26 - Profit Payment Method

We have to admit that most of current procedures relating to Islamic banking, including profit distribution methods that we discussed in last few topics were designed by those who started Bank Islam Malaysia Berhad. We should thank the staff and management of Bank Islam for pioneering Islamic banking in Malaysia. When BNM allowed the establishment of dual banking system (commonly known as "Islamic Windows") and subsequently other Islamic banks (including Islamic subsidiaries) all these methods are being adopted and most are still in use although some had undergone a number of revisions by BNM.

Due to above reasons, the Writer decided to also write about the old methods so readers of this blog will be able to know how the operations of Islamic bank in Malaysia evolves.

Before we close the topic on Profits Distribution Method, we need to also know the two (2) types of "Profit Payment Methods" as follows:-

1. Maturity method

• Under maturity method, the applicable profit rate for the a particular deposit tenor (irrespective the number of months) is the final rate determined on maturity.  For example, let's assume the final profit rate for a 6-month tenor MGIA is  4.50% per annum. The said profit rate shall be applicable from month 1 to month 6.  What it means here is that "single profit rate" applicable for the whole six months;

• Now, assume the same MGIA is renewed for another 6 months. On next maturity date i.e. 6 months later, the maturity profit rate is only 4.0% per annum. Likewise, the applicable profit rate for the whole 6 months period is only 4.0% per annum (a reduction by 0.50% per annum from previous placement)

2. Actual method

• On the otherhand, under Actual Method, the profit rate varies from month to month. For example, the profit rates applicable for a 6-month tenor MGIA will be six (6) different profit rates based on "actual" percentage declared each month as per example in Chart 1.

      Chart 1

Note:  Some Islamic banks are using "moving average ratio" before declaring the profit rates to avoid erratic movement of profit rates. Examples of moving average rate charts are as follows:

Chart 2

"Moving average rate" formula is popularly used about 10 years ago but it is not surprising some Islamic banks may still use this to cushion the profit rates. Calculation for Chart 2 is as follows:

Chart 3

The advantage in using the "moving average profit rate" is that if the profit rate suddently hike due to say, large collection during the month, the profit rate can be reduced to avoid too much margin differences between the previous month's profit rates. Whatever the differences between the actual profit rate and the reduced profit rate due to "moving average rate" formula, will be transferred back to the general profit pool. Excess profit CANNOT be treated as extra income to the Bank.


One very important disadvantage in using this "moving average profit rate" is that during reducing profit rate trend instead of paying lower profit rate, the bank will be paying higher profit rate as per example in Chart 4 below:

Chart 4

Based on Chart 4, although the actual profit rate, say on month 13th is 4.30% per annum, due to the moving average formula, the Islamic bank will be paying 4.58% per annum. The bank will pay-out 0.28 percent more than what it should declare. As a result, the additional profits need to be deducted from "Profit Equalisation Reserve" to pay the extra amount.

The Writer opines that 'moving average profit rate" formula should not be used as it's like taking away what is due to the depositors during rising profit rate trend and it will have adverse effect on the bank on reducing profit rate trend. The best option is to declare actual profit rate.

Now, let's make comparison between the Maturity and Actual Method as follows:

Chart 5

Note: Zoom your view to higher level - 150% to read this Chart.

In next topic we shall discuss a bit more on the "Profit Equalisation Reserve" (PER). Why banks are allowed to create this account?

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25 - Profit Distribution Table

In our previous sessions, we have discussed the concept of profit sharing, how profits are recognised as income by the bank and how profits are distributed. The Writer shall now reveal the step-by-step profit calculation method using Microsoft Excel table (commonly referred to as "Profit Distribution Table) with Table/Chart examples,  with the hope that ALL existing and potential users of Islamic banking system will be able to visualise how profits are actually distributed by Islamic banks.

It should be noted that the guidelines in calculating profits for distribution are stipulated in the Profit Distribution Framework issued by BNM (some of the terminologies used by the Writer may not be same as the framework) to ensure industry standard and one of the main items that BNM auditors normally audit in Islamic banks is Profit Distribution Table (PDT) records.

In most Islamic banks, the profit distribution table are prepared manually using Microsoft EXCEL but there are probably about three (3) Islamic banks (maybe) that have automated this process. The Writer opines that the PDT should be one of the items that Shariah Department and Bank's Internal Auditors should audit, since this process is still mostly done on manual basis thus open to possible calculation errors.

In Malaysia, there are two (2) profit distribution methods, namely;

 (1) Weightage-Average-Ratio (WAR) Method, and

(2) Profit-Sharing-Ratio (PSR) Method .

The Writer wish to reiterate that this subject is very technical but the Writer will try to explain in the simplest way possible. Let us start this session with the WAR Method.

