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  • RM-6 RM-6 Rate of Return Risk

    • RM-6.1 RM-6.1 Rate of Return Risk

      • RM-6.1.1

        This Chapter sets out principles in respect of rate of return risks. The rate of return risk is generally associated with overall balance sheet exposures where mismatches arise between assets and balances from fund providers.

        January 2013

      • RM-6.1.2

        Since Islamic bank licensees' responsibility is to manage their IAHs' expectations and their liabilities to current account holders, the rate of return risk is a strategic risk issue forming part of Islamic bank licensees' balance sheet risk management.

        January 2013

    • RM-6.2 RM-6.2 Definition and Profiles of Rate of Return Risk

      • RM-6.2.1

        Islamic bank licensees are exposed to rate of return risk in the context of their overall balance sheet exposures. An increase in benchmark rates may result in IAHs' having expectations of a higher rate of return. Rate of return risk differs from interest rate risk in that Islamic bank licensees managing Shari'a-compliant products are concerned with the result of their investment activities at the end of the investment-holding period. Such results cannot be pre-determined exactly.

        January 2013

      • RM-6.2.2

        A consequence of rate of return risk may be displaced commercial risk. Islamic bank licensees may be under market pressure to pay a return that exceeds the rate that has been earned on assets financed by IAHs when the return on assets is under-performing as compared with competitors' rates. Islamic bank licensees may decide to waive their rights to part or their entire Mudarib share of profits in order to satisfy and retain their fund providers and dissuade them from withdrawing their funds. Displaced commercial risk derives from competitive pressures on Islamic bank licensees to attract and retain investors (fund providers). The decision of Islamic bank licensees to waive their rights to part or all of their Mudarib share in profits in favour of IAHs is a commercial decision, the basis for which needs to be subject to clear and well defined policies approved by the Islamic bank licensee's BOD.

        Amended: January 2020
        January 2013

      • RM-6.2.3

        A Profit Equalisation Reserve (PER) is the amount appropriated by Islamic bank licensees out of their gross income, before allocating the Mudarib share, in order to maintain a certain level of return on investment for IAHs and increase owners' equity. The basis for computing the amounts to be so appropriated should be predefined and applied in accordance with the contractual conditions accepted by the IAH and after formal review and approval by the Islamic bank licensees' BOD.

        January 2013

      • RM-6.2.4

        An Investment Risk Reserve (IRR) is the amount appropriated by Islamic bank licensees out of income of IAHs, after allocating the Mudarib share, in order to cushion the effects of the risk of future investment losses on IAHs. The terms and conditions whereby IRR can be set aside and utilised should be determined and approved by the BOD.

        January 2013

      • RM-6.2.5

        The CBB does not set any required minimum levels of appropriation or balances of PER and IRR relative to IAHs funds. It recommends that Islamic bank licensees pay due regard to relevant IFSB Guidance Notes and Standards in relation to PER and IRR with particular reference to the IFSB Guidance Note GN-3 dated December 2010 (Practice of Income Smoothing the Profits Payout to Investment Account Holders).

        January 2013

    • RM-6.3 RM-6.3 Operational Considerations

      • RM-6.3.1

        Islamic bank licensees must establish a comprehensive risk management and reporting process to assess the potential impacts of market factors affecting rates of return on assets in comparison with the expected rates of return for IAHs.

        January 2013

      • RM-6.3.2

        Islamic bank licensees must take necessary steps to ensure that the management processes relating to the identification, measurement, monitoring, reporting and control of the rate of return risk (including appropriate structure) are in place. Since the rate of return risks are emanating from various balance sheet positions, Islamic bank licensees must recruit competent staff to undertake the analysis of risk exposures arising from their consolidated balance sheet activities.

        January 2013

      • RM-6.3.3

        Islamic bank licensees must be aware of the factors that give rise to rate of return risk. The primary form of rate of return risk to which the Islamic bank licensees are exposed comprises increasing long-term fixed rates in the market. In general, profit rates earned on assets reflect the benchmark of the previous period and do not correspond immediately to changes in increased benchmark rates.

