New Guidance on How Islamic Banks May “Smooth” Returns to Investors

The way in which Islamic banks “smooth” the returns they pay to their investment account holders is complex and lacks transparency.

The Guidance Note issued by the Kuala Lumpur-based Islamic Financial Services Board (IFSB) in December 2010 does a good job of summarizing industry practices and making recommendations for how to improve them. The IFSB’s report is worth reading in full – you can download it from the home page of the Board’s website (www.ifsb.org) — but here is a summary of the main issues.

What is smoothing?
Islamic banks have three main types of funding: equity; demand deposits known as “qard hassan,” which pay no return and are repayable in full on demand; and investment accounts. Investment accounts are divided into two types: “unrestricted”, whereby the funds are invested at the discretion of the bank, and “restricted”, whereby they are invested in a pre-agreed manner.

In principle, investment accounts pay a return which reflects the actual return made by the assets which they fund. If the assets generate a profit of 5%, the investment account holders (IAH) should receive a return of 5%, minus a pre-agreed share to the bank as the fund manager. If the assets were to lose 50% of their value, then the IAH are entitled to receive only 50% of their original investment – in such a case, not only would the relevant items on the asset side of the balance sheet be written down in value, but so would the corresponding items on the liability side. Unlike depositors in a western bank, IAH do not have a general claim on the bank – their claims do not extend beyond the investment fund and any reserves which it may have accumulated.

In practice, the people who invest in these accounts expect them to behave like bank deposits rather than like mutual funds. This is particularly the case for “unrestricted” investment accounts. If the bank’s actual returns on assets is poor, and as a result the bank pays out less than its rivals, it runs the risk that customers will withdraw their funds and place them elsewhere. (This is known as “Displaced Commercial Risk,” DCR.) To mitigate this risk, banks may use a variety of smoothing techniques.

(Note that the unrestricted investment accounts are presented on the balance sheet of the bank, even though they are in principle closer in nature to a mutual fund than a conventional bank deposit. Restricted investment accounts, which are even closer to a mutual fund than unrestricted accounts, are generally presented off balance sheet.)

How does smoothing work?
There are four ways of doing it:

  1. The bank gives up some of its management fees. In Islamic parlance, the bank is acting as a “mudarib,” or fund manager and takes an agreed share of any investment profits (though it does not share in losses unless it is guilty of malfeasance). The bank can decide to cede some of these fees to the investment account holders.
  2. The bank may give some of its retained earning to the investment account holders.
  3. The bank may use funds from a Profit Equalisation Reserve (PER)
  4. The bank may use funds from an Investment Risk Reserve (IIR)

It is in the workings of the PER and IIR that things get complicated. The best way to think about these reserves is in terms of a) how are they accumulated, b) who owns them, c) how may they be used, and d) how are they managed.

A PER is accumulated from general profits of the bank before the bank, in its capacity as mudarib, has been paid its investment management fees and before profits have been assigned to IAH or shareholders. It is owned by the IAH and the equity holders of the bank. It can be used to boost the return paid out to IAH (but it may not be used to transform an investment loss into a profit) or to enhance dividends paid to banks’ shareholders. It is managed by the bank.

An IRR is accumulated from the returns attributable to the IAH (i.e. after deducting the mudarib’s share of profits). It is owned by the IAH alone. It can be used to cover a loss in the funds but not to smooth profits. (That is, it can only be used to bring the value of the investment up to, or closer to, par.)  It is managed by the bank.

There are some obviously governance issues with the PER and IRR. In the case of the PER, the reserve belongs to the IAH and the shareholders jointly, but the IAH have no say in how the reserves are accumulated or distributed. There is also the issue of inter-generational fairness – a short-term investor is disadvantaged when some of today’s robust profits are squirreled away into a reserve fund and then used in future years (after the short-term investor has left the fund) to make up for lower returns prevailing at that time. 

Furthermore, as the IFSB Guidance Note says, “By maintaining stable returns to (unrestricted investment account holders) regardless of whether it rains or shines (an Islamic bank) automatically sends a signal that (it) has a sustainable and low-risk earnings stream for (those account holders), while the reality may be quite different.”

To be clear, all smoothing techniques create an illusion of stable returns, not just the use of the PER and IRR.

There is also the issue of valuation. The PER is owned in part by the shareholders of the bank and in theory may be entirely appropriated by them. At a minimum it needs to be disclosed in the accounts. Beyond that, some judgment has to be made as to how much value it adds to the bank (since in practice, it is unlikely that all of it will be appropriated by the shareholders). Even the IRR, over which the shareholders have no claim, may add to the value of the bank by reducing losses to investors and so helping the bank to maintain its customer base.

So what is to be done? Some of the governance issues seem intractable – it’s hard to see how to mitigate the misalignment between ownership and control of the PER. In theory, a representative group of IAH could join the shareholders in making common decisions regarding the use of the reserve, but in practice, that would be unworkable.

On the other hand, good disclosure would go a long way to addressing the dilemmas outlined above. At a minimum banks should disclose the actual return on their investment funds, and then the extent of any smoothing and the source of funds used for that smoothing. The value of PERs or IRRs should be disclosed, along with any existing agreements between the bank and its customers on how such reserves may be used.

To get a flavor of how smoothing is presented in practice, take a look at the financial statements of some Islamic Banks.

  • Note 24 to Qatar Islamic Bank’s 2009 financial statements shows that the shareholders made a contribution of QR141mn ($39mn) to the unrestricted investment account holders, taking their return for the year to QR510mn.
  • Notes 51 and 54 of Dubai Islamic Bank’s 2009 financial statements show that the bank drew down Dh201mn ($55mn) from its Profit Equalisation Provision (which seems to be what the ISFB would call an IRR) in 2008 and another Dh200mn in 2009 in order to boost returns to unrestricted investment account holders.
  • Note 14 to Bahrain Islamic Bank’s 2009 financial statements shows the movements in the bank’s PER and IRR during the year.