Managing displaced commercial risk in selected GCC Islamic banks: an empirical test for robustness

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Profit sharing investment accounts (PSIAs) are unique and foundational to Islamic banking. PSIAs are a hybrid between current accounts (unstable sources of funding due to withdrawal risk) on one extreme, and partnership (stable sources of funding due to risk taking nature) on the other extreme. In the literature, considerable interest has been attached to this nature of the PSIAs in the capital structure of Islamic banks, specially, with respect to its implications for banking stability and regulatory capital assessment. Recognising the hybrid nature of the PSIAs, the Islamic Financial Services Board (IFSB) introduced two formulas addressing the inherent risk in the full range of the hybrid nature of PSIAs. The standard formula treats the PSIAs as partnership and risk taking. The supervisory discretionary formula treats the PSIAs as deposits tempting to migrate between banks seeking higher rate of returns. If depositors have to migrate, shareholders have to face the migratory depositors' risk displaced on their responsibility. In quantitative terms how much this displaced commercial risk will be in a particular Islamic bank? The measure is known as the Alpha factor in the second IFSB formula. In this paper we empirically address the robustness of the Alpha factor in the selected GCC Islamic banks. We show that the regulatory practice in this regard needs improvement on credibility. If Islamic banking has to make a difference in the global scene, the management of PSIAs requires a deep rooted reform. We set the pillars of such a reform that policy makers may find useful in supporting the promotion of genuine Islamic banking.
Displaced commercial risk , PSIA management , Capital adequacy of Islamic banks , Islamic banking
Khan, T., & Latheef, S. (2016). Managing displaced commercial risk in selected GCC Islamic banks: an empirical test for robustness. Journal of Islamic Economics, Banking and Finance, 12(3), 48-74.
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