13. TREATMENT OF PSIAS AND ASSOCIATED RISKS

13.1. General

(1) Islamic banks typically raise funds through PSIAs, because interest-bearing deposits are not permitted by Shari’ah.

(2) This Chapter sets out the treatment of unrestricted PSIAs and the risks (rate of return risk, withdrawal risk and displaced commercial risk) that are associated with PSIAs.

(3) This Chapter also sets out:

(a) the responsibilities of an Islamic bank, as an unrestricted PSIA manager;

(b) the requirements for policies, warnings, terms of business, contracts and financial and other periodic statements in relation to PSIAs; and

13.2. PSIAs

(1) A Profit-Sharing Investment Account (or PSIA) is an account, portfolio or fund that satisfies the following conditions:

(a) it is managed by an authorised firm in accordance with Shari’ah and is held out as being Shari’ah-compliant;
(b) under a management agreement with an Islamic Bank, the IAH concerned and an Islamic Bank agree to share any profit in a specified ratio and the IAH agrees to bear any loss not caused by an Islamic Bank’s negligence, misconduct, fraud or breach of contract.

(2) A PSIA may be unrestricted or restricted. An Unrestricted PSIA (UPSIA) is a PSIA for which the IAHs authorise the PSIA manager to invest the IAHs’ funds in a way that the manager considers appropriate, without any restriction as to where, how or for what purpose the funds may be invested (provided that the investments are Shari’ahcompliant).

(3) A Restricted PSIA (RPSIA) is one where the IAHs authorise an Islamic Bank to invest the IAHs’ funds, with specified restrictions as to where, how and for what purpose the funds may be invested.

(4) The contractual relationship between an Islamic Bank and the IAHs under the PSIA requires the IAHs to bear the commercial risks associated with the assets funded by the PSIA. An Islamic Bank is responsible for managing the investment of the assets and has the fiduciary duty to safeguard the interest of the IAHs through sound and prudent policies in the management of the assets.

Guidance

PSIA is usually offered by an Islamic Bank on the basis of a mudarabah partnership between an Islamic Bank as the entrepreneur or mudarib and the IAH as the investor or rabb al-mal.

13.3. Powers of AFSA

Despite anything in these rules, the AFSA may direct an Islamic Bank to treat, or not to treat, an arrangement between an Islamic Bank and a party (for example, by way of wakalah or musharakah) to be a PSIA.

13.4. Role of governing body—PSIAs

(1) An Islamic Bank’s governing body must ensure that an Islamic Bank has policies that enable an Islamic Bank to prudently manage assets and risks associated with PSIAs.

(2) It is the responsibility of the governing body to provide effective oversight and monitoring to ensure that PSIAs are managed in the best interests of the IAHs. In particular, the governing body must oversee:

(a) the financing and investment activities undertaken on behalf of IAHs;

(b) the fiduciary duties performed by an Islamic Bank to ensure that they are in accordance with the terms and conditions of the contracts between an Islamic Bank and its IAHs; and

13.5. Policies for managing PSIAs

An Islamic bank’s policies on managing PSIAs must include the following:

(a) how to ensure that PSIAs are managed in accordance with their IAHs’ instructions;

(b) how to ensure that the funds of each PSIA are invested in accordance with the relevant terms of business;

(d) how the interests of the IAHs are safeguarded;

(e) the basis for allocating expenses and profits or losses to IAHs;

(f) how provisions and reserves against equity and assets will be applied;

(g) to whom those provisions and reserves would revert in the event of a write-off or recovery;

(h) how liquidity mismatch will be monitored;

(i) how the value of each PSIA’s assets will be monitored;

(j) how any losses incurred as a result of negligence, misconduct, fraud or breach of contract on the part of an Islamic Bank will be dealt with;

(k) an acknowledgment of the right of IAHs to monitor the performance of their investments and the associated risks, and how IAHs can exercise that right.

