1. Introduction

The phenomenal growth of Islamic banking and finance in recent years has highlighted needs for policies to help integrate Islamic finance in the national and global financial systems. There has also been an understandable increased interest of researchers into understanding unique aspects of Islamic banking and finance and how it can be standardized across the globe. Risk management in particular is drawing a lot of interest given the current turmoil in the financial system and infrastructure. Few Islamic bankers believe that Islamic banks overall are less susceptible to risk on account of their nature. However an overwhelming majority rightly feel that in addition to risks which conventional banks incur, Islamic banks face certain risks which are unique to its nature. These risks include risks like fiduciary risk and Displaced Commercial Risk.

Displaced Commercial Risk (DCR) is a special risk Islamic banks are exposed to in a dual banking environment due to the commercial pressure of a 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.

Banks employ a great deal of measures to combat this risk. 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 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.