        January 2013

      • RM-6.3.4

        Islamic bank licensees must assess the effect of the level of their dependency on current account holders' funds. Although no returns are expected by current account holders, the sudden withdrawal of these funds would have an adverse impact on the overall potential rate of return for Islamic bank licensees.

        January 2013

      • Rate of Return Risk Management

        • RM-6.3.5

          Islamic bank licensees must implement appropriate systems for identifying and measuring the factors which give rise to rate of return risk.

          January 2013

        • RM-6.3.6

          When calculating a rate of return, Islamic bank licensees must employ a gapping method for allocating positions into time bands with remaining maturities or re-pricing dates, whichever is earlier. Fixed and floating rate assets of Islamic bank licensees must be classified according to their receivable dates because the returns on these receivables represent the fund providers' direct and beneficial ownership of the assets.

          January 2013

        • RM-6.3.7

          Actual cash flows may indicate a gap for a given time band, affecting the rate of return for that period. Depending on the complexity and the nature of their business operations, Islamic bank licensees may employ techniques ranging from simple gap to advance simulation or dynamic approaches to assess future cash flow variability and net income. The estimates derived from selected approaches may provide acceptable approximations of periodic future earnings' variability; hence, the outcomes will yield different levels of expected returns to IAHs.

          January 2013

        • RM-6.3.8

          The measurement of rate of return risk highlights the importance of cash flow forecasting for instruments and contracts where Islamic bank licensees are required to simulate and assess their behavioral maturity, underlying assumptions and parameters, which must be reviewed periodically for reliability. The materiality of potential threats to future earnings and the usefulness of the resulting information must be considered in determining the type and extent of forecasted behavior for Islamic bank licensees.

          January 2013

        • RM-6.3.9

          In assessing whether a potential threat is likely to have a material, likely and imminent impact on a balance sheet position, Islamic bank licensees must ensure that they understand the different characteristics of their balance sheet positions in the different currencies and jurisdictions within which they operate.

          January 2013

        • RM-6.3.10

          In assessing exposure to rate of return risks, Islamic bank licensees must take into account the non-contractual behavioral maturity of the transactions in the context of the environment in which they operate and changing market conditions.

          January 2013

        • RM-6.3.11

          With reference to Paragraph RM-6.3.10, in case of early repayment made by the customer (in Murabaha or Ijara transactions), Islamic bank licensees may accept full settlement but give rebates on subsequent transactions, while in other cases, the Islamic bank licensees may give rebates immediately at their discretion without any reference to this in the contract.

          January 2013

        • RM-6.3.12

          Islamic bank licensees are encouraged to employ balance sheet techniques to minimize their exposures using the following strategies, among others:

          (a) Determining and varying future profit ratios according to expectations of market conditions;
          (b) Developing new Shari'a-compliant instruments; and
          (c) Issuing secuntisation tranches of Shari'a permissible assets.
          January 2013

      • Displaced Commercial Risk Management

        • RM-6.3.13

          Islamic bank licensees must have in place an appropriate framework for managing displaced commercial risk, where applicable.

          January 2013

        • RM-6.3.14

          Islamic bank licensees must have in place a policy and framework for managing the expectations of their shareholders and IAHs. Where market rates of returns of competitors' IAHs are higher than those of Islamic bank licensees' IAHs, the Islamic bank licensees must evaluate the nature and extent of the expectations of its IAHs and assess the amount of the gap between competitors' rates and their own IAHs' expected rates.

          January 2013

        • RM-6.3.15

          Islamic bank licensees must develop and maintain an informed judgment about an appropriate level of the balances of PER, bearing in mind that its essential function is to provide mitigation of displaced commercial risk. Some Islamic bank licensees must maintain the proportion relating to IAHs in this reserve within the IAHs equity, with the purpose of smoothing returns to IAHs, and in particular, to enhance their returns if these are below those of competitors. This implies that there will be years in which the balance of this reserve will be increased, and others in which it will be depleted.

          January 2013