13.6. Warnings to investment account holders

An Islamic Bank must warn a prospective IAH in writing that:

(a) the IAH bears the risk of loss to the extent of the IAH’s investment; and
(b) the IAH would not be able to recover that loss from an Islamic Bank, except in the case of negligence, misconduct, fraud or breach of contract on the part of an Islamic Bank

13.7. Terms of business

An Islamic Bank must ensure that the following information is included in the terms of business given to an IAH:

(a) how and by whom the funds of the IAH will be managed and invested;

(b) the PSIA’s investment objectives and details of its policy on diversification;

(d) a summary of the policies for valuing the PSIA’s assets;

(e) if an Islamic Bank uses PER or IRR as a smoothing technique, a summary of the policies for transferring funds to and from the reserve;

(f) particulars of the management of the PSIA;

(g) particulars of the management of any other person to whom the owner has outsourced, or will outsource, the management of the PSIA, including:

(i) the person’s name;

(ii) the person’s regulatory status; and
(iii) details of the arrangement;

(h) details of any arrangement for early withdrawal, redemption or other exit and any costs to an IAH as a result;

(i) confirmation of the IAH’s investment objectives;

(j) whether funds from the PSIA will be mixed with the funds of any other PSIA;

(k) any applicable charges and the basis on which such charges will be calculated;

(l) any fees that an Islamic Bank can deduct from the profits of the PSIA;

(m) how the IAH can monitor the performance of investments and associated risks.

13.8. Form of contracts for PSIAs

(1) The terms and conditions of a contract for a PSIA must be clear, concise and easily understandable by an IAH. The contract must state the type, purpose, terms and period of the contract and the profit-sharing ratio agreed at the time of the opening of the account.

(2) The following must also be stated in the contract:

(a) the rights and liabilities of both parties—in particular, in the circumstances where losses are to be borne by the IAH;
(b) the implications for the IAH of early withdrawal, early redemption or other exit;
(c) the duty of an Islamic Bank to disclose accurate, relevant and timely information to the IAH on the investment of funds, including its performance, investment strategies, valuation, and frequency of valuation of the PSIA’s assets;
(d) how any losses incurred as a result of negligence, misconduct, fraud or breach of contract on the part of an Islamic Bank will be dealt with;
(e) how any subsequent changes in the profit-sharing ratio will be disclosed;
(f) any smoothing techniques that an Islamic Bank uses.

13.9. Financial statements—specific disclosures

(1) An Islamic Bank must ensure that its financial statements contain the following disclosures:

(a) the role and authority of the Shari’ah supervisory board in overseeing an Islamic Bank’s business;
(b) the method used in the calculation of the zakat base;
(c) if zakat has been paid, the amount that has been paid;
(d) if zakat has not been paid, information to allow an IAH or prospective IAH to compute its liability to zakat.

(2) The financial statements must also contain the following disclosures in relation to each PSIA managed by an Islamic Bank:

(a) an analysis of its income according to types of investments and their financing;
(b) the basis for allocating profits between the owner and the IAHs;
(c) the equity of the IAHs at the end of the reporting period;
(d) the basis for determining any PER or IRR;
(e) the changes that have occurred in any of those reserves during the reporting period;
(f) to whom any remaining balances of any of those reserves is attributable in the event of liquidation.

(3) Any deductions by an Islamic Bank from its share of income, and any expenses borne by an Islamic Bank on behalf of the IAHs, as a contribution to the income of IAHs must also be disclosed in an Islamic Bank’s financial statements if the contribution is significant.

13.10. Periodic statements

(1) An Islamic Bank must give each IAH of a PSIA a periodic statement about the PSIA at intervals stated in the contract or terms of business. The interval must not be longer than 6 months.

(2) An Islamic Bank must ensure that the periodic statement contains the following information as at the end of the period covered by the statement:

(a) the number, description and value of investments held by the PSIA;

(b) the amount of cash held by the PSIA;

(c) details of applicable charges (including any deductions of fees that an Islamic Bank is allowed to deduct from the profits of the PSIA) and the basis on which the charges are calculated;

(d) the total of any dividends and other benefits received by an Islamic Bank for the PSIA;

(e) the total amount, and particulars, of all investments transferred into or out of the PSIA;

(f) details of the performance of the IAH’s investment;

(g) the allocation of profit between the owner and the IAH;

(h) any changes to the investment strategies that could affect the IAH’s investment.

13.11. PSIA accounts to be kept separate

An Islamic Bank must keep its accounts for unrestricted IAHs separate from accounts for restricted IAHs. An Islamic Bank must record all its transactions in investments for these accounts separately.

13.12. Rate of return and other risks

(1) Rate of return risk (or ROR risk) is the risk that an increase in benchmark rates may result in IAHs’ having expectations of a higher rate of return. It is the risk of facing a lower rate of return on assets than currently expected by an Islamic Bank’s IAHs.

(2) Rate of return risk may result in withdrawal risk and displaced commercial risk. It can give rise to liquidity problems in an Islamic Bank.