1. Weightage-Average-Ratio Method (WAR)

Under this method, the Bank will use various ratios known as the Weighted Average Ratio (WAR) for each deposit placement tenor (e.g. 3, 6, 9 months and so on) to represent the importance of one deposit tenor in comparison with another. For example, 12-month tenor deposit is considered more stable for the operation of an Islamic bank when compared to a 1-month tenor deposit. If a Customer places deposit for 1-month tenor, operationally the bank needs to monitor the deposit movement closely (especially for large deposits) as it does not have assurance that the 1-month tenor deposit will remain with the bank on maturity compared to a 12-month deposit tenor. Although depositor can still uplift the 12-month deposit prematurely, at least the bank does not have to worry about it for the next 11 months. Thus, to ensure fairness in term of profit distribution, depositors who place funds under a longer tenor deposit shall be paid higher profits (as required by Shariah) compared to those who place deposits under a shorter tenor. To do this, higher  WAR will be assigned to a longer tenor deposits. Under WAR method, the profit sharing ratio (PSR) is fixed until maturity and if the bank decides to change the standard profit sharing ratio, it has to write to BNM with their justification (the Writer is not sure whether BNM has the rights to reject the request) and any changes on the PSR for existing accounts can only be affected on renewal. For automatic renewal accounts, consent must be obtained from the depositors.


Under conventional fixed deposits (FD), it is quite common where FD rates for longer tenor deposits are at times lower than the shorter tenor or vise verse depending on the deposit taking strategy of the bank thus, comparatively its more flexible compared to the Islamic bank WAR method. But if we are to look at it positively, conventional banks do not subscribe to the principle of fairness as compared to Islamic banks.

However, in practise there are still Islamic banks (perhaps 1 or 2 in Malaysia) that are not really following the principle of fairness mentioned earlier as the Writer observes that there are times when lower profit rates are declared for longer tenor deposit compared to shorter tenor. Perhaps, the bank is using the PSR Method where different profit sharing ratio is assigned for different deposit tenor. As for the PSR Method, most Shariah scholars are of the opinion that the principle of fairness does not apply since customer is aware of the profit sharing ratio for each type of deposit tenor before placing the funds i.e. element of offer and acceptance is presence prior placement of deposits. We shall discuss about the second method in details once we have examined the WAR Method.

Now, let's see how profits is calculated using WAR method. At a glance, detailed view of the Profit Distribution Table is as per Chart 1 below.

Chart 1

Note: You can use zoom level of 150% to view Chart 1 clearly. The purpose of each columns will be clarified in next few charts as follows:-

Chart 2

Chart 2 can be explained as follows:

# Column A  is the description of the various types of deposits (including other liability items) that are eligible to be included the PDT.

# Column B is the total daily balance comprising sum of daily balances for the whole month e.g. On Feb-1, the day-end balance is RM 50,000 while on Feb-2 the day-end balance is RM45,000. Thus, total daily balance for the first two (2) days is RM95,000. (Take note that to simplify our example, we are using RM50,000 as the daily day-end balance throughout the month). So, to get the total daily balances, system will accumulate the daily balances up to month-end. The month end total sum result will then be divided by the number of days in the month (for our example, we are using 30 days in the month) and that will give us the Monthly Average Daily Balances (MADB).

To understand the calculation, let's examine Chart 3 below:-

Chart 3

All the RM50,000 as shown in Column C of Chart 3 above, is the MADB for the respective tenor deposits. [Calculation for Line 10 Column A  - RM1,500,000 divide by 30 or number of days in the month = RM50,000].

Now, how Weighted Average Ratio works? Let's examine Chart 4 below:-

Chart 4

# As earlier mentioned, the Weightage Average Ratio in Column D of Chart 4, is the ratio assigns  to a particular deposit tenor to determine the importance of a particular deposit tenor compared to another. Under Column D, you will see that the WAR for 1-month tenor deposit is 0.76 while the WAR for 48-month tenor deposit is 1.21 and so on,  as recommend in the BNM Profit Distribution Framework. As earlier mentioned, the WARs can be changed but the Islamic bank is required to inform BNM with their justification for changing the same.

# Thereafter, the AMDB of RM50,000 times the WAR of 0.76 will give us the Weighted Proportion of Profits (WPP) of RM38,800. What it means here is that although the original deposit amount is RM50,000 but for profit distribution purposes, the deposit placed with the Bank is treated as though it is only RM38,000 for profit distribution purposes. Likewise, for 48-month tenor deposit of RM50,000 with WAR of 1.21, the Weighted Proportion of Profits is RM60,500 [RM50,000 x 1.21 = RM60,500]

Once, all the WPPs are obtained for all types of deposit tenors, profits can now be distributed. For our example, let's assume gross income from operations is RM2,182.74 (refer to Chart 5 below)

Chart 5

What is Chart 5 all about? Simple understanding of the chart - Capital funds + Deposits equal to total deposits of RM600,000 for bank's operations. From the total deposit,  we deduct statutory reserve (SR) , say 4% (RM24,000) and liquidity ratio, say 15% (RM86,000), that will gives us RM576,000 available for investment and financing activities.

We further assume bank's only financing account (without taking into BNM other requirements such as large financing, single customer limit etc.) is RM400,000. At financing profit rate of 7.50% per annum, monthly income to the bank is say, RM 2,465.75.

Whatever amount not used for financing purposes plus liquidity amount, totally RM176,000 will be placed in the Islamic Interbank Money Market (IIMM). At a IIMM average profit rate of 1.50% per annum, the bank earns RM216.99 for the month which gives us the amount of RM2,182,74 for profit distribution.

