DCR

Displaced commercial risk is a unique risk applicable to an Islamic bank particularly in a dual banking
environment. Displaced Commercial Risk (DCR) is defined as the risk arising from assets managed on
behalf of Investment Account Holders which is effectively transferred to the Islamic Financial Institutions
own capital because the Institution forgoes part or all of its Mudaribs share (profit) on such fund, when it
considers this necessary as a result of commercial pressure in order to increase the return that would
otherwise be payable to Investment Account Holders (IFSB 2005/2-Standard para76). In other words
DCR is the risk accrued to Islamic banks due to the commercial pressure of having to pay a rate of return
equivalent to a competitive rate of return and absorb a portion of losses which normally would have been
borne by investment account holders in order to prevent massive withdrawal of funds.

Profit Equalization Reserves (PER) and Investment Risk Reserve (IRR) play a critical role in the
management of DCR in Islamic banks. The PER is retained from the total income before the profit is
allocated between shareholders and Investment Account Holders and the calculation of Mudarib Share.
IRR is retained only from the profits attributed to Investment Account Holders (after deduction of
Mudarib share). The provisioning for these reserves is generally outlined in the contract and is decided by
the management. Islamic banks normally invest these reserves to generate additional returns to
investment account holders and smooth the returns on Profit Sharing Investment Account (PSIA). If the
reserves are adequate to avoid the transfer of income from shareholders to Investment Account Holders,
there is no exposure to DCR. However DCR is positive if these reserves are insufficient and there is

transfer

of

some

proportion

of

shareholders

returns

to

depositors.

The recognition of DCR requires adjustment to Capital adequacy ratio of Islamic banks. IFSB has come
up with two methods to adjust the capital adequacy ratio of Islamic banks to account for DCR. The first
method excludes risk weighted assets funded by PSIA and hence assumes that the risks are fully absorbed
by

investment

account

holders.

The second method requires a proportion % of risk-weighted assets financed by PSIA to be included in
the calculation of capital adequacy ratio. This method is more aligned with the market reality in that it
recognizes that investment account holders do not fully absorb the risk. % which can take any value
between 0 and 1 is taken as a proxy of DCR and moves in a positive relationship with DCR. % is
decided by the central bank and all Islamic banks within its jurisdiction are expected to key in this value
while calculating their capital adequacy ratio.