(3) An Islamic Bank must manage the expectations of its shareholders and IAHs. If market rates of return of competitors’ IAH are higher than those of an Islamic Bank’s IAHs, an Islamic Bank must evaluate the nature and extent of the expectations of its IAHs and assess the amount of the gap between competitors’ rates and its own IAHs’ expected rates.

13.13. Withdrawal risk and displaced commercial risk

(1) Many Islamic Banks consider their IAHs as behaving like conventional depositors who might withdraw their funds in the case of lower-than-expected profit rates (withdrawal risk). The withdrawal of funds by IAHs can expose a firm to liquidity risk.

(2) Another consequence of rate of return risk may be Displaced Commercial Risk (or DCR), which is the risk resulting from competitive pressures on a firm to attract and retain IAHs as fund providers. An Islamic Bank 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 those assets is under-performing compared with competitors’ rates.

Guidance

(i) For example, an Islamic Bank that acts as mudarib for an IAH may give up a part of its mudarib share or its profit to the IAH in order to smooth profit payouts. The risk of an Islamic Bank being obliged to give up the share or profit for commercial or other reasons is a DCR.

(ii) The term ‘displaced’ is used because, initially, the risk from the volatility of returns is to be borne by the IAH as rabb-al-mal but that risk has been displaced onto an Islamic Bank.

(iii) If a firm is able to manage the distribution of returns on PSIAs entirely through adjustments to its PER (that is, without having to give up part or all of their mudarib share of profits and without making any unilateral transfer to IAHs from the shareholders’ current or retained profits), there is no DCR and there is no requirement for an Islamic Bank to support an additional Capital charge for that risk.

13.14. Role of governing body—rate of return risk

(1) An Islamic Bank’s governing body must ensure that an Islamic Bank’s rate of return risk management policy:

(a) gives an Islamic Bank a comprehensive firm-wide view of the significant sources of rate of return risk; and
(b) is consistent with an Islamic Bank’s risk profile and systemic importance.

(2) The governing body must also ensure that an Islamic Bank has adequate policies and staff to identify, measure, evaluate, manage and control or mitigate its rate of return risk.

(3) The governing body must approve the basis for computing the amounts to be set aside by an Islamic Bank for the PER or IRR.

(4) The governing body must regularly review an Islamic Bank’s investment policies and the performance of the assets in which IAHs’ funds are invested.

13.15. Policies—rate of return risk

An Islamic Bank’s rate of return risk management policy:

(a) must describe the approach to managing an Islamic Bank’s rate of return risk and any resulting withdrawal risk or DCR;
(b) must establish procedures to assess:
(i) the behavioural and contractual maturity profiles of IAHs;
(ii) the impacts of market factors affecting rates of return on assets in comparison with the expected rates of return for IAHs; and
(iii) the effect of the level of an Islamic Bank’s dependence on current account holders’ funds;
(c) must state the basis, and procedures, for any decision to give up part or all of its share of profits in favour of IAHs;
(d) must set an Islamic Bank’s risk tolerance for DCR; and
(e) must include requirements for provisioning, and transfers to and from reserves, in accordance with the agreed contractual terms and conditions for IAHs.

13.16. Smoothing techniques

(1) To mitigate withdrawal risk and DCR, an Islamic bank may use one or more of the following techniques. The objective of smoothing techniques is to satisfy and retain fund providers and dissuade them from withdrawing their funds.

(2) An Islamic Bank may give up part or all of their mudarib share of profits. The decision to give up part or all of its mudarib share of profits in favour of IAHs is a commercial decision.

(3) An Islamic Bank may make unilateral transfers (by means of hibah) to IAHs from the shareholders’ current or retained profits. Hibah is the unilateral transfer of ownership of a property or its benefit to another without any counter-value from the recipient.

(4) An Islamic Bank may establish a Profit Equalisation Reserve (or PER) by setting aside amounts from the investment profits, before allocation of share of profits between IAH and an Islamic Bank (for their respective shares in the PSIA pool) and before calculating their mudarib share of profits. The PER is to maintain a level of return on investment for IAHs.

Guidance

Even before using smoothing techniques, an Islamic bank is encouraged to employ balance sheet techniques to minimise its exposures to rate of return risk. Examples of the strategies that an Islamic Bank might use include:

a. determining and varying future profit ratios according to expectations of market conditions

b. developing new Shari’ah-compliant instruments

c. issuing securitisation tranches of Shari’ah-permissible assets.

An Islamic bank should develop and maintain an informed judgement about an appropriate level of the balances of its PER. The nature of the reserve implies that there will be years in which the balance of the reserve will be increased, and others in which it will be depleted.