It should be noted that the gross profit to be distributed to bank and customer is after deducting allowed cost by BNM such as general provision, specific provision, commission and fees (as discussed earlier under Topic 23). Operating cost will be borne entirely by the Bank. Take note again that for above example, we assume GP is provided based on amortized basis i.e. full amount to be provided is divided equally over 12 months (max). In practise, whatever GP amount must be provided within the same year and some banks, provide GP based on their projected financing balances to avoid large provision amount that may impact their monthly profits. We shall discuss more on GP in later Islamic Accounting session.

Our next calculation is to get the gross profit before distribution. Before we go into details, let's take a look at Chart 6 below that shows the amount of profits to be distributed and how the same is converted into percentage as follows:-

Chart 6

The gross profit before distribution amount of RM2,182.74 will be placed in total column in the PDT (Line 19/Column F) and since we are using EXCEL formula, the profits will be automatically distributed upwards to the type of deposits and WPP amount assigned to it.

Now, let's see how profits are distributed. (refer to Chart 7 below):

Chart 7

To calculate the Profit Allocation amount, we take the WPP for 48-month deposit tenor of RM60,500 and divide the same with the total weighted proportion of profits (Line 19/Column E) amount of RM596,000 [ 60,500/ 596,000] times the gross profit amount of RM2,182.74, and that will give us RM221.57 [ (60,500/596,000) x 2,182.74 =221.57) ] profit allocation for 48-month tenor deposits. This means, although the placement amount for 48-month deposit tenor is RM50,000, since it is a long-tenor deposit with WAR of 1.21 and assigned-deposit amount of RM60,5000, profit sum of RM221.57 from the total RM2,182.74 is allocated.

So, before we show you further the steps to calculate the percentage, the Writer which to explain on why we MUST convert the amount distributed into a percentage instead of showing the absolute amount, say RM221.57.

Why we need to explain this..? Till today, there are still Muslims who said that the profits normally declared in "percentage form" is "riba" because it emulates the "interest-rate percentage" of conventional bank. The Writer wish to reiterate that for conventional bank, the end-result is actual rate represented by percentage (%) but for Islamic bank, the actual end-result is an absolute amount in figure. But to analyze and to compare the performance of each deposit types and also to compare Islamic bank's deposit performance against the conventional FD, we need to convert the end-result from absolute amount into percentage. Thereafter to convert the amount into percentage, we take the profit amount of RM221.57 divide by the original placement amount of RM50,000 x 100 (to convert to percentage) times [365 days in the year and then divide by 30 days in the month], that will give us a gross profit percentage of 5.39% as shown in Chart 7 above.

Take note that the gross or "R" rate ("R" actually means Reference or reference rate) for 12-month tenor  deposit  currently being by Islamic banks as the profit-sharing ratio negotiation benchmark for Islamic Interbank Money Market (IIMM). For this reason, the WAR for 12-month tenor is 1.0 (We will learn more on IIMM in later session)

Once we already obtained the gross profit before distribution for each deposit tenor, the next step is to distribute the profits according to the agreed profit sharing ratio. In Chart 8, the PSR is 50:50 (normally written as Depositors: Bank which means 50% for Depositors and 50% for Bank). The "R" rate for this example is 4.46 (Line 14 Column G).

How let's look at Chart 8 below.

Customers' profit is calculated by taking the gross profit amount of RM221.57, then times that amount with the profit-sharing ratio of 50% to give a return of RM110.79. To calculate the effective return in percentage to the Customer, we take the net amount distributed i.e. RM110.79 divide by the original amount (RM50,000) times 100 x 365 days and divide by number of days in the month, which is 30 in this example. That will give us a profit percentage of 2.70% per annum. Since PSR for the bank is also 50%, the bank shall also be allocated the amount of RM110.79 with profit percentage also at 2.70% per annum.

Chart 8

From Writer's own experience, it is important to explain to bank's management of Islamic subsidiary parent bank that the percentage 2.70% which is high (maybe compare to conventional FD rate of say, 2.5% prevailing at the time) does not mean that the bank is out-of-pocket in comparison with conventional FD at 2.50% per annum. Since the PSR is 50:50, when we pay depositor the rate of 2.70% per annum, the bank shall also be allocated with 2.70% per annum. Some people in the parent bank may misunderstood that Islamic bank is over-paying to their long-tenor depositors.

Now, how to know whether our calculation is correct? To counter-check, the total profits payable to depositors (RM 853.32) plus the total profits due to the Bank (RM1,329.42), will equal to the amount or gross profit before distribution i.e. RM2,182.74 as per Chart 8

THE ABOVE EXAMPLES ARE STEP-BY-STEP CALCULATION OF THE WEIGHTAGE AVERAGE METHOD but another method which is allowed by BNM is the Profit Sharing Ratio Method to be explained below.

2. Profit-Sharing-Ratio Method (PSR)

The Profit-Sharing Ratio Method is the simplest method of profit distribution. The Bank will assign different profit-sharing ratios for the various deposit tenors. For example, for the same 18-month tenor, the profit-sharing ratio offered may be, say 80:20 (Depositor: Bank) in favour of depositors while for 24-month deposit tenor, the profit-sharing ratio may be 85:15.

