05 Islamic Banking - Deposits

8/10/2019 05 Islamic Banking - Deposits

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Islamic Banking Deposits

(Sources of Funds)

ISF 1101 Foundation of Islamic Finance


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Presentation Outline

WadiahDeposit Products

Mudarabah-based Deposit Products Profit/HibahComputation

Negotiable Islamic Debt Certificate (NIDC)

Commodity MurabahahDeposit

Structured Deposit Product Other Deposit Product Structures

Issues in Deposit Products Unsuitability of the WadiahContract

Displaced Commercial Risk and Income Smoothing Guarantee of MudarabahInvestment Accounts

Implications of Capital Adequacy

Quasi-guarantee by bank-mudarib


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RecapFinancial Intermediation

BankSurplus Units Deficit Units

Banks Liabilities Banks Assets

Financing

Sources of funds

Deposits

Denotes flow of funds

Note that deposits are not the only source of funds for a bankSome banks also access the money market for funding (essentiallyshort-term borrowings from other banks, investors, the government


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Common Deposit Products and ShariahConcept Used

Deposit Type ShariahConcept Used

DemandDeposit

Current Account Wadiah

Qard

Savings Account Wadiah

Mudarabah

TimeDeposit

Variable-rate InvestmentAccount

Mudarabah, Wakalah

Fixed-rate Investment

Product

Bay al-inah, BBA,

Murabahah, Tawarruq

Negotiable Deposit

Instrument

Bay al-Dayn


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The WadiahContract

Literal meaning

Leave, that is, the thing left with a person (not the owner)for the purpose of safe-keeping

Legal definition

The authorization of a person to keep the property of

another in his safe custodyby explicit or implicit terms Legal basis

and if one of you deposits a thing on trust with another, let

the trustee (faithfully) discharge his trust, and let him fear

his Lord [Al-Baqarah:283]


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WadiahDeposit Products

In contemporary Islamic banking, the contract of wadiah is combined with the

contract of guarantee (dhaman) to emulate the functionality of the

conventional savings and current accounts

Such a modification in the use of the wadiahcontract has been commonly

known as wadiah yad dhamanah

Its use is common in South East Asian countries

Salient features of its application as a deposit instrument The bank guaranteesdeposited monies

Depositor can withdraw monies at any time

The bank can use the deposited monies to generate profit

Depositor is not entitled to profits generated by the bank

The bank typically gives a returnto the depositor in the form of

discretionaryand voluntary hibah(gift)

Usually applicable to savings account only

Bank is allowed is charge a fee for custodianship

Usually applicable to current account only


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The MudarabahContract

An arrangement whereby the owner of some property (rabbal mal) gives

a specified amount of capital to another person (mudarib) who is to act

as the entrepreneur to trade with the capital

Profitof the venture will be sharedbetween the two parties according to

a mutually agreed ratio

Profit sharing cannot be a fixed amount or a fixed percentage of

capital contribution

Profit sharing must be a percentage of the profit

Losseswill be borne bythe rabbal malas the financier

The mudaribbears the frustration of fruitless effort

Types of mudarabah

Unlimited mandate (mudarabah mutlaqah)

Limited mandate (mudarabah muqayyadah)


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Mudarabah-based Deposit Products

One contemporary application of mudarabahin Islamic banking

is in structuring a variable-rate deposit

Salient features

Contractually the deposited amount is not guaranteed by the

bank (no capital protection)

Theoretically, in the event of losses, the entirety of any

diminution in value would be borne by the depositor

Rate of returnis not pre-fixed(ex-ante) but only indicative

rates (typically based on historical rates of return) are given

Actual rate of return is only calculated and distributed at the

end of investment period (ex-post), which may or may not

differ from indicative rates


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Mudarabah-based Deposit Products (continued)

Using the concept of mudarabah, both demand deposits and time deposits can be

structured

Savings Account (demand deposit)

Return to depositor given on the basis of balance held in account calculated at

intervals

Mudarabahinvestment account (time deposit)

