Equalization Reserves Research Articles

Islamic banks and capital buffer behavior: A view from the Gulf cooperation council markets

This study explores the determinants of the capital buffer behavior (CB) of Islamic banks (IBs) using a sample of 42 IBs in the Gulf Cooperation Council (GCC) markets during 2009–2018. We also investigate the transmission mechanism, efficacy of the macroprudential policies, relationships between these policies, and financial stability of these banks. Unlike previous research, this study considers certain peculiarities of IBs, including the effects of profit–loss-sharing investment accounts (PSIAs); the impact of capital adjustment costs; external factors such as market power and competition; and institutional influences such as the rule of law and the potential corruption perceptions index. Overall, our results show that CB is countercyclical, which is in line with Basel III requirements. Furthermore, CB is positively affected by bank size, level of profitability, and competition and negatively impacted by nonperforming loans, credit risk, and displaced commercial risk (DCR). The regulatory determinants are important as well, suggesting that strengthening the official macroprudential supervision encourages banks to strengthen their CBs. Conversely, although banks have adequate capital, regulatory tools increase the burden, increasing banks' capital costs and forcing them to limit risk-weighted asset expansion and credit growth. Furthermore, the regulatory pressure, proxied by a discretionary countercyclical buffer, is not binding and does not increase CBs as they are already moving countercyclically, making macroprudential tools redundant for IBs. Other important implications suggest that IBs do not require additional CBs to cover the DCR associated with PSIAs, as PSIAs' provisions, profit equalization reserves, and investment risk reserves already cover this risk. Additionally, the positive relationship between IB size and CB might indicate that the “too big to fail” hypothesis does not apply to large IBs in the GCC.

PROFIT EQUALIZATION RESERVE (PER) AS AN EFFORT TO MITIGATE THE RISK OF RETURNS IN SHARI'A BANKING IN THE PERSPECTIVE OF THE RULES الْمَشَقَّةُ تَجْلِبُ التَّيْسِيْرِ

The application of Profit Equalization as an effort to mitigate the risk of returns on Islamic financial institutions, especially Islamic banking is still being a question for practitioners and academics, some groups support and some groups criticize, so this research aims to examine the application of the Profit Equalization Reserve (PER) as an effort to mitigate the risk of returns in Islamic banking perspective of third main principle, namely الْمَشَقَّةُ تَجْلِبُ التَّيْسِيْرِ, Method in this study is a qualitative method with secondary data processing taken from literatures which related to PER management. This research shows that the risk of returns is masyaqqoh al 'azimmah, which is a serious difficulty and can affect the continuity of the Islamic banks activities. So, rukhshoh is needed which in this problem is the application of income smoothing without mitigation or with mitigation (PER), PER in this case is Takhfif Taqdim which is, risk mitigation efforts before they arise. The result of this research is that PER application is permissible and legitimate as long as it does not violate the Shari'a and Islamic economic principles, meaning that all of reports and information must be conveyed clearly to customers so as to avoid gharar elements.

The Dynamic Link Between Islamic and Conventional Deposit Rates in a Dual Banking System

Purpose — This study empirically assesses the extent to which the conventional deposit rate (CDR) affects the Islamic deposit rate (IDR) in Indonesia and Malaysia within the dual banking system. Design/Methodology/Approach — This study uses non-linear autoregressive distributed lag (NARDL) and panel cointegration. Monthly data are employed, but the time period for the two countries examined is different because of data availability. The study thus covers the period 2009:M1 to 2020:M12 for Indonesia and 2000:M1 to 2020:M12 for Malaysia. Findings — The findings confirm evidence of the long-run link between IDR and CDR, where the IDRs in Indonesia and Malaysia asymmetrically respond to changes in CDRs. In addition, Indonesia’s IDRs adjust faster in response to the decline in CDRs compared to increases in CDRs. However, Malaysia’s IDRs adapt faster in response to increases in CDRs than their decreases. The panel cointegration results reinforce the asymmetric findings. Originality/Value — To the best of our knowledge, this paper is the first study to examine the extent to which IDRs asymmetrically respond to CDRs in a dual baking system in Indonesia and Malaysia. Practical Implications — Islamic banks (IBs) follow CDRs in determining IDRs due to uncompetitive IDRs, implying that IBs suffer from displaced commercial risk. Therefore, IBs may adopt a policy to address liquidity issues through investment risk reserves (IRR) and profit equalization reserves (PER) to reduce the distinctive gap between IDRs and CDRs.

