Smoothing Returns With Reserves
Baraka Bank has USD 500 million in unrestricted mudaraba investment accounts, USD 100 million in current accounts and USD 50 million of shareholders’ equity. For the year it earns USD 45 million from financing and investments. The mudaraba contract gives investment account holders (IAH) 80% of profit and the bank 20% as mudarib. The bank has a profit equalisation reserve (PER) of USD 8 million and an investment risk reserve (IRR) of USD 3 million. Treasury proposes to (i) pay current account holders a 2% gift from the IAH profit share; (ii) transfer USD 5 million from the IAH share to the PER to keep the published return stable; and (iii) use USD 2 million of the IRR to cover a loss on one defaulted murabaha. The Sharia board’s approved policy caps PER transfers at 10% of IAH profit and prohibits use of the IRR for expected losses. Last year’s published return was 4.2%.
1. Calculate the profit allocation before and after the proposed transfers, and assess whether each proposal is permissible.
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Profit before distributions is USD 45 million. Under the 80:20 sharing, the IAH share is USD 36 million and the bank’s share is USD 9 million. Current accounts are qard and have no contractual right to profit; a 2% gift on USD 100 million is USD 2 million and must be paid from the bank’s USD 9 million share, leaving USD 7 million, and must be disclosed as discretionary, not a return. The PER transfer of USD 5 million is 13.9% of the IAH share and breaches the 10% cap; the maximum is USD 3.6 million. The transfer must follow the approved policy and cannot be used to create an impression of guaranteed returns. The IRR of USD 2 million cannot be used for the defaulted murabaha because the policy prohibits it for expected losses; the default is an identified credit event, so provision against the financing and recognise impairment. After allowed adjustments, the IAH share is USD 36 million minus USD 3.6 million, or USD 32.4 million; the bank share remains USD 9 million, or USD 7 million if the gift is paid. The final return to IAH depends on the PER balance and must be disclosed.
2. Explain the governance and disclosure requirements for the PER and IRR, and how the bank should communicate with IAH.
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The Sharia board must approve the PER and IRR policies, caps and uses; the board risk committee should monitor them; treasury cannot act unilaterally. Disclosure should explain the PER and IRR balances, movements, ownership, the smoothing policy and the effect on returns. The reserves belong to IAH, not shareholders, and should not be presented as bank equity. The bank must avoid language that promises a stable return. If the bank uses its own funds to support returns, that is a gift and must be disclosed and approved. The published 4.2% return should be corrected if the prior calculation used a transfer above the cap. Communication to IAH should be in plain language and should include the risk of loss.
3. If the bank suffers a loss next year, how should it be allocated among IAH, current account holders, reserves and shareholders?
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IAH bear losses on their share of the pool unless the bank was negligent or breached the contract. The bank as mudarib loses its share of profit and its effort, but not the IAH capital. Current account holders are not exposed because their deposits are qard. The PER can be used to smooth returns but not to absorb a loss that should be recognised; the IRR can absorb unexpected losses subject to policy and Sharia approval, but not expected ones. If the loss exceeds the reserves, the IAH return is reduced or capital is impaired, and the bank must disclose this. The bank cannot use shareholders’ funds to guarantee the loss without a clear, approved and disclosed policy.