Justifying the Need for Smoothing Tools by Islamic Banks

el Barka: Journal of Islamic Economic and Business Vol. DOI p-ISSN e-ISSN : 4 (1), 2021, 18 - 41 : 10.21154/elbarka.v4i1.2446 : 2657-1153 : 2657-1862 JUSTIFYING THE NEED FOR SMOOTHING TOOLS BY ISLAMIC FINANCIAL INSTITUTIONS Mohammad Bilal Khan, Seedy Conteh, Shaiq Ahmad Ghafoorzai, Mohammed Meeran Jasir Mohtesham, Abdul Hai International Institute of Islamic Banking and Finance (IIiBF) Malaysia , , , , Abstract: This paper focuses on the positive impacts of using smoothing tools such as Profit Equalisation Reserve or PER and Investment Risk Reserve or IRR to smoothen the rate of return or profit on investments to investment account holders (IAH) of Islamic financial institutions (IFIs). Since the goal of introducing PER and IRR into Islamic banks is to compete with the conventional banking industry, it is a shield used by Islamic banks to protect their risks such as displaced commercial risk (DCR), withdrawal risk (WR), and reputation risk. This is a qualitative review of the positive impacts of using smoothing tools in Islamic financial institutions. One of the major issues highlighted is Islamic banks' sensitivity to the conventional interest rate changes because many Islamic banking products are benchmarked against the conventional interest rate. Moreover, the limited techniques and instruments available to mitigate the rate of return risk also need the regulators' serious attention. Before the use of smoothing, tools were restricted by BNM, Islamic banks were allowed to save up until 15% from profit gain. However, in certain circumstances, BNM has allowed IB's to save up to 30% from profit gains. Hence, smoothing tools like PER and IRR enabled Islamic banks to be competitive and manage their unique risks. This research is focused on the positive aspects of using smoothing tools (STs) and does not cover the negative aspects from the Shari'ah, legal or Volume 4, No. 1 Januari - Juni 2021 18 Justifying the Need for Smoothing Tools by Islamic Financial Institutions corporate governance point of view. Since the abandonment of smoothing tools by IFI's after the instructions of Bank Negara Malaysia (BNM) in 2014, there has not been much debate about the benefits of using STs. Therefore, this paper might provide a spark required to reignite the whole debate once again. Keywords: Smoothing Tools; Islamic Investment Account; Profit Equalization Reserve (PER); Investment Risk Reserve (IRR) Abstrak: Penelitian ini fokus pada dampak positif dari penggunaan alat penstabil seperti Profit Equalization Reserve (PER) dan Investment Risk Reserve (IRR) untuk memperlancar tingkat pengembalian atau keuntungan investasi kepada investment account holders (IAH) dari Islamic financial institutions (IFIs). Karena tujuan memperkenalkan PER dan IRR ke bank syariah adalah untuk bersaing dengan industri perbankan konvensional, itu adalah perisai yang digunakan oleh bank syariah untuk melindungi risiko mereka seperti displaced commercial risk (DCR), withdrawal risk (WR), dan reputation risk. Penelitian Ini menggunakan tinjauan kualitatif tentang dampak positif penggunaan alat penstabil di lembaga keuangan Islam. Salah satu isu utama yang disoroti adalah sensitivitas bank syariah terhadap perubahan suku bunga konvensional karena banyak produk perbankan syariah yang dibandingkan dengan suku bunga konvensional. Selain itu, keterbatasan teknik dan instrumen yang tersedia untuk memitigasi risiko tingkat pengembalian juga perlu mendapat perhatian serius dari regulator. Sebelum penggunaan alat penstabil dibatasi oleh BNM, bank syariah diperbolehkan menabung hingga 15% dari perolehan keuntungan. Namun, dalam keadaan tertentu, BNM mengizinkan IB untuk menghemat hingga 30% dari perolehan keuntungan. Oleh karena itu, alat penstabil seperti PER dan IRR memungkinkan bank syariah menjadi kompetitif dan mengelola risiko unik mereka. Penelitian ini difokuskan pada aspek positif dari penggunaan smoothing tools (STs) dan tidak mencakup aspek negatif dari sudut pandang syari'ah, hukum atau tata kelola perusahaan. Sejak ditinggalkannya alat pemulusan oleh IFI setelah instruksi Bank Negara Malaysia (BNM) pada tahun 2014, tidak banyak perdebatan tentang manfaat penggunaan STs. Oleh karena itu, tulisan ini bisa memberikan masukan yang penting dalam menanggapi isu yang sedang diperbincangkan. Volume 4, No. 1 Januari - Juni 2021 19 Mohammad Bilal Khan & Firends INTRODUCTION Islamic banks typically operate in a dual banking system where conventional banking has existed for many years. While conventional banks are leading the market and can easily offer products with a fixed rate of return, Islamic banks, on the other hand, are deterred from acting the same way as their counterparts and are encouraged to offer products with profit and loss sharing principles. Therefore, it is difficult for Islamic banks to compete with their counterparts and become exposed to several risks. One of the many risks is displaced commercial risk (DCR), leading to the withdrawal risk and liquidity risk (Faouzi M.H, 2013). For instance, this risk may emerge when returns from Investment Account Holders (IAHs) fund are lower than the market rate of return. In this scenario, IAH may withdraw his funds from the bank's Investment account on short notice and place them with other conventional or Islamic banks. This withdrawal risk consequently affects the bank's liquidity position and expose it to the liquidity risk. As these risks can reach systemic proportions and can put barriers for Islamic banks in competing with conventional banks, some Islamic institutions such as Accounting and Auditing Organization for Islamic Financial Institutions (AAIOFI), Islamic Financial Services Board (IFSB), and Bank Negara Malaysia (BNM) advised Islamic banks to use smoothing tools, such as Profit Equalization Reserve (PER) and Investment Risk Reserve (IRR). They also point out that the primary role of these reserves is to mitigate volatility in rates of return and reduce the risk of paying dividends in times when actual profits are lesser than expected (Salman S. & Htay, 2013). Due to the fluctuations in the rate of return and risks associated 20 el Barka: Journal of Islamic Economics and Business Justifying the Need for Smoothing Tools by Islamic Financial Institutions to Islamic banks and investment account holders, BNM introduced the guidelines for these two reserves in 2004 that Islamic banks are allowed to save up to 15% from profit gain. However, in certain circumstances, BNM has allowed save up amount to be up to 30% (Bank Negara Malaysia, 2010). This practice was common before the Bank Negara Malaysia (BNM) made amendments in the Islamic Financial Services Act (IFSA) in 2013, post which the use of PER and IRR has been completely discontinued. Bank Negara Malaysia (BNM), in its guidelines on Islamic investment account dated 14th March 2014, directed Islamic banks (IBs) not to use the profit smoothing tools or Displaced Commercial Risk (DCR) te (...truncated)