee has been concerned to address.
However, given the existence of what was termed type (b) smoothing (within
the equity of PSIA), we would not wish to argue that type (a) smoothing involving
displaced commercial risk, combined with the value of the “put option” discussed
in Sec. 2.4 above, necessarily compensates PSIA in full for the cost to them of the
Mudarib share. Lack of transparency in the financial reporting of Islamic banks,
combined with other market imperfections, has created conditions in which, while
sharing the same underlying asset risk as shareholders, investors in unrestricted
PSIA tend to receive a lower rate of return from those assets. As noted above, such
market imperfections appear to result in a substantial “free lunch” element from
PSIA to the shareholders of Islamic banks. It will be interesting to see to what
extent the disclosures required by the AAOIFI accounting standard on provisions
and reserves [3] will mitigate this market imperfection.
References
[1] Accounting and Auditing Organization for Islamic Financial Institutions, Discus-
sion Memorandum: The Purpose and Calculation of the Capital Adequacy Ratio for
Islamic Banks (AAOIFI, Manama, Bahrain, 1998).
[2] Accounting and Auditing Organization for Islamic Financial Institutions, Statement
on the Purpose and Calculation of the Capital Adequacy Ratio for Islamic Banks
(AAOIFI, Manama, Bahrain, 1999).
[3] Accounting and Auditing Organization for Islamic Financial Institutions, Finan-
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On Capital Structure, Risk Sharing and Capital Adequacy in Islamic Banks Oleh Archer

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May 9, 2006 16:9 WSPC-104-IJTAF SPI-J071 00362

International Journal of Theoretical and Applied Finance

ON CAPITAL STRUCTURE, RISK SHARING AND

RIFAAT AHMED ABDEL KARIM∗

Received 6 December 2004

270 S. Archer & R. A. A. Karim

which are “capital certain”, or in the form of proﬁt-sharing investment accounts

Capital Structure, Risk Sharing and Capital Adequacy 271

2. The AAOIFI Capital Adequacy Committee and its Analysis

In March 1999 the AAOIFI Capital Adequacy Committee issued a statement:

from PSIA to shareholders of an Islamic bank, it identiﬁed two sources of risk to

2.2. Displaced commercial risk: Some empirical evidence

272 S. Archer & R. A. A. Karim

2.3. Smoothing within the equity of PSIA

Capital Structure, Risk Sharing and Capital Adequacy 273

274 S. Archer & R. A. A. Karim

2.4. The PSIA holder’s right to withdraw funds

Capital Structure, Risk Sharing and Capital Adequacy 275

3. Displaced Commercial Risk: Sketch of a Theoretical

276 S. Archer & R. A. A. Karim

Capital Structure, Risk Sharing and Capital Adequacy 277

Another possibility arises, as suggested above, based on the following

The asset beta of the PSIA portfolio, betaA , is equal to:

[std devA /std devM ] ∗ corr(A, M ),

std devA /std devM .

If the proportion of total risk absorbed by the shareholders through “displaced

(1 − p) std devA /std devM , a decrease of p ∗ std devA /std devM .

278 S. Archer & R. A. A. Karim

will be to increase it by the proportion:

p × PSIA/(PSIA + shareholders’ funds).

Capital Structure, Risk Sharing and Capital Adequacy 279

However, as we argued in Sec. 3, the picture is not complete without an expla-

280 S. Archer & R. A. A. Karim

[4] T. Al-Deehani, R. A. A. Karim and V. Murinde, The capital structure of Islamic

[8] W. L. Megginson, Corporate Finance Theory (Addison-Wesley, 1995).

Homewood, IL, 2000).

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