RM-3.1.1

This Chapter sets out the principles and rules pertaining to the management of risks inherent in the holding of equity instruments for investment purposes. In particular, for Islamic bank licensees, the relevant instruments are typically those based on the Mudarabah and Musharakah contracts. This Chapter focuses on such instruments. The risks entailed by holding equity instruments for trading or liquidity purposes are dealt with under market risk in Chapter RM-4. While investments made via Mudarabah and Musharakah instruments may contribute substantially to Islamic bank licensees' earnings, they entail significant market, liquidity, credit⁸ and other risks, potentially giving rise to volatility in earnings and capital.

⁸ One example of credit risk exposure arises from the Mudarib's obligation to pay the agreed share of profit to the Islamic bank licensee as Rabb al-mal when such payment falls due. Failure to meet this obligation constitutes a case of misconduct and negligence in the part of the Mudarib.

RM-3.1.2

The capital invested through Mudarabah and Musharakah may be used to purchase shares in a publicly traded company or privately held equity or invested in a specific project, portfolio or through a pooled investment vehicle. In the case of a specific project, Islamic bank licensees may invest at different investment stages.

RM-3.1.3

One distinct difference between Mudarabah and Musharakah financings is in terms of Islamic bank licensee's involvement in the investments during the contract period. In Mudarabah, the Islamic bank licensee invests its money as a silent partner and, the management is the exclusive responsibility of the other party, namely the Mudarib. In contrast, in Musharakah financing the Islamic bank licensee invests funds with partners, and the Islamic bank licensee may be a silent partner, or may participate in management. Regardless of the authority under which the profit sharing instruments are used, both Musharakah and Mudarabah are profit-sharing financings, under which the capital invested by the provider of finance does not constitute a fixed return, but is explicitly exposed to impairment in the event of losses (capital impairment risk).

RM-3.2.1

The type of equity investment risk dealt with in this Chapter may be broadly defined as the risk arising from entering into a partnership for the purpose of undertaking or participating in a particular financing or general business activity as described in the contract, and in which the provider of finance shares in the business risk.

RM-3.2.2

The characteristics of such equity investments include considerations as to the quality of the partner, underlying business activities and ongoing operational matters. By nature, this type of equity investment is exposed to a confluence of risks associated with Mudarib or Musharakah partner, business activity and operations.

RM-3.2.3

In evaluating the risk of an investment using the profit sharing instruments of Mudarabah or Musharakah, the risk profiles of potential partners (Mudarib or Musharakah partner) are crucial considerations for the undertaking of due diligence. Such due diligence is essential to the fulfilment of an Islamic bank licensee's fiduciary responsibilities as an investor of IAH funds on a profit-sharing and loss-bearing basis (Mudarabah) or a profit and loss sharing basis (Musharakah). These risk profiles include the past record of the management team and quality of the business plan of, and human resources involved in, the proposed Mudarabah or Musharakah activity.

RM-3.2.4

Factors relating to the legal and regulatory environment affect equity investment performance, and need to be considered in the risk evaluation. These factors include policies pertaining to tariffs, quotas, taxation or subsidies and any sudden policy changes affecting the quality and viability of an investment.

RM-3.2.5

Islamic bank licensees are exposed to the risks attaching to a lack of reliable information on which to base their investment appraisals, such as an inadequate financial control system. The mitigation of these risks may require the investor to take an active role in monitoring the investment, or the use of specific risk mitigating structures.

RM-3.2.6

Although timely allocation of profit can be agreed upfront, Islamic bank licensees should be prepared for delays and variations in cash flow patterns and possible difficulties in executing a successful exit strategy.

RM-3.2.7

The risks arising from the use of profit sharing instruments for financing purposes do not include credit risk in the conventional sense, but share a crucial characteristic of credit risk because of the risk of capital impairment.

RM-3.3.1

Islamic bank licensees must implement appropriate strategies, risk management and reporting processes in respect of the risk characteristics of equity investments, including Mudarabah and Musharakah investments.

RM-3.3.2

Islamic bank licensees must define and set the objectives of, and criteria for, investments using profit sharing instruments, including the types of investment, tolerance for risk, expected returns and desired holding periods. Islamic bank licensees must define their investments exit strategy (see paragraphs RM-3.3.14–16 for more details).