Requires commitment of deposit for specified time periods (for e.g., 3, 6, 9, 12

months) In the event of early withdrawal, principal usually made available (returned)

to depositor but no return will be given on the deposit

Rates tend to track that of conventional fixed deposit accounts and are generally

higher than savings account rates

Two types are common General Investment Account (mudarabah mutlaqah)

General mandate given to the bank, standard profit sharing ratio

Specific Investment Account (mudarabah muqayyadah)

Customer specifies constraints on use of capital, negotiated profit

sharing ratio


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Profit / HibahComputation

While numerous variations may exist, common

computation of profit/dividend/hibahfor demand

deposits (see Example 1 in handout)is based on either

The Accumulated Daily Average Method, or

The Daily Balance Method Some Islamic banks offer multi-tiered rates (See

Example 2 in handout)

For mudarabahinvestment accounts, distributed

profit is based on ex-post quoted rates for

stipulated intervals (See Example 3 in handout)


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Computation of Profit/HibahRate

All sources of funds (savings and mudarabahinvestment accounts ofvarious maturities) are pooled

Deposits of longer duration are assigned higher profit sharing ratios In Shariahterms, this is operationalized via the following:

Depositors forming the common pool of fundshave a musharakahrelationshipwith each other

The pool of funds, in its collective capacity, enters into a mudarabahcontract

The pool acts as rabbal-maland the bank serves as mudarib Any profit generated is shared according to an agreed profit sharing

ratio, between the pool of funds and the bank

The pool of funds share of profit is then distributed among depositorsof varying maturities according to an agreed set of profit sharing ratios(typically giving longer durations a higher share)

However, sharing of loss would be strictly according to the respectiveinvestment ratio

The computed profit/hibahrate, stated in annualized terms, is thenapplied to individual account balances to determine distributedprofit/hibah

(See Handout for an example of the computation)


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Negotiable Islamic Debt Certificate (NIDC)

A deposit instrument offered by some Islamic financialinstitutions in Malaysia

Classified as a short term (less than 12 months), fixedrate deposit

Islamic version of negotiable certificate of deposits

(NCD) Based on the principle of bay al-inah(sale and buy-

back)

The instrument is negotiable, providing the depositor with

liquidity Negotiability effected via the principle of bay al-daynat a

discount


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Bay al-dayn

Bay al-inah

Negotiable Islamic Debt Certificate (continued)

DepositorBank

Share certificates of bank

RM100,000 Cash(Deposit)

Share certificates of bank

RM105,000 in 6 months

Debt certificate

(syahadah al-dayn)

issued

Secondary

Market

Possible sale to

obtain liquidity


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Commodity MurabahahDeposit-i

CommoditiesBroker B

Depositor

Bank

CommoditiesBroker A Commodity

USD1m Cash

Commodity

USD1.1m

Deferred

Commodity

USD1m Cash

Structured based on the concept of tawarruq

Due to relatively high transaction costs, suitable for high net worthindividual (HNWI) deposit accounts only


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Structured Deposit Product

Depositor BankDeposit$100K Fixed Return

Instruments

- commoditymurabahah

- sukuk, IslamicABS

(at 7.53%)

Invest $93K

Higher Return

Investments- equity, derivatives

(at 28.57%)

Invest$7K

Quasi-Capital

Protectionfor $100K

Gross Expected(Potential) Return of

$9K

Bank acts as

agent (wakalahcontract) ininvestingdepositors

money & chargesa fee for the

service


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Other Deposit Product Structures

Qard-based Deposits A creditor-debtor relationship is established betweendepositors and the bank

To attract and mobilize deposits, some banks havebeen known to offer incentives in the form of:

Prizes or cash bonuses

Exemption from, or discount in, payment of commission andfees,

Priority in use of banking facilities

Such a practice is common among Islamic banks in Iran

Shariahscholars caution that such gifts must becompletely discretionaryand notgiven on a regularbasis (so as not to lead to depositors expectations ofthe gifts)


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Other Deposit Product Structures (continued)

Wakalah-based Deposits

Islamic bank acts as wakil(agent/representative) ofdepositors/investors and manages funds on their behalf for a

fixed fee

Combination Structures

Deposited monies are split into stipulated portions

Qard/ Mudarabah, Wadiah/ Mudarabah, etc.

