profit equalization reserve and profit...
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PROFIT EQUALIZATION RESERVE AND PROFIT SHARING INVESTMENT
ACCOUNTS: EMPIRICAL EVIDENCES FROM MALAYSIA
Noor Fadhzana binti Mohd Noor1
Centre of Development and Foundation Studies (CDFS),
University of Selangor (UNISEL)
ABSTRACT
The relationship between profit equalization reserve and profit sharing investment
accounts is generally anticipated since the former is technically created to smooth the
returns to the account holders. This study examines (1) the provisioning of profit
equalization reserve and (2) utilization of the reserve against the profit sharing investment
account of Malaysian Islamic banks. Pooled ordinary least square (OLS) and panel (fixed
effect) models are employed and these result in insignificant association between profit
equalization reserve provision and profit sharing investment account when control for Tier
1 capital and gross domestic product growth. The utilization of profit equalization reserve
has yielded the converse result, where significant relationship between the reserve and
profit sharing investment account can be observed. Thus, these findings suggest that the
provisioning of the reserve is empirically determined by other factors e.g. capital, earnings
or bank specifics and not the profit sharing investment account. But, the utilization of the
reserve is considered effective thus implying the fulfilment of the reserve’s original
function, to minimize the displaced commercial risk embedded in profit sharing investment
accounts in Islamic banks.
Field of Research: Finance, Islamic Banking.
INTRODUCTION
The nature of Islamic bank is unique compared to the conventional system since it adhered
to Islamic principles. According to the principles, Islamic banks cannot rely on fixed rate
of income which normally generated from interest. Therefore, it is vital that they depend
on investment based products namely on the basis of profit sharing (Siddiqui, 2008). With
this, they are exposed to a mixture of risks, such as rate of return risk and displaced
commercial risk (Archer, 2010; Toumi, 2010). In the practice of Islamic banks throughout
the world, they rely on several mechanisms to mitigate risk and their performance are
subject to the managerial discretions. But, most of Islamic banks rely on profit equalization
reserve (per) and investment risk reserve (irr) as mitigation tools to mitigate the risk (IFSB,
2005; Sundararajan, 2005; Sundararajan, 2008; Taktak, 2011; Atmeh, 2012, Sayd, 2012).
As for PER, BNM has issued a guideline on it but the effectiveness of this reserve to
become a displaced commercial risk mitigation tool has yet to be discovered.
LITERATURE REVIEW
In order to overcome the displaced commercial risk in profit sharing investment products,
several methods have been taken by Islamic banks. These methods consist of investing a
1 Lecturer at Centre of Development and Foundation Studies (CDFS), University of Selangor (UNISEL),
Shah Alam Campus, 40000 Shah Alam, Selangor. Currently she is pursuing her PhD (Islamic Banking and
Finance) at IIUM Institute of Islamic Banking and Finance (IIBIF). She can be contacted through
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significant part of unremunerated accounts in assets with certain return and lower risk
(short-term maturity) which generates additional returns for shareholders and provides a
cushion for Islamic banks to facilitate and the variation of the percentage of profit taken by
Islamic banks. Islamic banks may also transfer some proportion of shareholders returns to
investment account depositors (Sundarajan, 2008). The shareholders’ decision to agree,
which is a Shariah condition, to give up part or all of their profits to increase returns to
investment account holders means that the shareholders accept that the risk attaching to the
returns of a portfolio of assets financed partly or wholly by profit sharing investment
accounts is displaced, so that is borne largely by themselves (the Shareholders) (Archer,
2007). Last but not least, is smoothing returns by using a combination of reserves retained
from the profits attributed to both investment account holders and shareholders, is the third
mechanism (Sundararajan, 2008; Archer, 2007; Sundararajan, 2007; Archer, 2006).
Retention of reserves is a common practice of the majority of Islamic banks (Sundarajan,
2008, Archer & Rifaat, 2006). These reserves are called profit equalization reserve (per)
and investment return risk (irr).