Equalization Reserves for Reinsurance and Non-Life Undertakings in Switzerland

Equalization reserves is an insurance liability with features of own capital. By law, Swiss reinsurance and non-life undertakings must hold equalization reserves within their statutory accounts. Regarding Swiss solvency modeling, the equalization reserves are set to zero. Swiss reinsurance and non-life undertakings define the upper limit and the corresponding transfer rule to the equalization reserves; however, this information is not disclosed. The goal of the study is to find a relationship between the equalization reserves and the publicly available technical account items, applying a generalized additive model (GAM). Thereafter, we transform the continuous variables into discrete ones, and we apply a generalized linear model (GLM). The study is based on published data from 1997 to 2018, whereby we restate the implicitly published equalization reserves. For reinsurance undertakings, the GAM model captures the relationship better than the GLM one; for non-life undertakings, the GLM model performs better. For reinsurance undertakings, the equalization reserves depend on the equalization reserves of the previous year, on the calendar year, on the legal form, on the technical result, on the administration and commission costs and on other costs. For non-life undertakings, the equalization reserves depend on the net claims payments, on the equalization reserves of the previous year, on the net change in claims reserves without change in equalization reserves, on the calendar year and on the net earned premium. Furthermore, we look at the need for equalization reserves: do the undertakings accumulate and release the equalization reserves? Further, the impact of taxes on the equalization reserves is looked at. The concept of equalization reserves avoids the misuse of tax optimization. We conclude that the discussion about disclosure of equalization reserves will restart. In addition, the definition of the upper limit of the equalization reserves could be widened by linking the equalization reserves to the insurance/reserving risk from the capital modeling.

PROFIT EQUALIZATION RESERVE AND DSN MUI NO: 127/DSN-MUI/VII/2019 IN MAQASHID SYARIAH PERSPECTIVE

This study aims to analyze the application of Profit Equalization Reserve (PER)and its relationship with the DSN MUI fatwa NO: 127 / DSN-MUI / VII / 2019 in the view of maqasid sharia.PER is used to maintain the competitiveness of yields in Islamic banking. The reserve fund can be used when the sharing of financing results goes down. That way, depositors' interest is maintained, because the reduced profit sharing can be covered with reserve funds. Based on existing sources, the authors argue that PER can be applied in the Islamic economic financial system as long as it does not violate existing regulations. However, the application of PER is not only applied to Islamic banking but also applies to the sukuk wakalah bil al istithmar.This is evidenced by the existence of the term PER which is allowed in DSN MUI NO: 127 / DSN-MUI / VII / 2019 concerning Sukuk wakalah bi al-Istithmar. The reason for the inclusion of PER in DSN MUI NO: 127 / DSN-MUI / VII / 2019 is because the result of the consideration of the meaning of Wakalah bi al-Istithmar is the wakalah contract to invest and develop Muwakkil's assets either in return (Wakalah bi al-Ujrah) or without compensation(Wakalah bi ghairi al-Ujrah).