RM-3.3.3

For purposes of Paragraph RM-3.3.2, a Musharakah structure may contain an option for redemption whereby the Islamic bank licensee as financier has a contractual right to require its partner periodically to purchase, under a separate contract, a proportion of the Islamic bank licensee's share in the investment at net asset value or, if the contract so specifies on some agreed basis (Diminishing Musharakah).

RM-3.3.4

Islamic bank licensees must implement and keep under review, policies, procedures and an appropriate management structure for evaluating and managing the risks involved in the acquisition of, holding and exiting from profit sharing investments. Islamic bank licensees must ensure proper infrastructure and capacity are in place to monitor continuously the performance and operations of the entity in which an Islamic bank licensee invests as partner. These must include evaluation of Shari'a compliance, adequate financial reporting by, and periodical meetings with, partners and proper recordkeeping of these meetings.

RM-3.3.5

Islamic bank licensees must identify and monitor the transformation of risks at various stages of investment lifecycles, for example, where the investee's business involves innovative or new products and services in the marketplace. Islamic bank licensees that employ different financing instruments (where one of which include Musharakah) at different contract stages must have appropriate procedures and controls in place, as different stages may give rise to different risks.

RM-3.3.6

Islamic bank licensees must analyse and determine possible factors affecting the expected volume and timing of cash flows for both returns and capital gains arising from equity investments.

RM-3.3.7

Islamic bank licensees should use, if applicable, Shari'a compliant risk-mitigating techniques, both financial and non-financial in nature, to reduce the impact of possible capital impairment of an investment.

RM-3.3.8

Islamic bank licensees must ensure that their valuation methodologies are appropriate and consistent, and assess the potential impacts of their methods on profit calculations and allocations. The methods must be mutually agreed between the Islamic bank licensees and the Mudarib and/or Musharakah partners.

RM-3.3.9

Islamic bank licensees must agree with the Mudarib and/or Musharakah partners before entering into any agreement, on the appropriate valuation methods and periods for which the profit is to be calculated and allocated taking into account market practices and liquidity features.

RM-3.3.10

Valuation and accounting play an important role in measuring the quality of an equity investment, especially in a privately held entity, for which independent price quotations are not always available nor sufficient in volume to provide a basis for meaningful liquidity or market valuation. An appropriate and agreed method to be applied to determine the profit of the investment can be in the form of a certain percentage of either gross or net profit earned by the Mudarabah or Musharakah business, or any other mutually agreed terms.

RM-3.3.11

In the case of a change of the partnership's shares in a Musharakah (for example in a Diminishing Musharakah), the shares changing hands must be valued at fair value.

RM-3.3.12

Islamic bank licensees must assess and take measures to deal with the risks associated with potential manipulation of reported results leading to overstatements or understatements of partnership earnings. Reported earnings can be either gross or net. If for some reason the practices of smoothing profits over accounting periods and the establishment of escrow accounts to hold certain profit portions during the life of an equity investment are recognised and agreed by all the investing parties, the Islamic bank licensee must incorporate their potential impact in the Islamic bank licensee's overall earnings.

RM-3.3.13

Islamic bank licensees may agree with the Mudarib and/or Musharakah partners to engage independent parties where necessary to carry out audits and valuations of the investments. Provided these are properly executed and completed, these measures will help to ensure transparency and objectivity in valuation and in the distribution of profits and the determination of amounts to be redeemed.

RM-3.3.14

Islamic bank licensees must define and establish the exit strategies in respect of their equity investment activities prior to commitment, including extension and redemption conditions for Mudarabah and Musharakah investments, subject to the approval of the Islamic bank licensee's Shari'a Board.

RM-3.3.15

Islamic bank licensees must establish the criteria for exit strategies, including the redemption of equity investments and the divestiture of under-performing investments.

RM-3.3.16

The criteria may include alternative exit routes and the timing of exit. In case of losses where improved business prospects exist, Islamic bank licensees may indicate an investment extension period. Islamic bank licensees' expectations should be based on their assessment that there are plausible grounds for believing that there will be a business turnaround during the period resulting in the view that the investment will, in a defined time period, recover and yield profits.

RM-3.3.17

Islamic bank licensees must recognise that, as a going concern, an investee may not always have the liquidity necessary to enable making profit distributions. Hence, Islamic bank licensees must agree with the investment partner the methods for the treatment of retained profits by the investee.