Despite that, few studies have emerged recently on displaced commercial risk. In Che
Arshad (2015), DCR was proven to affect the stability of Islamic banks in Malaysia. This
study however relied on Value at Risk in the percentage of total profit sharing investment
account and the difference between investment profit and benchmark profit as in Capital
Asset Pricing Model (capm). Using this formula, however the study did not indicate the
provision of the profit equalization reserve. Even though it was found that displaced
commercial rsik swayed bank’s stability (z-score), the study does not explain the function
of the reserve in details. Che Arshad (2014) also found that displaced commercial risk
arisen in Islamic banks are determined by several factors, beside the dual banking
competitive return rates, and they are the investment account holder fund, total deposit, rate
of return and interest rate. This study used a panel data of 17 banks throughout 1994-2012.
However, the inclusion of reserves, which is technically profit equalization reserve and
investment return risk reserve in the study was not elaborated.
IFSB (2010), described profit equalization reserve as a reserve comprised of amounts
appropriated out of the gross income from the profit sharing investment accounts to be
available for smoothing returns paid to the investment account holders and the
shareholders, and consists of a profit sharing investment account portion and a
shareholder’s portion. According to IFSB 2010, it is created by appropriating to the reserve
amounts out of the profits earned on the commingled pool of assets before the allocation to
shareholders and unrestricted investment account or general investment account
(Mudharabah) holders. The amounts appropriated to the reserve yielded reduced profits
that are available for distribution to both categories of investors – shareholders and
investment account holders. There is also a further effect on the shareholders’ share of
profits, because the reduction in the amount of profit available to the unrestricted
investment account holders also reduces the amount of the return to shareholders or the
bank. The reserve allows Islamic banks to mitigate considerably their exposure to DCR and
related problems of asset–liability management. Theoretically, this reserve belongs to
unrestricted investment account holders and shareholders collectively although the former
has no say in its management and disposition.
While the purpose of this reserve is to enhance the profit payout to unrestricted investment
account holders in periods when the assets in an Islamic bank’s asset pool has
underperformed, where the returns to unrestricted investment account holders may be lower
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for that Islamic bank than for its Islamic and conventional peers, it is also the case that this
reserve can be used for smoothing or enhancing dividend payouts to shareholders if so
desired by the management. It should be noted, however, that while shareholders benefit
from the reserve, it is not clear that investment account holders do so, as they have no
choice as to the amounts of their profits that are withheld, and may not even be aware that
the profit performance of their investment is riskier than is apparent from the (smoothed)
profit payouts.
In the Framework of Rate of Return, (BNM, 2004) the reserve was mentioned as a new
item in the calculation table to standardize the calculation of the return rates by Islamic
banks. In term of its allocation, though there is no specific guideline, it is mostly depended
on discretionary power of the banks. However, the banks are only permitted to allocate
maximum 15% of the gross income plus net trading income, other income and irregular
income on monthly basis. The ceiling amount of the accumulated profit equalization reseve
(per) to be maintained is at 30% of the banks’ shareholders fund. Since the reserve is the
amount appropriated from total gross income shared between the bank and the depositors,
it is therefore classified as liability in the balance sheet and as expense in the banks’
financial income statements. Nevertheless, the collected data of this study revealed that
provision of this reseve is recorded in the banks’ financial statement, where returns of
commingled funds; deposit or investment, mudharabah or non-mudharabah are all subject
to deduction of the reserve’s provision before the returns are available for distribution
between the customers and the bank, in support of (Ramli, 2012).
In 19 May 2011, BNM has issued its revised Guidelines on Profit Equalisation Reserve
(BNM, 2011) to be effective on or after 1 July 2011. Within the revised guideline, four
options were given to Islamic banks in order to manage the displaced commercial risk
namely, (i) proceeding with the practice of profit equalization reserve, or (ii) supporting the
function of profit equalization reserve with investment return risk reserve, or (iii) forgoing
all or part of the Islamic banks’ shares of profit to the investment account holders by way
profit sharing rate variation, or (iv) transferring the Islamic banks’ profits to the investment
account holders by way of hibah (gift). As a result, Islamic banks were given more
alternatives despite the use of the reserve. As a result, changes in the practices of the reserve
may be observed. In addition, in 2013, Islamic Financial Services Act 2013 (IFSA) has
been introduced to replace the two Islamic banking main legislations namely, Islamic
Banking Act and Banking 1983 (IBA) and Financial Institutions Act 1989 (BAFIA) (BNM,
2013). According to the new law, investment account has to be redefined where
transformation of all Mudharabah deposits which principal guaranteed as deposit as a non-
pure investment account. Thus, the function of profit equalization reserve has been
minimised to mitigate the rate of return risk of merely the pure investment account. As a
result, a significant shift of Mudharabah deposits into non-Mudharabah deposits by several
banks can be predicted. With this, significant shift of profit equalization reserve
provisioning and utilization is also expected.