Before we go into details, lets look at the overall PDT under the PSR method as per Chart 9

Chart 9

Now, lets' go into details (refer to Chart 10)


Chart 10

Unlike the WAR Method, under PSR Method, we need to determine the deposit volume percentage. This means, profits will be distributed based on the volume of each deposit type. So, based on our example in Chart 10 above, the Monthly Average Daily Balance of RM50,000 is divided by Total Average Monthly Balance of RM600,000 (Line 21/Column C) to get the percentage of deposit volume, which is 8.33% [50,000 /600,000 x 100 = 8.33% ]

Once the deposit volume percentage is obtained, we take the gross profit amount of RM 2,182.74 times 8.33% and that will give profit allocation of RM181.90 [RM2,182.74 x 8.33% = RM181.90 ]

Once we obtained the profit allocation, the same can be distributed immediately according to the profit sharing ratio for each type of deposit as per Chart 11 below:

Chart 11






Under the PSR method, the profit-sharing-ratio for longer tenor deposits can be lower than the shorter tenor. Since prior placement, depositor is made known on the profit-sharing-ratio, once the deposit is placed, the profit sharing ratio remains until the deposit matures. One very important advantage in using this method is that Islamic banks can response quickly to market demand on deposits. Islamic bank can raise the PSR immediately for new, say 1-month deposit tenor, if it needed large funds to meet sudden huge withdrawals. The bank can also offer varies PSR for different tenor deposits (refer Chart 12)

Chart 12

To check whether the PDT is correct, add the total amount to be distributed to the Customer and the profits due to the bank. If the amount is equivalent to the gross profit before distribution, the PDT is correct.

In order for Islamic Bank to gain better share of the profits, Islamic Bank will have to manage its deposit by offering lower sharing ratio to depositors e.g. using Tier-2 profit sharing ratio which means, if a Corporate depositor placed RM1.0 million under standard profit sharing of say, 50:50, any other amount above the RM1.0 million, the Bank may accept further deposits but at say, 60:40 (Bank:Depositor). This situation normally occurs when the market is flush with deposits.

This conclude our session on profit distribution and in our next session, we shall discuss on some related issues related to the Profit Distribution Table such as:-

1. Payment of profits - comparison between actual and maturity method. Why Islamic banks should use actual method;

2. Profit Equalisation Reserves;

Thereafter, we shall discuss about types of treasury products, Islamic Interbank Money Market and financing products.

Before we end this session, as promised for those who are interested to do some exercise on profit distribution Table, you may email to the Writer at islamicbankway@gmail.com for profit distribution table exercise worksheet. In your request email, just let the Writer know your nature of business and your location (country)  for the Writer's internal survey purposes according to the following category:

Student (country)

Conventional banker (country)

Islamic banker (country)

Legal Practitioner (country)
Shariah Scholar (country)

Non of the above (country)

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24 - Profit For Distribution

Before we deal in depth on the profit distribution table, let's look at two (2) examples on how profits are extracted for income recognition purposes prior distribution.

Let's take Account No. 1 (Chart 1) where income is calculated using Monthly Rest formula (or reducing balance method). Details of Account 1 are as follows:

# Financing period = 12 months
# Profit rate = 10.0% per annum
# Unearned income = RM550.40
# Sale price [ RM10,000  + RM550.40) ] = RM10,550.40
# Monthly installment = RM879.20
# Profit for Month-1 = RM83.81 [Formula RM10,000 x 10 divided by 1200 ]

Chart 1

Based on simple calculation as above, profit for the first month is RM83.81 (actual calculation using system, the calculation shall be principal balance x profit rate % x no. of days in the month divided by 365 days).

Account No. 2 (Chart 2) is based on Flat profit rate commonly used for hire purchase financing or Ijarah Thumma Al-Bai as offered in Malaysia. For flat rate financing, even though the pricing is quoted at 5.50% flat, effectively (when we convert to Monthly rest calculation) the rate is about 10.0% per annum.

Now, let's look details of Account 2:

# Financing period = 12 months

# Profit rate = 5.50 Flat per annum

# Unearned income = RM550.00. In chart noted as RM465.38 (RM550.00-84.62)

# Sale price [ RM10,000 + RM550.00) ] = RM10,550.00.

# Monthly installment = RM879.20

# Profit for Month-1 = RM84.62 [ profit higher by 0.81 compared to Chart 1]

From the examples, you will notice that the installments are the same but the profit due under Rule 78 formula, is higher i.e. RM84.62 compared to the profit calculated using Monthly Rest formula. This means, under Rule 78, the profit portion will exhaust faster compare to the normal monthly rest profit rate. In other words, when you take up financing using Rule 78 and decide to prepay the facility, it's worth settling the same early because towards maturity, more amount will be used to pay-off the principal portion.

Chart 2

From the above two (2) examples, the profits are extracted as follows:

Chart 3

Chart 3 is the simplest example on how profits are shared.  Profits from both Chart 1 & 2 when combined, will give us a gross profit amount of RM168.43. Based on straight forward profit sharing ratio of 70:30 [Customer: Bank], profits payable to the Customer is RM117.90 while the balance RM50.53 is payable to the Bank.

To calculate the effective profit rate, let's assume the bank's total deposit is RM20,000. Based on simple formula above, the profit rate that the Bank will declare is 7.07% p.a. but normally, bank will use effective rate by multiplying the same by 100 times 365 days over no. of days in the month.

