Econ 3430 - Islamic Banking And Finance Sources Of Funds PDF

ECON 3430 - Islamic Banking and Finance Islamic Banking Sources of Funds Outline Wadi’ah Mudarabah Other deposit products  Wadi’ah (Safe-keeping) Literal meaning: Leave, that is, the thing left with a person (not the owner) for the purpose of safe-keeping Legal...

ECON 3430 - Islamic Banking and Finance Islamic Banking Sources of Funds Outline Wadi’ah Mudarabah Other deposit products  Wadi’ah (Safe-keeping) 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 custody by explicit or implicit terms Legal basis Loading… “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:238] Two types (of wadiah accounts) Wadi’ah yad amanah: Gives no return on the deposits, allow depositors to withdraw funds anytime Wadi’ah yad dhamanah: current account and saving account The bank may at its own discreation pay the depositors positive return in the form of hiba (gift), depending on banks profitability No pre-determined/priori guarantee of benefits  Wadi’ah Contracts (2) Wadi’ah yad amanah Wadi’ah yad dhamanah Pure safe custody Guaranteed safe custody Original contract of wadi’ah Modification of original contract, combines wadi’ah with contract of guarantee (kafalah or dhaman) No liability on custodian in case of loss or Custodian liable for any loss or damage damage (except if negligent) Not entitled to any profit gained Profit gained from use of deposited property exclusively the right of custodian Custodian not allowed to use or benefit from Deposited property can be used for trade the deposited item Deposited property must be kept separately, no Deposit properties need not be segregated pooling of funds Owner of asset (depositor) can take back the deposited asset at any time Custodian is allowed to charge a fee for custodianship but traditionally wadi’ah has been a charitable act  Wadi’ah yad dhamanah In contemporary Islamic banking, the contract of wadi’ah yad dhamanah is used to emulate the conventional savings account Salient features of its use The bank guarantees deposited monies Loading… 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 return to the depositor in the form of discretionary (optional) and voluntary hibah (gift) or token of appreciation Issues in Wadi’ah yad dhamanah Although the bank is not contractually obligated to give a hibah return, depositors expect it In the minds of depositors, there is no such things a free lunch Wadi’ah yad dhamanah deposits perceived as equivalent to conventional savings account (but is Shari’ah-compliant) Islamic banks’ failure to give consistent and competitive hibah returns is likely to result in deposit withdrawal As such, in practice, hibah returns are obligatory (by way of market operation, that is, forced onto the banks) which is against the spirit behind wadi’ah yad dhamanah and hibah In wadi’ah yad dhamanah, the custodian is given the opportunity to benefit from the use of deposited assets and keep any profits, in (fair) exchange for guaranteeing the deposited asset De facto required hibah returns seem to attach an additional condition to the contractual arrangement albeit not formally Hibah is meant to be a charitable act, driven purely by moral obligation or sense of appreciation (syukur), not motivated by economic forces  Issues in Wadi’ah yad dhamanah (2) Conceptually, a wadi’ah yad dhamanah savings account is similar to a loan (qard) by the depositor to the bank As such, hibah cannot be advertised (e.g. ‘open a savings account and win a free hand phone’) based on a hadith of the Prophet: “If one of you has advanced a loan and the debtor offers the creditor a bowl (of food), he should not accept it…” The bank should not even indicate the hibah rate In practice this is difficult to monitor and implement because counter personnel may indicate hibah rate verbally to the customer Some jurists opine that if the hibah is customary (‘urf), such widespread practice is tantamount to an implied term of the contract For these reasons, many feel that the wadi’ah yad dhamanah savings account should be phased out E.g. IFSB standards calling for the retirement of such wadi’ah account by 2007  Issues in Wadi’ah yad dhamanah (2) Questionable sources of income of depositors In terms of the Shari’ah, the bank is not obligated to ascertain the nature of depositors’ funds However, as a matter of policy, the bank can decide to reject deposits from questionable sources In Malaysia, this would be in line with the Anti-Money Laundering Act (AMLA)  Mudarabah (Profit-Sharing) An arrangement between capital provider (rabbul mal) and the person needing the capital/entrepreneur (mudarib) Rabbal mal gives specified amount of capital to mudarib who is to act as the entrepreneur to trade with the capital If the business project results in profit: Profit will be shared between 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 In the case of losses: Financial losses will be borne by the rabbal mal as the financier The mudarib bears the frustration of fruitless effort (non-payment on his/her effort) Mudarabah (Profit-Sharing) Because of the financial risk taken by the rabbul mal, according to the shari’ah that justifies the claims to part of the profit The rabbul mal is also compensated for the TVM in the form of a floating rate that is pegged to the debtor’s profits. Mudarabah in Banking One contemporary application of mudarabah in Islamic banking is in structuring a variable-rate deposit The mudarabah investment account has been loosely compared to the conventional fixed deposit (FD) Loading… Similarities Requires commitment of deposit for specified time periods (3, 6, 9, 12 months) otherwise no return will be given on the deposit Rates tend to track that of FD’s and are generally higher than savings account rates Differences Contractually the deposited amount is not guaranteed (no capital protection) Rate of return is not pre-fixed (ex-ante) but only indicative rates are given Actual rate of return is only