This paper is divided into 6 sections. Following the introduction and literature review,
Section 3 develops the theoretical framework on provisioning and utilization of PER and
its association with profit sharing investment accounts. The subsequent section develops
hypotheses to be tested. Section 4 discusses the data and methodology while Section 5
provides the descriptive statistics as well as regression results. Section 6 concludes the
findings with some suggestion for further related studies.
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THEORETICAL FRAMEWORK
In order to observe the provisioning and utilization of profit equalization reserve (per),
annual financial statements of each bank has been studied. The provisioning of profit
equalization reserve (per) is studied descriptively and empirically. Descriptive analysis
presents the provisions of profit equalization reserve (per) for each financial year, from
2008 to 2014. This provisions later regressed with profit sharing investment account (psia)
for that current year while controlled by Tier 1 capital (capital) and gross domestic product
per capita (gdp). Using pooled ordinary least square (OLS) and fixed effect (FE) models,
this estimation is predicted to prove the determining effect of profit sharing investment
account (psia) on profit equalization reserve (per). In other words, the provision of profit
sharing investment account (psia) is determined by profit sharing investment account
(psia). Later, using the same model, lagged value of profit equalization reserve (per) is
employed since the utilization of previously reported provision of the reserve should be
linked to the current profit sharing investment account. In other words, the reserve
provisioned previous year is considered the utilized provision of the reserve for the current
financial year. This lagged value variable nonetheless has limited the use of Breusch-Pagan
Lagrange test (1979) and is replaced with Breusch-Pagan version for unbalanced data by
(Soca Escudero & Bera, 2008). The same independent variables are employed for this
second equation. The Tier 1 capital (capital) is used as control variable for profit
equalization reserve since Tier 1 capital consists of retained earnings of the bank, inclusive
of the profit equalization reserve. Gross domestic product per capita (gdp) also acted as
control variable since it implicitly express the bank financial stability and the economic
volatility.
Based on the literature review and theoretical framework, the hypotheses are developed as
follows;
𝐻1:
𝐻2:
There is a significant relationship between the provision of profit equalization
reserve (per) and profit sharing investment account.
There is a significant relationship between the utilization of profit equalization
reserve (per) and profit sharing investment account.
DATA AND METHODOLOGY
Sample Selection
Data was collected from annual reports of 16 Islamic banks in Malaysia, both local and
foreign from the year of 2008 to 2014. This is almost the subsequent years as Ramli (2012),
who conducted the study from 2003-2010 on all Malaysian Islamic banks, comprising of
15 banks at that time. The initial dataset is comprised of strongly balanced panel of from
16 Islamic banks for the 7 years’ period but due to unavailability of data on PER, merely
11 Islamic banks are maintained. The final dataset gives a range of 5 variables for 11
Islamic banks in Malaysia for 7 years’ period. The sample has purposively excluded non-
commercial or investment banks operating Islamic banking business in Malaysia.
Estimation Method
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We use Pooled Ordinary Least Square (OLS) and Fixed Effect models to ascertain the
relationship between profit equalization reserve (per) and profit sharing investment account
(psia). The key independent variable is profit sharing investment account (psia) while the
control variables are Tier 1 capital (capital) and gross domestic growth per capita (gdp).
Data on profit equalization reserve (per) in financial reporting of Islamic banks are
considerably adequate. The model to study profit equalization reserve provisioning
behaviours of Islamic banks employs 77 bank-year observations to run the following
regression equation;
𝑝𝑒𝑟𝑖𝑡 𝛽0 + 𝛽1𝑝𝑠𝑖𝑎𝑖𝑡 + 𝛽2𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑡 + 𝛽3𝑔𝑑𝑝 + 𝜀0 (1)
𝑙𝑎𝑔𝑔𝑒𝑑𝑝𝑒𝑟𝑖𝑡−1 𝛽0 + 𝛽1𝑝𝑠𝑖𝑎𝑖𝑡 + 𝛽2𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑡 + 𝛽3𝑔𝑑𝑝 + 𝜀0 (2)
where,
Dependent variable
𝑝𝑒𝑟𝑖𝑡 Profit equalization reserve of bank i at year t normalized by total
asset.