In our next session, we shall discuss on more technical topic on profit distribution table i.e. how to use the Profit Distribution Table where various income are captured for distribution purposes.

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ALLAH KNOWS BEST.

23 - Income Recognition Method

How are profits recognized and earned?

When we talk about income recognition, we have to admit that Islamic banks do not have its own income recognition formula for debt financing facility. Except for Musharakah and perhaps Ijarah (considered as pure rental income) there is "no hadith" (perhaps Shariah scholars can help us on this issue) that distinguish the profit and principal portion meant for debt financing facility. Thus, Islamic bank today are actually adopting the conventional bank's formula for debt financing facility with strict modification that income cannot be earned on COMPOUNDED basis.

What do we meant by "on compounded basis?" My straight forward answer is that when recognising financing income, Islamic banks cannot adopt the "interest-upon-interest" method used by conventional banks. For example, when a conventional bank customer defaulted his installment this month, the unpaid interest amount will be added to the following month opening principal balance [ i.e. unpaid interest + principal outstanding = new month opening balance.]  Thus, interest for the following month is calculated over the new opening principal balance.

For Islamic banks, unpaid profit shall remain as "profit earned but not yet paid" and that amount CANNOT  become part of principal amount of the following month or the month after  irrespective whether the customer defaulted or the account is to be restructured or rescheduled.

The Writer had earlier mentioned there is no 'hadith" specifying the formula and how income is to be earned thus, the Writer opines that banks' Shariah Committees are  not worry about income "recognition formula" as long as the calculation method and the amount calculated are not deemed as ' interest ' when earned. Although there may be disagreement among the Shariah Scholars  as to whether certain Islamic products or structures are shariah compliant, to-date, Shariah Scholars tend not to get involved in the "formula arithmetic" in determining the profits. One important Shariah requirement when it comes to income recognition is that earning MUST be based on NON-COMPOUNDING basis and should never emulate the conventional method where compounding or "interest-upon-interest" method has been  in used since ages. Although from some information there are Islamic banks that earn "compounding income", we really hope that this is not the case. If you are an Islamic banker, why not do a quick check on how your bank earns their financing income for default cases?

Based on Writer's past banking experience, income for financing under lease, debt or profit sharing contract can be recognised using the undermentioned formulas :-

Note : Some of the formulas may no longer in use.

1. Payments to be treated as profit first (cash accounting)

Using straight line method as per example in Chart 1, for the first four (4)  years whatever installments received are to be treated as profits/ income to the bank while the principal amount is payable over the remaining financing tenor.

Before we show you the various charts on the income recognition methods, lets understand the table columns showed in the chart 1:

a) Month - the month installment due and income earned;

b) Monthly Installment - can only calculate this if we know the (i) financing amount (ii) financing tenure or financing period and (iii) profit rate which can be based on monthly rest, flat rate, daily rest or yearly rest depending on the type of structure.

c) Amortisation - the distribution of profit to be earned by the bank and gradual payment of principal amount, embedded together in the monthly installment;

d) Unearned profit - total profits due (for whole facility) to the bank and payable by the customer. The longer the financing period, the higher will be the unearned income. Unearned income plus principal will equal to sale price for debt financing. For conventional banking there is no sale price but the same can be determined by calculating the installment amount times financing period in no. of months.

e) Original Principal  - this equal to the original financing amount;

f) Balance Outstanding - comprise [ original principal + unearned income after net off the monthly installment.] Only when this figure is zerorised, the financing facility is considered paid in full. In debt financing facility, the balance outstanding is equal to the sale price outstanding amount.

Now let's look at Chart 1 again.

Chart 1

Workings

# Unearned Income  [ 10,000,000 x 8.25% x 10 years = 8,250,000 ]
# Installment [ 10,000,000 + 8,250,000 = 18,250,000 divide by 10 years = 1,825,000 ]

Is there a bank earning using the above formula? Yes..! but the Writer is not sure whether this bank still exits or still doing it. In 1996, the Writer attended an Islamic banking seminar in Istanbul, Turkey. One of the speakers in the said seminar reiterated that his family bank (Gulf based) earned income based on above method because it is privately owned bank (then) and does not depend on public deposits.

2. Amortize monthly using straight line method over deferred payment tenure

Under this method, amortization of profits and principal are divided equally over the payment periods (refer Chart 2) . In real situation, this type of formula is normally used for short term financing e.g. 3 to 6 months financing period.

Chart 2

Workings

# Unearned Income [ 6,000,000 x 8.25% x 0.5 months  = 247,500]
# Principal payment [ 6,000,000/ 6 months = 1,000,000 ]
# Profits [247,500 / 6 months =  41,250 ]
# Installment [1,000,000 + 41,250 = 1,041,250 ]

Since the principal balance is on reducing balance, while income amount is the same throughout the financing tenure, effective yield (due to same income but lower principal balance) become higher as the facility is about to mature e.g. 25% on the 6th month.

3. Amortize monthly using similar amortization formula  (a) Monthly Reducing Balance; or (b) Flat Profit Rate (Rule 78)

(a) Monthly Reducing Balance (MRB)

The most common earning formula used by existing Islamic banks is MRB formula (refer to Chart 3). Under this formula, income earning can be divided into two (2) types:-

(i) Pre-scheduled method - similar to calculation using Microsoft Office EXCEL programme. This formula is also known as Constant Rate of Return Formula.

 and

(ii) Reducing Method - profits are calculated based on outstanding principal balance on month-to-month basis.  

