Mudaraba Profit Equalisation Reserve and the Investment Account Holder Split
An Islamic bank pools depositors' funds in a mudaraba with a 60:40 profit share (bank as mudarib: 60% of profit after the bank's own share of capital). In year 1 the pool earns a gross profit of 90 million before any reserve movements. The bank's historical average return to investment account holders (IAH) is 5.5% on an average pool of 1,200 million, i.e. a benchmark distribution of 66 million. Actual distributable profit to IAH before reserves would be 36 million (40% of 90m). The Shari'ah board has approved a profit equalisation reserve (PER) policy that smooths returns within a 4.5%-6.0% band. Management wants to release 20 million from the PER to top up the IAH distribution toward the benchmark, and also take a 5 million investment risk reserve (IRR) deduction. The auditor questions whether the PER release is permissible given the pool's actual performance and whether the bank's own mudarib share can be used to fund the shortfall.
1. Distinguish the PER and the IRR and assess whether the proposed 20m PER release and 5m IRR deduction are within the AAOIFI framework.
Read the worked answer
PER is an appropriation from profit before allocating the mudarib share, designed to smooth returns to IAH across periods. IRR is an appropriation from the IAH's share of profit after allocation, designed to absorb future investment losses. They are not interchangeable.
Application here:
- Gross profit 90m. A PER appropriation (or release) is applied at the pool level before the 60:40 split.
- The proposed 20m PER release would raise distributable profit from 36m to 56m. That equates to a return of 56/1,200 = 4.67%, which sits inside the approved 4.5%-6.0% band. A release is permissible only if the reserve was built from prior-period profits and the Shari'ah-approved policy permits smoothing within the band. It is, so the release is within framework provided the reserve has at least 20m available.
- The 5m IRR must be deducted from the IAH share (after the split), reducing the IAH distribution, not from the bank's mudarib share. It must be disclosed as a reserve, not income.
The bank must not use its own mudarib share to manufacture the benchmark return; that would breach the profit-sharing contract and the fiduciary duty to IAH. Disclose reserve movements and the policy band.
2. If the PER had only 12m available, how much could be released and what would the resulting IAH return be? Show the reasoning.
Read the worked answer
A PER release cannot exceed the available reserve balance. So maximum release = 12m.
- Distributable profit before PER: 36m
- Add PER release: 12m
- Distributable to IAH: 48m
- Less IRR deduction (from IAH share): (5m)
- Net to IAH: 43m
- Return = 43 / 1,200 = 3.58%
This is below the 4.5% floor of the band. The bank cannot top up further because the reserve is exhausted and it cannot fund the shortfall from its mudarib share. The result is a disclosed shortfall against the benchmark; the bank should explain the reserve depletion and the return actually achieved. This tests that the reserve is a genuine smoothing mechanism constrained by its balance, not a guarantee of benchmark returns.