𝑙𝑎𝑔𝑔𝑒𝑑𝑝𝑒𝑟𝑖𝑡−1 Lagged value of profit equalization reserve. Previous amount of
profit equalization reserve is used for the current financial year and
considered the amount of utilized per.
Independent variables
𝑝𝑠𝑖𝑎𝑖𝑡 Total profit sharing investment account of bank i at year t normalized
by total asset.
𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑡 Tier I capital of bank i at year t normalized by total asset.
gdp Gross domestic product per capita
𝜀0 Error term
Empirical Findings
Descriptive Analysis
From the original data consisting of 11 Islamic banks of the period of 2008-2014, the
provisioning of profit equalization reserve (per) ranges from 0 to 1.7% of the total asset of
the bank i at year t. The average provisions by banks by year ranges from 0.003% to 0.3%
of the banks’ total asset.
Table 0.1: Summary of PER of 11 Islamic banks (by year)
Year N Mean sd min max skewness Kurtosis
2008 11 0.289608 0.499229 0 1.74393 2.519989 7.964534
2009 11 0.240235 0.436907 0 1.50199 2.463929 7.693738
2010 11 0.11799 0.288897 0 0.97589 2.697364 8.574776
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2011 11 0.052243 0.066526 0 0.20969 1.301688 3.801192
2012 11 0.011404 0.01845 0 0.05982 1.833771 5.386532
2013 11 0.004481 0.008902 0 0.02901 2.129178 6.409321
2014 11 0.002855 0.009176 0 0.03051 2.841702 9.085024
Total 77 0.102688 0.285976 0 1.74393 4.449596 23.32329
Table 0.2: Summary of PER of 11 Islamic banks (by bank)
id N Mean sd min max skewness Kurtosis
1 7 1.43E-06 2.44E-06 0 5.00E-06 0.948683 1.9
3 7 0.612404 0.777666 0 1.74393 0.515874 1.485823
5 7 0.137496 0.152468 0.01488 0.43971 1.188638 3.195467
6 7 0.05386 0.092694 0 0.20835 0.998916 2.068793
8 7 0.009386 0.009776 0 0.02412 0.579348 1.763712
9 7 0.065579 0.060383 0 0.1398 0.120028 1.343079
11 7 0.070369 0.083302 0 0.22941 1.006564 2.864726
13 7 0.085501 0.165133 0 0.43282 1.57064 3.885867
14 7 0.058063 0.084588 0 0.20942 0.981023 2.337643
15 7 0.01108 0.011412 0 0.02832 0.396005 1.692419
16 7 0.025827 0.046178 0 0.12567 1.695036 4.326038
Total 77 0.102688 0.285976 0 1.74393 4.449596 23.32329
Figure 0.3: Provision of PER by Islamic Banks (Overlay)
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Figure 0.4: Provision of PER by Islamic banks (Individual bank)
Figure 1.3.1 shows the overall provisions of profit equalization reserve (per) by all Islamic
banks. Although the provisions are small, we can still observe descending trend of the
provisions from 2011 onwards. On the other hand, Figure 1.3.2 exhibits the provisions of
0.5
11
.52
0.5
11
.52
0.5
11
.52
2008 2010 2012 2014
2008 2010 2012 2014 2008 2010 2012 2014 2008 2010 2012 2014
1 3 5 6
8 9 11 13
14 15 16
PE
RO
RI
YEARGraphs by ID
0
.5
1
1.5
2
PE
RO
RI
2008 2010 2012 2014 YEAR
id = 1 id = 3
id = 5 id = 6
id = 8 id = 9
id = 11 id = 13
id = 14 id = 15
id = 16
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PER by individual Islamic bank in 2008 to 2014. From the graphs, it shows that the
provisioning of profit equalization reserve (per) is very small compared to total asset of
each bank and the different provisions of profit equalization reserve (per) by year also do
not indicate significant gap, except for bank id3.