More detailed examples of the above will be discussed in our our later session on "Islamic Accounting"

Chart 3

For Excel table, you can use the following formula:

#Monthly Installment:  = PMT(PR/100)/12, Tx12, - P  where PR=Profit Rate, T=Tenure and P=Principal

# Sale Price = Monthly Installment x [ Tenure x 12 ]
# Unearned Income = Sale Price - Principal

or use the formula as follows:





































(b) Flat Rate

The flat rate profit method (also known as Rule 78) is used for hire purchase (Ijarah Thumma Al-Bai) and lease financing (Ijarah or Ijarah Muntahiya Bitamlik). Example of Rule 78 is as per Chart 4.

Chart 4

The formula:

4. Joint-Venture Profit Sharing Method

Profit is calculated based on agreed profit sharing ratio (PSR) pre-determined prior entering the joint-venture contract. Profit/(or losses, if any) is normally determined on completion of project/maturity of financing term. If profits are paid in advance (normally at certain agreed percentage), the advances amount will be re-calculated once actual profit/(or losses) has been determined. Example of profit sharing ratio table is as per Chart 5 below.

Chart 5

5. Yearly Rest Method

Yearly rest method is used by most banks sometime late 1980s or early 1990s. This formula was later discontinued when the BNM (through the Association of Banks Malaysia) issued a new regulation to standardize the formula calculation for term loans etc. Based on Chart 6 below, the profit/(or interest since this is commonly used by conventional banks) it re-calculated every January 1st based on the outstanding principal balance on 31 December each year.

Chart 6

Normally for yearly rest calculation, the amount outstanding may take slightly longer period to be paid due to the way the profit (or interest) is calculated and also depending on the prevailing interest/(profit). Based on simulation as per Chart 7 below, the financing/loan only full paid on 10.4 years.

Chart 7















6. Daily rest method

Daily rest method is normally used for Cash Line (or overdraft) financing facility. Daily rest calculation is similar to the monthly rest method but the only different here is that profit is calculated on daily basis based on daily principal balance. Unlike conventional banking, the daily profits cannot be compounded. At month-end whatever daily profit accrued will be totalled up as income for the month.

Thus, based on the above examples, there are six (6) profit calculation methods (maybe there's more) but most commonly used by Islamic banks today are method 3, 4 and 6.

In our next session, we shall discuss about profit distribution using the reducing balance method.

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22 - Application of Funds

In next few sessions we shall be discussing on a very technical subject relating to how profits are shared between the Islamic banks and their depositors. For those who have been following my blog just to know about Islamic banking in general, go through the topics to have a surface understanding on subject matter but, for students planning to make Islamic banking as their future career and also to practising Islamic and conventional bankers with intention to move their career to Islamic banking,  my suggestion is for all of you to spend some time on my next few topics to appreciate how the profit sharing mechanics work. It is interesting to note that last two (2) years or so, there was a survey forwarded to all Islamic banks on a new or additional profit sharing method using "deposit bucket" but the same is yet to be implemented.  

Towards the end of this session (which shall be divided into several topics), the Writer will provide a blank Profit Distribution Table worksheet (excel form) with some questions. Those interested to understand this topic in depth,  suggest you complete the said exercise.

Before we discuss about the profit sharing methods, we must understand this simple application of funds comparison between conventional and Islamic bank. Let's examine:-

1. Conventional bank makes money from the interest charges on loan it lent out and the cost of deposits (to be more precise - cost of funds) it has to pay to fund the loan, apart from other auxiliary income such as fees and commission etc. On the otherhand;

2. Islamic bank makes money after it has paid its depositors’ portion of the profits based on agreed profit sharing ratio. Under this profit sharing principle, the depositors are the Bank’s joint venture partners ( also share the risk) thus whatever profits paid out by the bank to the depositors are technically, not an expense item (contrary to what is presented in Islamic bank P&L and Balance Sheet) but the depositors’ share of the overall profits distributed by the Bank (who acts as an entrepreneur) in running the business on behalf or jointly with the depositors i.e. depending on types of funds.

Before we discuss on the more technical part of this topic, lets evaluate the overall application of funds of a bank through this simple chart as follows:-

Chart 1 - Application of Funds (Islamic)

Looking at Chart 1, you will notice that sources of funds comprise mainly from three (3) deposit types namely, savings, current and general investment accounts. Although commodity murabahah is also used to garner counter deposits, it is more popularly used by Treasury Department to secure large deposits at fixed rate.

In Malaysia, savings and current deposits accounted to about 20-30% while MGIA is about 50-60% and commodity murabahah is about 10% or maybe lesser. After setting aside certain portion for statutory reserves (currently 1% set by BNM) and for liquidity purposes (normally ranging from 10-15% but in practise depending on how effective the Bank manages its liquidity), the difference is used for financing and investment activities for the bank to generate income. Whatever income derives from these activities are placed in a General Profit Pool (gross profit) prior distribution. After deducting general provisions or certain provisions as required under IFRS accounting, broker's fee, specific provision, income-in-suspense (most Islamic banks still maintain this treatment) and profit equalisation reserves (PER), the balance will be distributed according to the agreed profit sharing ratio between the bank and the depositors. It should be noted that service charges and commissions which are non-financing related are normally not shared with the depositors thus, it will be treated as full income to the Bank.