(5) An Islamic Bank may establish an Investment Risk Reserve (or IRR) by setting aside amounts from the investment profits of IAHs, after allocating PER (if any) and deducting an Islamic Bank’s mudarib share of profits. The IRR is to cushion against future investment losses for IAHs and must not be used for any other purpose.

13.17. Calculating rate of return

(1) An Islamic bank must use the gapping method to allocate positions into time bands based on remaining maturities or repricing dates.

(2) Fixed-rate and floating-rate assets of an Islamic Bank must be classified according to their receivable dates because the returns on these receivables represent the IAHs’ direct and beneficial ownership of the assets. Actual cash flows may indicate a gap for a particular time band, affecting the rate of return for that period.

(3) Depending on the nature, scale and complexity of an Islamic Bank’s business, an Islamic Bank may employ techniques ranging from simple gap to advance simulation or dynamic approaches to assess future cash flow variability and net income.

Guidance

i) The estimates derived from selected approaches might provide acceptable approximations of periodic future earnings’ variability, and the outcomes would yield different levels of expected returns to IAHs.

ii) The measurement of rate of return risk highlights the importance of cash flow forecasting for instruments and contracts where the Islamic Bank is required to simulate and assess their behavioural maturity, underlying assumptions and parameters, which should be reviewed periodically for reliability. The significance of potential threats to future earnings and the usefulness of the resulting information should be considered in determining the type and extent of forecasted behaviour for an Islamic Bank.

13.18. Relation to stress-testing

When carrying out stress-testing or review of stress scenarios, an Islamic bank must take into account an Islamic Bank’s vulnerability to loss under adverse benchmark rate movements.

13.19. Calculation of Capital adequacy ratio—no smoothing

If an Islamic Bank does not smooth profit payouts to IAHs, an Islamic Bank’s Capital adequacy ratio is calculated by dividing an Islamic Bank’s Regulatory Capital by the amount calculated in accordance with the following formula:

(TRC + TRM + TRO) - (PRC + PRM)

where:

TRC is total risk-weighted assets adjusted for credit risk.

TRM is total risk-weighted assets adjusted for market risk.

TRO is total risk-weighted assets adjusted for operational risk.

PRC is total risk-weighted assets financed by PSIAs, adjusted for credit risk.

PRM is total risk-weighted assets financed by PSIAs, adjusted for market risk.

Guidance

If an Islamic bank does not smooth profit payouts to IAHs, an Islamic Bank is not required to hold Regulatory Capital against credit or market risks arising from assets funded by the PSIAs. The RWAs funded by such accounts are excluded in respect of those risks in calculating the denominator of an Islamic Bank’s CAR, leaving only operational risk.

13.20. Calculation of Capital adequacy ratio—smoothing

If an Islamic bank smooths profit pay-outs to IAHs, an Islamic Bank’s Capital adequacy ratio is calculated by dividing an Islamic Bank’s Regulatory Capital by the amount calculated in accordance with the following formula:

(TRC + TRM + TRO) - (PRCR + PRMR) - ((1 - α) (PRCU + PRMU) - α(PRCV + PRMV))

where:

α represents the proportion of assets funded by unrestricted PSIAs, and is set at 0.35 by the AFSA.

TRC is total risk-weighted assets adjusted for credit risk.

TRM is total risk-weighted assets adjusted for market risk.

TRO is total risk-weighted assets adjusted for operational risk.

PRCR is total risk-weighted assets financed by restricted PSIAs, adjusted for credit risk.

PRMR is total risk-weighted assets financed by restricted PSIAs, adjusted for market risk.

PRCU is total risk-weighted assets financed by unrestricted PSIAs, adjusted for credit risk.

PRMU is total risk-weighted assets financed by unrestricted PSIAs, adjusted for market risk.

PRCV is total risk-weighted assets financed by the PER and IRR for unrestricted PSIAs, adjusted for credit risk.

PRMV is total risk-weighted assets financed by the PER and IRR for unrestricted PSIAs, adjusted for market risk.

Guidance

If an Islamic bank smooths profit pay-outs to IAHs, an Islamic Bank is required to hold regulatory Capital against credit or market risks arising from assets funded by the PSIAs, to cater for DCR. In this approach, credit and market risks of assets financed by unrestricted PSIAs are considered to be borne proportionately by both the IAHs and an Islamic Bank. Therefore, a proportion of the RWAs funded by unrestricted PSIAs is required to be included in the denominator of the CAR.

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