To further explore on the utilization of profit equalization reserve (per), five Islamic banks
have been excluded due to their policy of stopping the practice of PER. The summary of
the data to be employed are presented below.
Table 0.5: Summary of all Variables.
Variable Obs Mean Std. Dev. Min Max
per --. 77 0.102688 0.285976 0 1.74393
L1. 66 0.119327 0.30601 0 1.74393
psia 77 20.12021 17.46794 0 68.6379
capital 77 8.538268 4.357873 3.780931 31.28213
gdp 77 280.2743 47.89491 202.26 338.1
Table 1.3.5 displays the descriptive statistics for the dependent variable of 11 Islamic banks
in Malaysia, from 2008-2014. The mean and standard deviation of profit equalization
reserve (per) is 0.10% and 0.29% per cent respectively. This proves that Islamic banks in
the sample provides 0.10% of profit equalization reserve (per) to total asset. This is
somehow slightly different with the findings of (Ramli, 2012) who found the provision of
profit equalization reserve (per) at mean value of -0.01% and the standard deviation is
0.28%. This may be due to the difference in measuring the value of profit equalization
reserve (per) since the study used the balance amount of total income minus the loan loss
provision (llp) and loan loss investment (lli). On the other hand, this study employed the
exact reported amout of profit equalization reserve (per) from the financial reports. Form
the table above, it is evident that the provision of profit equalization reserve (per) is in
compliance with the restrictions provided by BNM, on the ceiling amount of the reserve
over the total gross income (monthly basis) and the accumulated portions of shareholder
funds, 15% and 30% respectively (BNM 2011, Nu Nu Htay, 2013; Mehmet, 2013). Lagged
value profit equalization reserve (per) reports the mean of 0.1% and standiard deviation of
0.3% for the remaining 66 observations. Profit sharing investment account (psia) yields the
mean value of 20% and standard deviation of 27%. The mean and standard deviation of
Tier 1 capital is consistent with the previous study data (Ramli, 2012) at 8.5% and 4.4% to
the total asset accordingly. The mean and standard deviation values of gross domestic
product is 280% and 48% respectively.
The correlational matrix of each dependant variables are presented below.
Table 0.6: Correlational Matrix for all Variables
perori perori psia capital gdp
perori --. 1 L1. 0.8758 1
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psia 0.3638 0.426 1 capital 0.0245 -0.0283 -0.1778 1 gdp -0.3793 -0.3531 -0.2765 -0.13 1
Table 1.3.6 evidences the correlation matrix for all the variables. A total of 66 observations
were available for this test (11 Islamic banks for 6 years). All tests were checked for
significance collinearity by reviewing the variance inflation factor (vif) for each variable.
The correlation coefficients among the independent variables are low (less than 0.80)
suggesting the absence of multicollinearity problems, except for lagged value of profit
equalization reserve (per). Still, this two dependant variables are analysed in separate
regressions. Also, for each regression conducted, the variance inflation factor (vif) indicates
value below 4.0, again to strengthen the absence of multicollinearity.
Regression Analysis
𝐻1: There is a significant relationship between provision of profit equalization reserve (per)
and profit sharing investment account (psia).
This study predicts a positive relationship between provision of profit equalization reserve
(per) and profit sharing investment account (psia). This is derived from the assumption that
the provision of profit equalization reserve (per) should corresponds to profit sharing
investment account (psia) as the beginning of financial year should reports the amount of
the reserve which is perceived to be adequate to mitigate the displaced commercial risk
embedded profit sharing investment account (psia).
Table 1.4.1. Provision of per and psia.
OLS FE OLS Robust S.d.
per Per per
psia 0.00396* 0.00112 0.00112
(2.31) (0.48) (0.52)
capital 0.0251*** 0.0392*** 0.0392**
(3.76) (4.72) (3.20)
gdp -0.00135* -0.00143* -0.00143
(-2.14) (-2.58) (-1.83)
_cons 0.187 0.146 0.146
(0.88) (0.68) (0.87)
N 77 77 77
t statistics in parentheses ="* p<0.05 ** p<0.01 *** p<0.001"
There is a significant positive relationship between the provision of profit equalization
reserve (per) and profit sharing investment account (psia) at 5%. The control variables also
indicate positive significant values between capital and profit equalization reserve (per).