Sale and Buy Back Agreement (SBBA)

Essentially a repurchase agreement (Repo)

Bank sells Islamic securities to depositor at an agreed price

Bank makes a unilateral binding promise (waad) to re-purchasethe Islamic securities from the depositor on a specified future

date and at an agreed price

Negotiability of Islamic securities provides liquidity options to the

depositor


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Issues in Deposit Products

Objection to the use of the wadiahcontract in structuring deposits

Displaced Commercial Risk and Income

Smoothing Guarantee of MudarabahInvestment

Accounts

Implications on Capital Adequacy Quasi-guarantee by bank-mudarib


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Unsuitability of the WadiahContract

Although return on wadiahdeposit accounts by way of hibahis not contractual,

there are arguably widespread depositor expectationsof it

Failure to give consistent and competitive hibah returns is likely to result in depositwithdrawals

Thus, in practice, hibahreturns are somewhat obligatory (by way of market operation)

De facto required hibahreturns seem to attach an additional condition to the

contractual arrangement albeit not formally

Some jurists opine that if the hibahis customary(urf), such widespread practice is

tantamount to an implied termof the contract

Conceptually, the wadiah yad dhamanahsavings account is similar to a loan

(qard)by the depositor to the bank

Thus the communication of the possibility, and likely magnitude, of benefits accruing

to the lender-depositor should be avoided

Banks should not indicate or advertise hibahrates

In practice this is difficult to monitor and implement because counter personnel

may indicate hibahrate verbally to the customer

Hence many (including IFSB standards) feel that the wadiah contract is not

suitable for the structuring of savings accounts, and should be replaced with the

mudarabahcontract


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Displaced Commercial Risk

Market pressure to pay investment account holders (IAH) a rate of return

higher than what should be payable under the actual terms of the

investment contract

Non-adherence to such pressures risks withdrawal of fundsby

depositors

Divergence between actual returns and depositors expected returns

may arise due to:

Banks underperformance for a given period

Increase in benchmark rates

To address this situation, banks can waive their portion of profits to

bolster rates of return

An extreme example of such self-imposed practice International Islamic Bank for Investment & Development (Egypt)

distributed all profits to IAH with shareholders receiving nothing from

mid 1980s to late 1980s

Recognition of the need to mitigate this risk has led to the standard

industry practice of income smoothing


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Income Smoothing

Profit Generated

from InvestmentAccount-financed

Assets

Profit EqualizationReserve (PER)

Set aside

MudarabahProfitto be distributed

Bank (mudarib)sshare of profit

InvestmentAccount Holder

(rabbal-mal)sshare of profit

As per profit sharing ratio

Investment Risk

Reserve (IRR)

Setaside

Actual profitdistributed toInvestment

Account Holder

Buffer /cushion tosmoothen

income


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Issues in Income Smoothing

A number of issues may arise from this practice of income smoothing

1. Investment account holders unawarenessof such adjustments in

returns

2. Investment account holders not having direct influence in the

manner of such adjustments thus possibly raising doubtand

uneasiness

3. Possible subsidizationof returns by short-term IAH vis--vis long-term IAH (see illustration on next slide)

To address such concerns, the following can be done

1. Adequate communication to investment account holders and

obtaining of their express consent (waiver of rights to profits)

2. Transparency in the method of adjustments and existence ofstandard guidelines or requirements specified by supervisory

authority

3. Applying adjustments to long-term investment accounts only


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Illustration of Subsidization of Returns

Jan Feb Mar Apr May Jun Average/NetActual Return 9% 10% 7% 5% 5% 6% 7%

Adjustment - 2% - 3% 0 + 2% + 2% + 1% 0

Distributed Return 7% 7% 7% 7% 7% 7% 7%

Investment account holders investing in the months of Jan and

Feb could have actualized an average return of 9.5%

Instead, they have to settle for a reduced average return of 7%


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Guarantee of MudarabahInvestment Accounts

An important feature of the mudarabahcontract is that there is

no capital guarantee for the rabbal-mal

In the event of loss, the rabbal-malmust bear any capital

loss

While Islamic banks, asmudarib, contractually do not

guarantee mudarabahinvestments, it is common for

mudarabahinvestment accounts to have a third party indirectguarantee, by way of,

Implicit guarantee from the government, or

Operationalization of a deposit insurance/takafulscheme

In Malaysia, such guarantee takes the form of a nationaldeposit insurance system managed by government-endorsed

Perbadanan Insurans Deposit Malaysia ( PIDM )

The issue is, should mudarabahinvestment accounts be

guaranteed, albeit indirectly?