Management and monitoring of the displaced commercial risk: a prescriptive approach

PurposeThe displaced commercial risk is one of the specific risks in the Islamic finance that creates a serious debate among practitioners and researchers about its management. The purpose of this paper is to assess a new approach to manage this risk using machine learning algorithms.Design/methodology/approachTo attempt this purpose, the authors use several machine learning algorithms applied to a set of financial data related to banks from different regions and consider the deposit variation intensity as an indicator.FindingsResults show acceptable prediction accuracy. The model could be used to optimize the prudential reserves for banks and the incomes distributed to depositors.Research limitations/implicationsHowever, the model uses several variables as proxies since data are not available for some specific indicators, such as the profit equalization reserves and the investment risk reserves.Originality/valuePrevious studies have analyzed the origin and impact of DCR. To the best of authors’ knowledge, none of them has provided an ex ante management tool for this risk. Furthermore, the authors suggest the use of a new approach based on machine learning algorithms.

Profit Equalization Reserve and Investment Risk Reserve: Issues and its Application

The Islamic Financial Institution (IFI) is a unique financial institution which has special characteristics, maqāsid, worldview, risk, and opportunity. One of the methods used to mitigate the unique risk of Islamic banks is the Profit Equalization Reserve (PER) and Investment Risk Reserve (IRR). However, there are some issues related to PER and IRR. Some issues have been identified in the Islamic Financial Services Board (IFSB) guidance note, including profit smoothing and other issues yet to be discussed. This paper tries to observe issues related to PER and IRR and their application in some Islamic banks using content analysis method on their annual reports and/or financial statements. The paper concludes that PER and IRR will bring bigger issues and risks to Islamic banks. This leads the writer to suggest that the regulator reconsider its permissibility. In addition, the paper also finds that the concept of PER and IRR has low acceptance among Islamic banks.

Profit Equalisation Reserve and Income Smoothing Practices in Malaysian Islamic Banks: Robust Statistical Analysis

Profit Equalisation Reserve and Income Smoothing Practices in Malaysian Islamic Banks: Robust Statistical Analysis

Leverage, Performance, Size and Reserve Management: Empirical Evidences in Malaysian Islamic Banks

This study examines the relationship between leverage ratio, bank’s performance, size and profit equalisation reserve. Using GMM estimators, both difference and system, we find significant relationship between current leverage ratio and previous leverage ratio and profit equalization reserve. Overall, our results are consistent with the several past literatures with addition of determining impact of profit equalization reserve on leverage ratios of Islamic banks in Malaysia.

DETERMINANTS OF ISLAMIC BANK’S LEVERAGE RATIO IN MALAYSIA

This study examines the relationship between leverage ratio, bank’s performance, size and profit equalisation reserve. Using GMM estimators, both difference and system, we find significant relationship between current leverage ratio and previous leverage ratio and profit equalization reserve. Overall, our results are consistent with the several past literatures with addition of determining impact of profit equalization reserve on leverage ratios of Islamic banks in Malaysia.

Measurement of the displaced commercial risk in Islamic Banks

The objective of the research is to quantify the displaced commercial risk (DCR) based on quantitative finance techniques. We develop an internal model based on the Value-at-risk (VaR) measure of risk to assess the DCR-VaR and the alpha coefficient αCAR in the capital adequacy ratio of Islamic banks. We identify first the scenarios of exposure of Islamic banks to DCR that depend on the actual return on unrestricted profit sharing investment accounts (PSIAU), the benchmark return as well as the level of the existing profit equalization reserve (PER) and investment risk reserve (IRR). Second, we quantify the DCR-VaR and the alpha coefficient αCAR−VaR for a given holding period and for given confidence level. We illustrate the DCR-VaR model on selected Islamic banks from Bahrain. Our model helps to better assess the needed equity to cover the DCR and an accurate capital adequacy ratio for Islamic banks. The model has also policy implications for regulators and the IFSB to develop better guidance on good practices in managing this risk.

On Steady Dividend Payment under Functional Mean Reversion Speed

We study how firms’ management can ensure steady dividend growth and payout to the share-holders in an emerging market. We create the dividend equalization reserve account whereby during high profit some amount of money is kept in order to top up dividends during deficiency. We use a mean reversion stochastic differential equation with a functional mean reversion speed to find the optimal dividend policy with optimal dividend equalization reserve. One of our results indicates that, it is optimal to pay high dividends when we have high mean levels. Also, we realized that a higher level of volatility which implies more dividend can be paid. And high dividend can also be paid as the interest rate rises but this is more significant when the firm makes profits above average. Lastly, we compared the buffer approach to a situation where hedging was not applied and found that the buffering approach is more suitable because it gives shareholders steady dividend payments.

