Risk Measurement and Disclosure in Islamic Finance and the Implications of Profit Sharing Investment Accounts

The paper discusses key issues in the measurement and control of risks in Islamic Financial Services Institutions, particularly the implications of profit sharing investment accounts (PSIA) for risk measurement, risk management, capital adequacy and supervision. Cross country data on a sample of banks reveal a considerable smoothing of returns paid to PSIA, despite wide divergences in risk. This suggests that the sharing of risks with PSIA is fairly limited in practice, although, in principle, well-designed risk (and return) sharing arrangements with PSIA can serve as a powerful risk mitigant in Islamic finance. Supervisory authorities can provide strong incentives for effective and transparent risk sharing and the associated product innovations, by linking the extent of capital relief on account of PSIA with appropriate supervisory review of the risks borne by the PSIA (equivalently the extent of displaced commercial risk assumed by the shareholders), and by requiring adequate disclosure of these risks. A value-at risk (VAR) methodology is proposed for measuring these risks.