given at the end of investment period (ex-post), which may or may not differ from indicative rates  Two-tier Mudarabah First-tier mudarabah If the Islamic banking system is working Rabbal-mal ideally, there would be a two-tier Mudarib mudarabah system. Mudarabah Bank Customer investment Bank (Entrepreneur) account holder Rabbal-mal Mudarib Second-tier mudarabah In Malaysian Islamic banking, such a theoretical model has not been used widely, if at all This is evident from the lack of mudarabah-based financing in Islamic banks’ asset portfolio (Risky. Why? Profit is uncertain on right side, but depositors expect positive returns on right side) Issues in Mudarabah Investment Account Two salient features in a mudarabah contract are No capital guarantee for the rabbal-mal : in the event of loss, the rabbal-mal must bear any/all capital loss No guaranteed positive return: profit is shared between rabbal-mal and mudarib only if there is profit With the mudarabah investment account, although the above two features are observed contractually, by virtue of market operation, they are not realized, at least in the intended spirit While the mudarabah contract does not guarantee capital preservation, there is an implicit third party guarantee (by BNM) Although the mudarabah investment account only provides indicative rates and the actual rate of return can differ (in theory can even be zero or negative), in practice, the eventual rate is very close to, if not equivalent to, the indicative rates Issues in Mudarabah Investment Account (2) The mudarabah contract is meant to be a productive risk-taking venture However, because of the two factors, risk-taking is significantly minimized Since BNM implicitly guarantees all bank deposits (including mudarabah investment accounts), it is in its best interest to ensure that risk-taking is at a minimal Given BNM’s regulatory authority, it has significant control and influence Mudarabah investment account holders expect to get positive returns Zero or negative returns are totally unacceptable, and will likely to result in withdrawal of deposits In the depositors’ minds, the mudarabah investment account is simply the Islamic version of fixed deposit Little effort is made to market or communicate the mudarabah investment account as a risk-taking venture  Issues in Mudarabah Investment Account (3) What are the effects of employing the mudarabah contract in this manner? (minimal risk-taking) While the mudarabah investment account as a financial instrument may be Shari’ah compliant, the objectives of the Shari’ah embodied in the mudarabah contract are not realized There is minimal risk-taking Because the Islamic banks’ liabilities (deposits) have so little room for risk- taking, the bank, in turn, is not able to invest in productive risk-taking ventures Islamic banks are forced to resort to fixed-rate financing instruments (such as BBA and murabahah) instead of mudarabah-based financing The two-tier mudarabah model cannot be implemented Emphasis is on credit risk, instead of profitability The substance of the Islamic banks’ financing is similar to conventional banks  Issues in Mudarabah Investment Account (4) Advertisement of gift prior to the contract Permissible, because unlike the wadi’ah yad dhamanah savings account, the mudarabah investment account is not a loan Gift to be paid out of shareholders’ funds or bank’s share of profits Investment from questionable sources Similar treatment as the wadi’ah savings account Bank not obligated to determine nature of source of investment funds But as a matter of policy, the bank can filter its investors  Other Deposit Products / Structures Negotiable Islamic Deposit Certificates (NIDC) A deposit instrument practised in Malaysia Based on the principle of bay’ al-’inah (sell and buy-back) The instrument is negotiable, providing the depositor with liquidity Offer as a wholesale/money market deposit product by several Islamic banks Negotiability effected via the principle of bay’ al-dayn at a discount Sale and Buy Back Arrangements (SBBA) Short term deposit (1 to 30 days) Back-to-back cash sale of identified basket of Islamic commercial papers  Other Deposit Products / Structures Commodity Murabahah Deposit-i Based on the principle of tawarruq – to buy on credit and sell at spot value with the objective of getting cash Example: Purchase a commodity on credit and sell it to a third party for cash Use by many Islamic banks for liquidity management and as a mode of financing Different from bay al-inah; accepted by Hanbali and Shafie jurists Requires the customer to appoint the Bank as an agent to purchase a commodity from a commodity trader on a cash basis Subsequently the Bank will buy back the commodities from the depositor on a deferred sale at a cost plus profit margin (customers are paid higher price which include profit) and it will sell the commodities back into the commodity market. Customer Bank Commodity Broker Appoint agent to buy Buy back commodity on cash comm on Sell dereferred sale commodity at comm market  Other Deposit Products / Structures Commodity Murabahah Deposit-i The Commodity Murabahah utilises crude palm oil and metal-based contracts as its underlying asset. All proceeds raised by the bank from the Commodity Murabahah are utilised in a Shariah-compliant manner.  The Way Forward Paradigm shift of Islamic bank depositors required Return only justified with the undertaking of risk Islamic bank “deposits” to have more characteristics of equity investments than of conventional bank demand or time deposits Education and communication important Ensure infrastructure and regulatory framework in place to safeguard rights of depositors Corporate governance, auditing, controls and monitoring to ensure better accountability of the Islamic bank Political will required to initiate and sustain such a change Islamic banks prefer the current model as it poses less challenges, essentially similar to the conventional banking model