Like conventional banking, Islamic banks also need funds to operate its banking activities. Basically there are two (2) main sources of funds, namely (a) shareholders’ working capital and (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 comingling 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, thus there shouldn’t be any issues regarding the source of the funds as there are Muslim scholars questioned on the source of capital injected for the scheme.
Deposits from customers are collected from various contracts, which can be briefly described as follows:
- 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 Deposits can be withdrawn through issuance of cheques, automated machines or over the banking counter during banking hours.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.
- Savings Account-i : Savings deposits are collected under various principles, namely:
- 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.
- 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.
- Mudharabah – Depositors (correct terminology should be investors) will be entitled for some profits based on agreed profit-sharing ratio pre-determined on placement of the funds.
- General Investment Account-i is 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 fund under longer tenure will be paid higher profits then depositors who place fund 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 next article.
- Specific Investment Account-i is 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.
- Commodity Murabahah-i is 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). 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.
- 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. When a bank is short of funds, assume all their investments have already been placed out/invested and to recall the investment would result to a loss for the bank, and there is an immediate need to cover its position (say, due to certain unexpected withdrawal by its large depositors or it has to make a large financing drawdown), it normally makes a call to another bank with excess fund 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, same principle earlier mentioned will apply.
The rate of returns on deposits depends on the returns on investments ventured by the individual Islamic banks. Unlike 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 to if they are to place 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 introduction article, Islamic banks do not impose any penalty for pre-matured withdrawal of general investment deposits unlike conventional banks, where it normally pay 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 has been quantified, Islamic Banks will not be able to translate the profit sharing ratio into actual return 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 will only act 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 investment, depositor are advised to study the profit rates trend of the Islamic Banks to ascertain potential return that they will get for the following months and so on.
Next week we shall highlight the profit distribution method and various value propositions that the customers will enjoy when placing funds with Islamic banks.
Asian Finance Bhd
4th February 2008