Malaysia Guidelines on Credit Transactions and Exposures with Connected Parties for Islamic Banks – An Overview and Summary of Requirements

• By: Staff Editor
• Date: May 20, 2013

• General Investment Account (GIA), an unrestricted investment account. Islamic banking institutions have full discretion to utilize the funds from GIA for the provision of finance and/or investments.
• Specific Investment Account (SIA), a restricted investment account. The financing and/or investment activities funded by SIA are confined to the investment mandate agreed between Islamic banking institutions and the IAH.

• Sound governance in the management of assets and risks associated with the PSIA
• Clear, comprehensive and enforceable PSIA contract stipulating the right and liabilities of the IAH and the Islamic banking institutions
• Strong management and information system to enable Islamic banking institutions to undertake diligent management of assets
• Disclosure of information to enable the IAH to make informed investment decisions.

• Islamic banking institutions forgo a proportion of their income assets funded by the PSIA and apportion its share to the IAH as part of smoothening returns and to mitigate potential withdrawal of funds by depositors. This act is known as Displaced Commercial Risks (DCR).   
• The mechanism to operationalize this act is known as Profit Equalization Reserve (PER).
• Islamic banking institutions should allocate adequate capital to cover credit and market risks exposures arising from the assets funded by the PSIA. This measurement of additional risk borne by the Islamic banking institutions arising from the application of DCR is represented by alpha (α), which quantifies the risk to be absorbed by the Islamic banking institutions for the purpose of the RWCR calculation.

• Islamic banking institutions should ensure that the terms and conditions of mudharabah contract between Islamic banking institution and IAH must be in accordance with Shariah principles and relevant laws, regulations and contracts governing the product.
• Islamic banking institutions should ensure that prohibited and imprudent activities are not undertaken in breach of the terms and conditions of the contract.
• Islamic banking institutions should disclose relevant details to the contracted parties such as the type, purpose, terms or period of the contract and profit sharing ratio agreed by the contracted parties
• Islamic banking institutions should obtain the consent of the IAH on the practice of smoothening IAH income.

• Islamic banking institutions have a fiduciary duty under the PSIA contract to safeguard the rights and interests of the IAH.
• Board of directors and senior management should provide sound oversight function to ensure that PSIA deposits are managed in the best interest of the IAH.
• The role and responsibilities of the Board in the management of the PSIA are as follows:

1. Approve and review the policies and strategies of the PSIA investments.
2. Perform oversight function on the management of the PSIA.
3. Establish effective governance infrastructure to facilitate effective monitoring and control of PSIA.
4. Approve policies on disclosure of information to IAH.

• The role and responsibilities of the senior management in the management of the PSIA are as follows:

1. Formulate and implement sound investment strategies, internal control and risk management system to safeguard the rights and interests of the IAH.
2. Establish and implement policy on DCR and monitor performance of assets funded by PSIA vis-à-vis IAH’s risk tolerance.
3. Ensure staff with the right skill set to manage the PSIA.
4. Disclose relevant information to assist IAH to make informed decision.

• Islamic banking institutions should ensure that the PSIA contract is comprehensive and enforceable.
• Islamic banking institutions should ensure that the IAH are fully aware and agree to the terms and conditions stipulated under the PSIA contract.
• The PSIA contracts’ terms and conditions should be transparent, concise and easy to understand.
• The following conditions should be explicitly disclosed in the PSIA contract:

1. The rights and liabilities of both parties, particularly, the circumstances where losses are to be borne by the IAH, the implication on the IAH’s contractual rights in case of the early withdrawal and early redemption
2. The accountability and responsibility of the Islamic banking institutions to disclose accurate, relevant and timely information to the IAH on the investment of the PSIA.

• Specific identification including tagging of assets should be established to clearly identify the sources of funding that belongs to GIA, SIA, shareholders fund and other funds.
• The tagging mechanism should enable Islamic banking institutions to differentiate the various assets funded by PSIA and other funding sources.
• The tagging mechanism should enable Islamic banking institutions to provide accurate allocation of income, expenses, profit and loss distribution to the respective fund providers.
• The identification of assets funded by PSIA funds should be based on either of following:

1. Proportionate tagging where Islamic banking institutions can utilize the funds from the general pool but should be able to ascertain the proportion of assets funded by the respective funding sources.
2. Matched tagging where the funds in the general and PSIA pools should be specifically identified.

• Islamic banking institutions should disclose the following information:

1. Policies governing the management of the PSIA funds.
2. Methodology in calculating profit attributable for distribution to the IAH and the policy on reserve management.
3. Types of financing and/or investment under the assets portfolio for each PSIA funds
4. The amount of Profit Equalization Reserve (PER) provided and the amount of PER being written back during the period by types of PSIA and by shareholders’ portion and depositors’ portion of PER.
5. Risks profile and investment strategy of the assets portfolio.
6. Historical performance on PSIA investment returns.
7. Mechanism for the valuation of underlying assets of PSIA.

• The information disclosed should enable the IAH to assess the risks and return profile of the PSIA asset portfolio. It should also provide the IAH with ample information to monitor the performance of the PSIA funds.

• Islamic banking institutions should ensure Standardized Measurement of Risk Absorbent, that is, they should:
  • Exclude the credit and market risk weighted assets funded by the Specific Investment Account (SIA) from the calculation of RWCR.
  • Not exclude credit and market risk weighted assets funded by the General Investment Account from the calculation of RWCR.
  • Exclude the credit and market risk weighted assets funded by the shareholders’ portion of PER.
• Islamic banking institutions should maintain sufficient data related to rate of return and DCR application for quantifying the risks to be borne by the GIA in the future.

Additional Resources

To read the guidelines in full, click here.