The gross domestic product per capita (gdp) also as assumed shows a significant negative
association with profit equalization reserve (per). However, using the Fixed Effect (FE)
model, there is no association observed between provision of profit equalization reserve
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(per) and profit sharing investment account (psia). The Breusch-Pagan Lagrange test for
heterogeneity has been conducted and the null hypothesis is rejected at 0.000, but still the
significant relationship cannot be observed as well as when using the robust standard
deviation model. Among the underlying reasons of insignificant result if FE model
compared to OLS is the efficiency and consistency of the estimators. In FE model, the
unobserved heterogeneity is treated using the difference between the actual data and the
average data across time for each variable (within estimators) (Baltagi, 2013). As a result,
FE model yields better fitted line for the all data individually. Hausman (1978) test also
indicate that the FE estimates is more efficient. With this, we reject the null hypothesis that
there is no significant relationship between the provision of profit equalization reserve (per)
and profit sharing investment account (psia).
𝐻2: There is a significant relationship between the utilization of profit equalization reserve
(per) and profit sharing investment account (psia).
Using the lagged value of profit equalization reserve (per) and current reported amount of
profit sharing investment account (psia), we conduct both ordinary least square (OLS) and
Fixed Effect (FE) models to determine the effect of the latter to the former.
Table 1.4.2. Utilization of per and psia
OLS FE Robust S.d.
laggedper Laggedper Laggedper
psia 0.00778** 0.00968** 0.00541*
(2.96) (2.97) (2.48)
capital -0.0104 -0.0317 0.516**
(-0.69) (-1.42) (3.09)
gdp -0.00162* -0.00163* -0.00183**
(-2.51) (-2.41) (-3.14)
_cons 0.525 0.665* 0.00390
(1.90) (2.08) (0.36)
N 66 66 66
t statistics in parentheses ="* p<0.05 ** p<0.01 *** p<0.001"
As predicted, there is a significant positive relationship between the utilization of profit
equalization reserve (per) and profit sharing investment account (psia). The utilized profit
equalization reserve (per) of previous year corresponds to the current reported amount of
profit sharing investment account (psia) at 1% significance. Both models yield the same
result. The Fixed Model (FE) has been applied since the unbalanced data version of
Breusch-Pagan Lagrange for unbalanced data test rejected the null hypothesis. Comparing
the p-value of the adjusted and unadjusted statistics as in (Soca Escudero & Bera, 2007;
2008), the misspecification is due to serial correlation and not the random effect, since the
dependant variable is a lagged variable. In addition, the heteroscedasticity problem has also
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been removed by modifying the data and using the robust regression on the modified data
(White, 1980; Verardi, 2009). The results are presented above. The significant relationship
between the utilization of profit equalization reserve (per) and profit sharing investment
account (psia) can still be observed at 5% confidence thus accepting the null hypothesis.
SUMMARY
The relationship between profit equalization reserve and profit sharing investment accounts
is generally anticipated since the former is technically created to smooth the returns to the
account holders. This study examines (1) the provisioning of profit equalization reserve
and (2) utilization of the reserve against the profit sharing investment account of Malaysian
Islamic banks. Pooled ordinary least square (OLS) and panel (fixed effect) models are
employed and these result in insignificant association between profit equalization reserve
provision and profit sharing investment account when control for Tier 1 capital and gross
domestic product growth. The utilization of profit equalization reserve has yielded the
converse result, where significant relationship between the reserve and profit sharing
investment account can be observed. Thus, these findings suggest that the provisioning of
the reserve is empirically determined by other factors e.g. capital, earnings or bank specifics
and not the profit sharing investment account. Still, the utilization of the reserve is
considered effective thus implying the fulfilment of the reserve’s original function, to
minimize the displaced commercial risk embedded in profit sharing investment accounts in
Islamic banks.
ACKNOWLEDGEMENT
Financial support is acknowledged from Ministry of Education (MoE) Malaysia under the
Exploratory Research Grant Scheme (ERGS) (ERGS/1/2013/SS05/UNISEL/03/01). We
also acknowledge the support of our home institution, University of Selangor (UNISEL)
and Business, Research Linkages and Consultancy (BRIC) particularly.
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