The impact of displaced commercial risk on the performance of Islamic banks

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Islamic banks are exposed to a particular risk that stems from one specific service that they offer: the collection and management of deposits in the form of unrestricted profit-sharing investment accounts. These accounts are the source of displaced commercial risk, which arises from assets managed on behalf of investment accountholders, effectively being transferred to the Islamic financial institution's own capital stock. This occurs because, when considered necessary, banks do not pay part or all of their due Mudharib shares, which would otherwise be paid to depositors, as a result of commercial pressure to increase returns. This study assesses whether this risk hinders the performance of Islamic banking institutions already struggling to compete for deposits in a system dominated by well-established conventional banks. Using the methodology developed by Beck and Katz (1995) to analyze data collected from Bahraini banks, the study demonstrates the existence of a negative and statistically significant relationship between DCR and the performance of Bahraini Islamic banks. This result suggests that increases in DCR are driven by dissatisfied profit-motivated depositors wishing to transfer their funds to more rewarding investments (either Islamic or conventional). Furthermore, an upsurge in this particular risk impels the bank to accumulate more investment reserves, which jeopardizes their profitability, especially when they are kept as idle cash or invested in illiquid assets. Therefore, our results provide regulators and decisionmakers in both Bahrain and other countries where Islamic and conventional financial institutions coexist with a better understanding of the unrestricted profit and loss sharing contracts of Islamic banks.