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Funding of Islamic Banks
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Like conventional banks, Islamic banks also need funds to operate its banking
activities.
Basically there are two main sources of funds: (a) shareholders’ working
capital (b) deposits collected from customers.
For a dual-window banking operation, all funds belonging to the Islamic banking
scheme are segregated from those related to conventional banking and to avoid
co-mingling of the funds, a separate accounting system is adopted.
The original source of the funds has to be ascertained to ensure it comes from
“halal” sources. Under a dual-window banking operation, the initial paid-up
capital is normally given on al-Qardh Hassan basis (benevolent loan) by the
parent conventional bank. Therefore, there shouldn’t be any issues regarding
the source of the funds as there are Muslim scholars vetting the source of
capital injected into the scheme.
Deposits from customers are collected from various contracts, which can be
briefly described as follows:
1. Current Account-i:
This type of deposit is contracted under the principle of Al-Wadiah or
guaranteed trust. Under this contract, the Islamic bank guarantees the return
of the principal deposit sum. Deposits can be withdrawn through issuance of
cheques, automated machines or over the banking counter during banking hours.
Since deposit is placed under trust, Islamic banks normally do not give any
returns for this type of deposits.
2. Savings Account-i:
Savings deposits are collected under various principles, namely:
a. Al-Wadiah – similar to current account except it does not have any
cheques facility. Under strict principle of Al-Wadiah, the bank is not supposed
to give any returns. Nevertheless, if the bank decides to give some returns, it
is given as a hibah or a gift. To compete with local conventional banks, local
Islamic banks do give out hibah on mas’lahah (public interest) reason.
b. Al-Wadiah & Mudharabah – alternative to Al-Wadiah savings where
the bank is not supposed to give any returns, a hybrid of Al-Wadiah and
Mudharabah (loss & loss sharing principle) deposit product was introduced.
Under this principle, certain portion of the profits derived from the
Mudharabah investment is shared with the depositors.
c. Mudharabah – Depositors (correct terminology should be “investors”)
will be entitled to some profits based on agreed profit-sharing ratio
pre-determined on placement of the funds.
3. General Investment Account-i
An investment account with pre-determined profit-sharing ratio and maturity
period. General investment deposits are contracted under the Mudharabah
concept, where depositors and the Islamic Banks agree at the time of placement,
the profit-sharing ratio and the placement duration.
To subscribe to the principle of fairness, depositors who place their funds
under longer tenure will be paid higher profits then depositors who place funds
on shorter tenure.
Thus, generally, the longer the placement tenure is, the higher the profits
will be for the depositors. Brief understanding of formulas used by Islamic
Banks in Malaysia on profit distributions shall be discussed in the next
article.
4. Specific Investment Account-i
A unique investment product where depositors will be advised on where the funds
will be invested, the minimum amount that they can invest, the projected
returns and the adherence risk that comes with it.
Generally, returns on specific investment account are very much higher, however
there are depositors who are keen to place their funds under this type of
deposits. Any losses from the project shall be borne entirely by the
depositors.
Generally, depositors for this type of deposits are by invitation only and
common projects that bank will use for this funds are real-estate related.
5. Commodity Murabahah-i
Another form of unique deposit contract. Under this contract, the customer will
purchase commodity (normally crude palm oil or metal) from a broker, say Broker
A, and sold to the bank on deferred payment (including customer’s profit
margin) basis. Once the ownership is transferred to the bank, the bank will
sell the commodity to another broker, say Broker B at a discount for cash.
Purchase and sale of the commodity are considered “real transfer”.
Any slip up on the transaction, one party may end up holding the commodity. On
maturity of the deferred payment term, the bank will pay the customer at the
agreed sale price. Technically, this product is a fixed profit rate deposit
account.
6. Islamic Interbank Money Market
Excess funds in the bank can also be invested with another bank. This type of
transaction can either be placed under the principle of Mudharabah or commodity
murabahah. In Malaysia, short-term funds (say, one day to a week) are normally
placed under Mudharabah. How this works is that, in the event that a bank is
short of funds -- assuming all their investments have been placed out/invested
-- and to recall the investment would result in a loss for the bank, it can
seek the assistance of another bank. This may be necessary because, there may
be an immediate need to cover the first bank’s position (say, due to certain
unexpected withdrawal by its large depositors or it has to make a large
financing draw-down).
The affected bank normally makes a call to another bank with excess funds to
invest (technically, under conventional banking it is termed as “borrowing”) by
making placement with them. Unlike normal general investment account-i
placement where the profit-sharing ratio has been pre-determined by the bank,
under interbank money market system, the banks will negotiate on the
profit-sharing ratio before making placement. If funds are placed under
Commodity Murabahah, the same principle mentioned earlier, will apply.
The rate of returns on deposits depends on the returns on investments ventured
by the individual Islamic banks. Unlike a conventional bank where depositors
will get a fixed return regardless of how the banks perform, depositors of
Islamic Banks will earn higher returns when profits on investments ventured by
the Islamic Banks are higher.
In fact, most Islamic banks offer profit rates declared on a month-to-month
basis where if a customer placed his deposit under 12-month tenure, he may be
paid with 12 different profit rates. Due to competition, the profit rates
offered by Islamic banks tend to follow the conventional interest rate trend.
If the conventional interest rate starts to hike, the customer who places under
longer tenure placement will enjoy higher return. In most situations, on
average, they enjoy higher returns compared with placing the same funds under a
longer tenure in conventional banks. The situation however may be reversed if
the interest rate is on reducing trend.
The writer is of the opinion that when the Islamic deposits, accounts for more
than 50% of the conventional bank, deposit performance of Islamic banks may no
longer be influenced by the interest rate trend. Currently, to avoid commercial
displacement risk (depositors moving from Islamic to conventional or vice versa
for better interest/profit rates), most Islamic banks are still somehow using
conventional interest rate trend as a benchmark to plan its deposit strategy,
except for longer tenure deposit (usually 15 months and above) where Islamic
banks’ profits are higher than conventional banks.
As mentioned in our introductory article, Islamic banks do not impose any
penalty for premature withdrawal of general investment deposits unlike
conventional banks, where it normally only pays half of the actual interest
contracted. Islamic banks on the other hand, will pay the actual profit rate
declared to the nearest available tenure on completed month.
One major issue where depositors are still not accustomed is the unavailability
of returns on the certificate of deposits for General Investment Account-i.
What will appear on the deposit certificate is a profit-sharing ratio. Since
returns on investment ventured by the bank can only be determined after profits
have been quantified, Islamic Banks will not be able to translate the
profit-sharing ratio into actual returns at time of placement thus they can
only provide “indicative profit rates” based on actual profit declared for
previous month.
A point to note, is that this indicative rate only acts as a guide to gauge the
kind of returns the depositors will get for their investments. And it is by no
means “the profit rate” for the following months. The returns on deposits for
the following months may be higher or lower (fluctuate), depending on the
actual returns on investments declared by the Islamic Banks on the following
months. Thus, before making an investment, depositors are advised to study the
profit rates trend of Islamic Banks to ascertain potential returns for the
following months and so on.
Next article we shall highlight the profit distribution method and various
value propositions that the customers will enjoy when placing funds with
Islamic banks.
This article is brought to you, courtesy of Asian Finance Bank (AFB). AFB is
the latest, full-fledged Islamic bank to operate in Malaysia. Backed by a
consortium of some of the most prominent names in the Middle East, Malaysia
shall serve as AFB’s regional hub, as it expands into neighbouring countries
and other parts of the region.
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