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Arguments Against Guarantee of MudarabahInvestments

1. Provision of such a guarantee would result in mudarabah

investment accounts to detract from having the economicsubstanceof a mudarabaharrangement as originally

intended by the Shariah

Mudarabahfunds are meant to represent risk capital

and should have equity finance characteristics

2. Given that mudarabahinvestment accounts typically

have positive returns, guaranteeing the capital sums may

entail riba

3. Deposit-side guarantee when not coupled with an asset-

side guarantee produces a risk-profile mismatch, which

hinders the realization of the Two-tier MudarabahModel


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Guarantees Complicate the Two-tier MudarabahModel

Risks of mudarabahfinancing cannot be passed on to

mudarabahinvestment accounts

Banks typically respond by shying away from

mudarabah-based financing

BankMudarabahinvestment

account holder

Rabbal-mal Mudarib

First-tier mudarabah

Third Party Guarantee

Minimal Risk Substantial Risk

Rabbal-mal Mudarib

Second-tier mudarabah

Bank Customer

(Entrepreneur)


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Arguments Supporting Guarantee of MudarabahInvestments

1. Mitigation of the systemic risk of contagious collapseand

its social costs To provide comfort to mudarabahinvestment account

holders and thus containing the effects of isolated

investment failures or atypical occurrences of

financial distress

2. Protection of interests of investment account holders

against moral hazard-related mudarabahfinancing

3. Paradigm shift in the depositor mindset to understand

and accept the true nature of mudarabahrequires time


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Implications on Capital AdequacyProfit Sharing Investment Accounts (PSIA)

Theoretically, mudarabahinvestment accounts are not

liabilities but rather can be seen as limited term, non-

voting equity Losses incurred on PSIA-financed assets pass-

through to investment account holders

Thus no regulatory capital needs to be maintained

in relation to such risk assets

AssetsWeightedRiskTotal

Capital2Tier1Tier(CAR)RatioAdequacyCapital


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Implications on Capital Adequacy (continued)

However, in practice, due to the following factors, such PSIA-

financed assets do have capital adequacy implications Displaced commercial risk

Guarantee via deposit takafulscheme

Fiduciary risk

The risk that bank (mudarib) negligence or misconduct

caused losses, in the event of which such losses wouldhave to be borne by the bank

Thus the envisioned pass-through feature is impracticable

Accordingly, IFSBs Capital Adequacy Standard provides an

alternative CAR where a proportion (alpha) of the risk-weighted

assets financed by PSIA is included in the denominator of the CAR

It would be up to the respective regulatory authority to determine

the proportion for each Islamic bank in its jurisdiction


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Quasi-Guarantee by Bank-Mudarib

Some regulatory environments require that deposits offered by financial

institutions (including Islamic banks) are guaranteedbythe institutionitself E.g., UK Financial Services and Market Act, Singapore Deposit Act

This would contradict Shariahstipulations pertaining to mudarabah-based

deposit instruments, where contractually, the bank (mudarib) cannot

guarantee the deposited amount

To address this legal impediment, additional clauses are inserted in the

memorandum and articles of association of the bank, to the effect that, in theevent of loss,

The bank will foregofees or its share of profits

The bank will draw upon available balance in the profit equalization

reserveaccount

The bank will abstain from distributing profitsto shareholders The bank would advise the depositor that the above is carried out to meet

local (secular) regulatory requirements, and that if the depositor accepts any

of the said amounts, such action is not in compliance with Shariahprinciples

05 Islamic Banking - Deposits

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