286 AN INTRODUCTION TO ISLAMIC FINANCE
profi ts to investment account holders while the shareholders received noth-
ing from the mid to late 1980s (Warde 2000). In 1988, the bank distrib-
uted to its depositors an amount exceeding its profi ts, and the difference
appeared in the bank’s accounts as “loss carried forward.” The practice of
forgoing part or all of its shareholders’ profi ts may adversely affect its own
capital, which can lead to insolvency risk in extreme cases.
The experience gained from such self - imposed practices to mitigate
the displaced risk has led to the development of two standard practices in the
industry. The fi rst practice is the maintenance of a Profi t Equalization Reserve
(PER), which the fi nancial institution funds by setting aside a portion of the
gross income before deducting its own share (as mudarib). The objective of
the reserve is to maintain a cushion to ensure smooth future returns and to
increase the owners’ equity for bearing future shocks. Similar to the PER,
an Investment Risk Reserve (IRR) is maintained out of the income of invest-
ment account holders/depositors after allocating the bank’s share, in order
to dampen the effects of the risk of future investment losses. It has been sug-
gested that the basis for computing the amounts to be appropriated should
be predefi ned and fully disclosed.
IFSB PRINCIPLES OF RATE OF RETURN RISK
Principle 6.1: [Islamic Financial Institution] shall establish a compre-
hensive risk management and reporting process to assess the poten-
tial impacts of market factors affecting rates of return on assets in
comparison with the expected rates of return for investment account
holders (IAH).Principle 6.2: [Islamic Financial Institution] shall have in place an
appropriate framework for managing displaced commercial risk, where
applicable.While maintaining reserves in this way is becoming common practice,
it has attracted objections as well. While the practice is in alignment with
prudent risk management, it raises a governance issue that needs attention.
Firstly, limited disclosure of such reserves makes investment account holders
uneasy and they do not have the right to infl uence the use of such reserves
and verify the exposure of overall investments. While those with long - term
investment objectives may welcome this practice, those with a short - term view
may feel that they are subsidizing the returns of the long - term investors.
Some banks require investment account holders to waive their rights on
these reserves.
IFIs should standardize the practice and the rights of their investment
account holders to these reserves should be clearly stated and explained to