Measurement of the displaced commercial risk in Islamic banks

The objective of the research is to quantify the displaced commercial risk (DCR) based on quantitative finance techniques. We develop an internal model based on the Value-at-risk (VaR) measure of risk to assess the DCR-VaR and the alpha coefficient $\alpha_{CAR}$ in the capital adequacy ratio of Islamic banks. We identify first the scenarios of exposure of Islamic banks to DCR that depend on the actual return on unrestricted profit sharing investment accounts (PSIAU), the benchmark return as well as the level of the existing profit equalization reserve (PER) and investment risk reserve (IRR). Second, we quantify the DCR-VaR and the alpha coefficient $\alpha_{CAR−VaR}$ for a given holding period and for given confidence level. We illustrate the DCR-VaR model on selected Islamic banks from Bahrain. Our model helps to better assess the needed equity to cover the DCR and an accurate capital adequacy ratio for Islamic banks. The model has also policy implications for regulators and the IFSB to develop better guidance on good practices in managing this risk.