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Profit Equalization Techniques
3.1 The preponderant portion of the profit-generating funds raised by IBs is based on Mudaraba and Wakala contracts. The funds raised are further deployed into the pool that the IB manages in its capacity as Mudarib or Wakil (“Fund Manager”), for both of which the IB enjoys certain rights and undertakes certain responsibilities. IAHs bear the commercial risk associated with the underlying investments made using their funds unless there is negligence, misconduct or breach of contract from the IB. Nevertheless, the return to be distributed to the IAHs can only be ascertained at the end of the investment period. Contractually, IAHs are only entitled to profits or returns if the pool’s underlying assets perform. The profit sharing and loss bearing contracts expose IBs to different risks, which require adherence to strong risk management governance and a high degree of transparency.
3.2 Therefore, one of the key risks IBs are exposed to is Displaced Commercial Risk (“DCR”) whereby the IB may be under market pressure to voluntarily pay a return that exceeds the rate that has been earned on the assets financed by IAHs’ funds, when the return on assets is underperforming when compared with competitors’ returns.
3.3 IBs are expected to develop and implement a sound methodology to identify, monitor, measure and report the impact of DCR and the amount needed to mitigate the exposure. The methodology must be applied systematically and reviewed regularly. Any changes to the adopted methodology must be justified and approved at the appropriate management level and the Board, if applicable.
3.4 In managing this risk, IBs may adopt the following profit equalization techniques:
- Establish an Investment Risk Reserve (“IRR”). This reserve represents the amount appropriated by the IBs out of the income of IAHs, after allocating the Mudarib’s profit, in order to cushion IAHs against future investment losses. IBs must develop models to determine the size of the IRR and the periodic contributions to be made to build up the IRR over time.
- Establish a Profit Equalization Reserve (PER) by setting aside amounts from the profits before allocation between the IAH and IB. IBs may fully or partly utilize the amount of the PER to improve the returns for IAHs during periods when the investment pool’s profits are below market expectations.
- Unconditionally, and based on the IB’s absolute discretion:
- Forgo part of or its entire profit as the Mudarib, in favor of the IAH in order to increase the profit attributed to the IAH; and/or
- Transfer the IB’s current profits or retained earnings to the IAH on the basis of Hibah / gift.
3.5 IBs may combine more than one technique in order to equalize the profit payout to IAH so as to match the current market returns. The techniques applied must be duly disclosed and compliant with the applicable laws and regulations, including HSA resolutions.
3.6 Subject to 3.1, the IRR and PER must be reflected in the audited financial statements in accordance with the appropriate accounting treatment and must be invested in Shari’ah compliant activities only. Any return from such investment must be credited back to the IRR and PER as applicable.
3.7 IBs must set limits for the amounts transferred to the IRR and PER and must distribute the rest to the IAHs.
3.8 If the IB has various Investment Accounts (“IA”) (with different categories/types/tiers), the IB must ensure that any accumulated reserve (appropriated from a specific category/type/tier) will benefit only the respective IAs, avoiding, in the process, any cross funding.