A profit equalisation reserve (PER) is a reserve that an Islamic bank builds by appropriating part of the income earned on funds invested for its profit-sharing depositors, before that income is divided between the depositors and the bank. In periods when investment returns are low, the bank releases amounts from the reserve to top up the profit distributed, so that the rate depositors receive stays close to what they expect and to what competitors, including conventional banks, are paying.
The reserve exists because of the way deposits work in Islamic banking. Savings and term accounts are commonly structured as mudarabah, a partnership in which the customer provides capital and the bank manages it for an agreed share of profit. The customer is entitled to a share of whatever is earned and bears any loss; the bank may not promise a fixed return. The PER is a tool for managing the commercial consequences of that arrangement.
The problem it addresses
In principle, returns on profit-sharing investment accounts should rise and fall with the performance of the underlying assets. In practice, account holders compare their returns with market rates. If an Islamic bank pays noticeably less than its rivals, customers may withdraw their funds, even though the contract entitles them to no more than the actual profit. The risk that a bank will feel obliged to pay more than the assets have earned, at the expense of its own shareholders, in order to prevent such withdrawals is known as displaced commercial risk.
A bank without reserves can respond only by giving up part or all of its own share of profit as manager, or by making a gift to account holders from shareholders' funds.
How the reserve works
The appropriation is made out of gross income from the pool of assets financed by the investment accounts, before the bank's share as mudarib is deducted. Both parties therefore contribute in proportion to their profit shares, and the reserve belongs partly to the account holders and partly to the bank's shareholders. The contract governing the account must disclose that the bank may make such appropriations and must obtain the customer's consent, normally in the account terms.
When returns in a later period fall short of the target, the bank transfers an amount back from the reserve into distributable income. The decision on how much to set aside or release is made by management under a policy approved by the board and reviewed by the bank's Sharia supervisory board.
Comparison with the investment risk reserve
The PER is usually discussed together with the investment risk reserve. The two differ in source and purpose:
- Profit equalisation reserve. It is taken from income before the bank's share is deducted, belongs to both account holders and shareholders, and is used to smooth the rate of profit paid.
- Investment risk reserve. It is taken from the account holders' share of income after the bank's share has been deducted, belongs entirely to account holders, and is used to absorb losses on the invested assets that would otherwise reduce their capital.
Smoothing of profit rates can use both, since the PER cannot be used to cover an outright loss of capital, which under the mudarabah contract falls on the account holders unless the bank has been negligent.
Regulatory and accounting treatment
The Islamic Financial Services Board has issued guidance on smoothing practices and on how displaced commercial risk should be reflected in capital. Under its capital adequacy standard, assets funded by profit-sharing investment accounts are in principle excluded from the bank's risk-weighted assets, because account holders bear the risk. Supervisors may, however, require a proportion of those assets, set by a factor commonly called alpha, to be included, reflecting the degree to which the bank in practice supports returns. The existence and size of reserves is one of the considerations in setting that factor.
Accounting standards issued by AAOIFI require the reserves to be disclosed, including the basis for appropriations, movements during the period and the balances attributable to account holders. Banks reporting under international standards must decide how the account holders' portion is presented, which is generally as a liability or as part of the equity of investment account holders rather than as shareholders' equity.
Criticism
The reserve is contested on several grounds. The first is fairness between generations of account holders. A customer who contributes to the reserve and then closes the account generally has no claim on it, so the benefit passes to later customers, and in most contracts the departing customer is treated as having waived the right. The second is transparency: account holders rarely know how much has been withheld from their returns or how release decisions are made, and they have no vote in the bank's governance.
The third is conceptual. Smoothing makes a profit-sharing account behave like a conventional interest-bearing deposit, which critics see as weakening the risk-sharing principle of Islamic finance and blurring the distinction between an unrestricted investment account and a deposit. Supporters reply that stable returns are needed to avoid destabilising withdrawals. The adequacy of disclosure and of the governing policy is typically examined in the bank's Shariah audit and as part of managing Sharia non-compliance risk.