Excess funds like liquidity reserves and money not use for financing and investment activities, will be placed in the Islamic Interbank Money Market (IIMM) or for purchase of halal securities, sukuks etc

Likewise, for Specific Investment Account, similar treatment is done but whatever income generated from application of this funds shall be placed in a specific pool where whatever balance after deducting similar allowed expenses under Specific Investment contract, shall be distributed only with the Specific Investment Depositors.

Human resources (HR) costs, administration and other operating expenses are to be borne solely by the Bank thus whatever income distributed thereof to the Depositors is technically on gross basis. Under normal non-banking business activities e.g. Sdn Bhd company, the HR, Admin and other costs would have been deducted first prior distribution of profits. As an Islamic bank, it is mandatory for the bank to pay zakat, in addition to the corporate tax payable to the Inland Revenue Department.

Now, let's examine how conventional bank earns its income.


Chart 2 - Application of Funds (Conventional)

At the glance, you can see that the application of funds by conventional bank is different from Islamic bank. Since most of its deposits cost (interest cost) are predetermined on deposit placement, income to the bank depends on how effective it manages its excess funds. Unlike Islamic bank, expenses such as general and specific provisions, brokers' fee, commission payable etc are direct expense items and borne solely by the Bank. After deducting its operating cost, the pre-tax profit is determined.

For our next topic, we shall discuss on various income recognition methods practise by Islamic banks.

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21 - Investment & Fixed Deposit Account

Three (3) common Shariah principles used in structuring deposit products are: :-

1. Mudharabah;

2. Murabahah; and
3. Wakalah.

Let's examine the Mudharabah Deposits first..!

1. MUDHARABAH DEPOSITS

Under Mudharabah Deposits, there are three (3) types of deposit contracts; namely

(i)   Mudharabah General Investment Account (MGIA):

(ii)  Mudharabah Special Investment Account (MSIA);

(iii) Mudharabah Specific Investment Account (MCIA).

Mudharabah Deposits accounted to almost 50-60% of the deposits volume for most Islamic banks in Malaysia. Before we discuss in details on the various types of Mudharabah deposits, let's understand the Shariah requirements for Mudharabah deposits, which can graphically explained in Chart 1 below:

Chart 1

In summary, Mudharabah Deposit can be described as follows:-

1- Profits (if any) arising from the business venture will be shared between the two parties in accordance with predetermined profit-sharing ratios;

2 - Should the entrepreneur suffer losses in his business ventures, the loss will be borne entirely by the depositor/investor (unless there is evidence of gross negligence on the part of the entrepreneur i.e. the bank);

3 - In this venture, there must not be any provisions for “loss sharing”;

4 - It should be noted that since actual profit is calculated on monthly basis, potential income (or return) from investment of the deposits differs from month-to-month depending on the overall deposit taking strategy of the Bank.What it means here, if the deposit is placed under 12-month deposit tenor, there may be 12 different profit rates applicable to it when the bank calculates profits normally payable on maturity.

What are the differences between Mudharabah and conventional FD? This can be summarized as follows:-

Chart 2

Now, what are the differences between the three (3) types of Mudharabah Deposits?

(i)  Mudharabah General Investment Account (MGIA)

MGIA is the most popular among the three (3) types of Mudharabah Deposits. It is common for depositors to compare the MGIA deposit rates with the conventional FD rates as generally, Islamic banks (most of them) in Malaysia (especially the Islamic subsidiary) tend to declare profit rates similar or as close to the conventional FD rates.

In practise, when a Customer intends to open MGIA deposit account, the counter staff will provide the followings:

a)  An application form (normally for first time applicant);

b) Bank will show the past few months profit rates that it had declared as an "indicative" of the future profit rates that the bank may be paying. Since actual profits will be declared at month-end (actually on 16th of each month), the bank (this is the tasks of the counter staff as front liners) cannot guarantee on the potential profit rates that it will be declaring.

c) Bank will advise the Customer the applicable or standard profit sharing ratio (PSR) and the deposit tenor available for placement. Irrespective whether the Customer is a Muslim or a non-Muslim, the counter staff MUST explain why only PSR will be printed in the MGIA certificate. For transparency purposes, the Customer must be made aware that:-

     
       (i) MGIA is not a fixed profit rate investment; and

      (ii) any losses (if incurred by the bank) shall be borne entirely by the Customer (of course in practise, there are various steps to be undertaken by the bank before deduction of any losses from the depositors' principal placement can be done. We shall discuss this in later sessions)

Note: The above terms are printed in the application form but generally, new Customer does not read thorougly the application form so it is good governance to inform Customer of the two (2) important differences between conventional FD and MGIA. Once the Customer is made aware of these terms, the Customer should then be able to decide on the amount and the placement tenor.

d) One very important document that the Customer must sign is a "Profit Equalisation Reserve" (PER) consent/waiver letter. By signing this letter, the Customer gave consent to the Bank to transfer certain percentage of the profits to PER and also agree whatever amount deducted by the Bank is to be treated as donation (tabarru'). We shall discuss in details on PER in later sessions.

