Do Malaysian Islamic Banks Manage Earnings Through Profit Equalisation Reserve?

The Islamic banking system has evolved globally at a rapid rate. The growing significance of the Islamic banking industry requires the development of an effective regulatory framework to provide an enabling environment to support the development of the industry. Malaysian Islamic banks have introduced another new mechanism for distributing profit for mudharabah investment. Known as the Profit Equalisation Reserve (PER), the PER was introduced to stabilise the rate of return (RoR) paid to the depositors. This practice is carried out for the purpose of income smoothing. The paper seeks to examine the provisioning behaviour of PER which reflects earnings and capital management of Islamic banks. It first focuses on detecting income smoothing practices, then it seeks to test whether PER is used for capital management purposes. Therefore, a simple conceptual framework of PER and how the reserve should vary over time will be explained. This study used a sample of two full-fledged Islamic banks and thirteen Islamic banking windows and covers the period from 2003 to 2010. The study shows that total capital before provision (TCABP) significantly affects PER and supports the hypothesis of capital management. The findings from this study will benefit the growing Malaysian Islamic finance industry which requires the development of an effective regulatory framework on best practices such as earning and capital management to provide the enabling environment to support the expansion of the industry. In addition, the findings are likely to catalyse innovative improvement towards strengthening the current Rate of Return Framework issued by Bank Negara Malaysia (BNM) and Islamic Financial Services Board (IFSB).