The management of refinancing risk in Islamic banks

Islamic banks have access to only short-dated funding sources resulting in asset liability mismatches when financing assets with longer maturities. Maturity mismatches give rise to a risk that an unexpected increase in the cost of refinancing liabilities as they mature will not be offset by corresponding asset returns. Exposure to refinancing risk is exacerbated by paying returns to providers of off balance sheet funds which do not covary with the returns of corresponding assets as they would from a stricter application of sharia principles underlying these funding structures. The active hedging of refinancing risk by Islamic banks is also challenged due to a lack of suitable hedging instruments as well as differing sharia opinions concerning their permissibility. As an alternative to risk transference through hedging, this paper develops a framework to quantify a reserve to instead absorb refinancing risk which is distinguished from reserves already in use by Islamic banks, namely the investment risk and profit equalization reserves.

Equalization reserves for natural catastrophes and shareholder value: a simulation study

This paper investigates the effects on the company value for shareholders of keeping equalization reserves for catastrophic risk in an insurance company. We perform an extensive simulation study to compare the performance of the company with and without equalization reserves for several standard profitability measures. Equalization reserves turn out to be beneficial for shareholders in terms of the resulting expected Sharpe ratio and also with respect to the value of the call option on assets at some reasonably large maturity time. Moreover, the expected total discounted tax payments are not smaller when using equalization reserves. The results are robust with respect to model parameters such as interest rate, time horizon, cost of raising capital and business cycle dynamics.

The Mudharabah Deposit Rate Behaviour in Relation to the Conventional Deposit Rate

This study examines the relationship between the conventional and mudharabah deposit rates of Malaysian banks in two separate periods — between January 1996 and September 2004, and between October 2004 and June 2011 — which signify the implementation of a framework for calculating the Islamic bank deposit rate and the profit equalization reserve (PER). Employing the autoregressive distributed lagged (ARDL) approach, this study finds the two rates to be cointegrated in the first period similar to previous findings. However, for the second period, there is largely no evidence of a long-term relationship. The significance of this finding is that in the second period, when Islamic banks employ a regulated PER as a displacement risk mitigating mechanism, Islamic banks do not benchmark against conventional rates. They possibly engage in income smoothing for economic efficiency or for signalling purposes. An important policy implication is that PER and any type of reserve to smooth income, that is regulated, may be prescribed as it may have a positive behavioural effect.

The nature of smoothing returns practices: the case of Islamic banks

PurposeThe purpose of this paper is to examine empirically the nature of smoothing returns practices in a sample of 79 Islamic banks across 19 countries during the period 2001‐2006.Design/methodology/approachPrevious researchers' methods, based on the variation and determination coefficients, are used in this study to detect the smoothing practices.FindingsResults indicate that the revenues from the “Shariah‐based products” derived from the profit and loss sharing principle show higher variability than the “Shariah compliant revenues” and that income from this source is relatively lower. They also show that a large number of Islamic banks engage in natural income smoothing. Based on the determination coefficient results, 70 per cent of banks were found to have less smoothed total revenue than their net income. Results based on variation coefficient further confirm this finding, with 67 banks having a coefficient of total revenue higher than that of the net income.Practical implicationsThe results suggest that Islamic banks should strengthen the use of smoothing techniques, such as the profit equalization reserves (PER) and the investment risk reserves (IRR), as they allow them to further stabilize the revenues payout for the investment account holders (IAH) and therefore mitigate withdrawal risk. Standardizing the smoothing techniques could be a solution to overcome the variability of this category of revenue.Originality/valueThis work is the first of its kind for Islamic banks. It extends previous research by examining whether or not managers may smooth their results naturally or intentionally. It also helped to bridge the gap in the literature by providing the empirical evidence on the smoothing returns in Islamic finance.

