Displacement Commercial Risk (DCR) and the Level of Risk Sharing between Unrestricted Investment Account Holders (URIAHs) and Shareholders in an Islamic Bank

Islamic banks are exposed to a unique risk such as Displaced Commercial Risk (DCR). DCR arises when the Islamic banks forgo part or all its share of profits on the unrestricted investment account holders’ funds in order to increase the return to the unrestricted investment account holders. The level of risk sharing indicates the level of DCR absorbed by the shareholders of an Islamic bank for the bank pay to a competitive rate to the unrestricted investment account holders. Displacement commercial risk and level of risk sharing are two important concepts for Islamic bank and the regulatory authority. To demonstrate the concepts, this paper employs the Value at Risk (VaR) model to estimate the DCR and level of risk sharing in two Islamic banks in Bahrain. The results indicate that one of the banks experienced a DCR of between $15.342 million and $15.843 million with a risk sharing level of 97% while the second bank did not face DCR and has a risk sharing level of 0%. The paper concludes that since the capital adequacy ratios of Islamic banks are very sensitive to changes in DCR and level of risk sharing, setting a common risk sharing level for the industry is not a good idea as this will result in either overstating or understating the capital requirements of Islamic banks and this has some implications on resilience and stability of the banks as well as their competitiveness in the marketplace Keywords: Islamic bank, shareholders, displaced commercial risk, level of risk sharing, value at risk, unrestricted investment account holders DOI: 10.7176/EJBM/15-16-04 Publication date:September 30th 202