Juristic Analysis of the Profit Distribution Method of Malaysian Islamic Banks

The relationship between depositors and Islamic banks is governed by a mudarabah contract. In principle, the former are regarded as rabb ul-mal (capital providers) while the latter are considered as mudarib (entrepreneurs). Profit generated from the business will be shared between both parties according to a pre-determined ratio. The present article reviews some Shari'ah issues which arise from the profit distribution method implemented in Malaysian Islamic banking institutions. It examines to what extent the current practices fulfil the principles and the ethical framework of the mudarabah contract as propounded by the classical jurists. The article analyses the justifications of the local Shari'ah scholars in modifying the doctrine to adapt to the modern banking business. This includes their decisions in authorising the Weighted Method (WM), the Profit Equalisation Reserve (PER), the indicative profit rate and the interim profit payment.

Do Islamic banks use loan loss provisions to smooth their results?

PurposeThe paper seeks to examine income smoothing practices in Islamic banks. It first focuses on detecting income smoothing practices. It then seeks to test whether loan loss provisions (LLPs) are used for earnings management purposes.Design/methodology/approachThe paper explores income smoothing practices on a sample of 66 Islamic banks over the period 2001‐2006 using Beidleman's and Eckel's coefficients. Data are obtained from the Bankscope database. To test the use of LLPs to smooth Islamic banks results, a regression model was developed and tested.FindingsThe results provide evidence on an extensive use of income smoothing by Islamic banks. More than 75 per cent of the examined banks have a determination coefficient between 0.5 and 1 and 44 per cent have a variation coefficient less than 0.5. However, income smoothing is not achieved through LLPs. The variable earnings before taxes and provisions are not significant in all model specifications. The paper advances that these smoothed incomes are derived rather by the use of profit equalization reserve (PER) and investment risk reserve (IRR). The finding is contradictory to the widespread view stating that those mechanisms are designed to stabilize rewards attributed to investment account holders.Research limitations/implicationsThe non‐disclosure of detailed information on PER and IRR prevented the empirical testing of the assertion on the use of these discretionary items to smooth Islamic banks' incomes.Originality/valueUnlike previous studies which implicitly assume that Islamic banks intentionally use accounting techniques to disclose smoothed results, this paper pioneers the study on detecting income smoothing practice by such institutions. Second, it explores the use of LLPs for earnings management purposes in the context of a fast growing industry where Islamic assets have grown on average by 30 per cent per year over the period 2002‐2007. Third, it is the first paper to give some evidence on the use of PER and IRR as income smoothing devices. Finally, the paper covers a larger number of Islamic banks and from various countries.

Openings in the body of ‘capitalism’: Capital flows and diverse economic possibilities in Kiribati

AbstractMuch of the post‐development agenda is concerned with decoupling Eurocentric imaginings of development from development practices in ‘remote’ regions and exploring new forms of economy that can enhance local well‐being. In the South Pacific (and elsewhere), small peripheral economies have confronted globalisation in varying ways. Some places, such as the Micronesian island state of Kiribati, have engaged directly with the global economy by investing capital generated locally in international financial markets rather than in domestic industries. Kiribati's trust fund, the Revenue Equalisation Reserve Fund, maintains a balanced portfolio of international equity and fixed income assets that produces a financial return, helping to augment Kiribati's other national income sources. In this paper we explore the results of capital flowing from Kiribati to global financial markets, noting that this alternative development practice can enhance local well‐being.

Solvency margins and equalization reserves

We indicate a simple solution to the evaluation of solvency margins and equalization reserves in a non-life insurance portfolio. One of our provision models is based on a combination of ruin and credibility theory. It takes characteristics such as variance of claims, correlation of claims and volume of portfolio into account.