An example of PER letter to be signed by Customer is as per Chart 3 below

Chart 3

The Customer must endorsed their agreement on the consent/waiver of PER otherwise the Bank should not open the account. An example of acknowledgement/or acceptance is as per Chart 4 below:

Chart 4

If the Islamic Bank has not obtain the PER waiver/consent letter, Shariahlly, the bank has to declare whatever gross profit amount due after deducting the eligible expenses approved by BNM. The situation will become more difficult when the bank has yet to request such waiver/consent from existing depositors. To ensure Shariah compliant (to validate the use of PER account), the Bank should make stern decision to withdraw or separate the deposits account, if such consent/waiver letters are not obtained from Depositors.

e) Unlike savings deposit where depositors can withdraw their money anytime without notice, any premature upliftment of MGIA before maturity, the bank reserves the right not to declare the full income potentials of the deposit placed. For example, when a 12-month deposit is uplifted prematurely on the 7th month, the Bank will still pay ACTUAL profits but payment shall be made using this formula:-

         i) Only completed month will be considered - For example, placement date is 1st Feb (refer Chart 5 below) and it was prematurely uplifted on 7th Sept. Completed months will be 7  i.e. up to 1st Sept and the additional 6 days, will not be counted

        ii) Subject to the lowest standard tenor to the completed month - For example, assume deposit tenors available are 1, 3, [ 6 ], 9, 12, 15, 18 and 24 months. Customer placed deposit for 12-month and decided to uplift prematurely on 7 Sept.  The nearest lower standard tenor for  7 completed months is the "6-month standard tenor" and for the past 7 months, the actual profit rates declared is say, (abcdefgh%). So, the bank will pay that profit rates (abcdefgh%) instead of paying the actual profit rates meant for 12-month deposit tenor.  Let's further examine using this simple and straight forward example in Chart 5.

Chart 5

Using Formula [ Principal x Profit rate x (Days in Month divide by No. of Days in Year or 50,000)  x 2.50% x 28/365 = RM95.89 ] for the month of March '10 and so on, up to the 7th month on Sep '10. Practically, the calculation is a bit more complex because in Malaysia, the profit rates are declared from 16th to the 15th of the following month. So, technically the Bank should apply profit rates declared from 1st to 15th and another from 16th to 31st of the month. We shall not discuss or argue on this issue but sufficient to say that the main reason for declaring profit rates within the period earlier mentioned is because most banks prepare their profit distribution table manually (using excel table) thus, to ensure sufficient time for collection and calculation of data, profit rates are only declare on 16th day of each month.

It is interesting to note that if conventional FD is uplifted before maturity, the depositor will either get half the contracted FD rate or based on savings rate. Thus, technically there is no penalty for upliftment before maturity for Islamic investment deposits.


 (ii). Mudharabah Special Investment Account (MSIA)

MSIA is normally used by Treasury Department when taking large deposit amount from Corporate Depositors or from another Bank for placement under Islamic Interbank Money Market (IIMM). Under MSIA, the depositor can negotiate the profit sharing ratio but minimum placement amount is at least RM50k.

We shall discuss further on MSIA when we talk about IIMM in our next couple of sessions.

 (iii). Mudharabah Specific Investment Account (MCIA)

MCIA can be graphically explained in Chart 6 below:

Chart 6

Under MCIA, the depositor is entitled to negotiate the profit sharing ratio (PSR) and also decide on the type of projects/risks that depositor intends to participate e.g. on telecommunication industry only. Profits earned from the specific project will be placed in a “special pool” where Bank share the profits/(or loss) solely with that particular “specific” depositor.

Specific depositor is not allowed to uplift their MCIA prematurely i.e. cannot terminate the contract before completion of project. If the contract is breached, the bank may at its discretion, choose not to pay whatever profits earned to-date but can claim whatever losses incurred to-date by reducing the original principal placement amount. Depending on the internal policy of the Bank, it can however, request Depositor to get a replacement depositor (to cover similar amount) but subject to the new depositor agreeing with the existing terms of the original specific contract.

2. MURABAHAH DEPOSITS (Fixed Deposit Account)

Literally Murabahah means cost-plus or mark-up sales. Murabahah contract can be used for "cash creation" for the purpose of investment or financing.

In structuring deposit product using Murabahah, Islamic Banks can use

(a) Bai Al-Enah contract which involves purchase and sale of Assets between two (2) parties; or

(b) Commodity Murabahah contract (or Tawwaruq) which involves purchase and sale of commodity such as palm oil, metal and the like, but  the transaction usually involves three (3) or four (4) parties.

Again, the Writer wish to stress that we should not argue about the validity of Bai Al-Enah or Tawarruq transaction. Let's the Shariah scholars argue about these principles. What the Writer will do is to comment on how the Bai Al-Enah or Commodity Murabahah transactions are conducted i.e. its practical implementation.

Now let's further examine the two earlier contracts mentioned.

a) Bai Al-Enah

Under Bai Al-Enah, the underlying assets are normally the bank's own Assets such as floor space/lot (identified by plots) or other assets such as company car and the like other than gold and silver. Some Shariah Committee insists that the Asset to be used for transaction purposes cannot be used but place as a display item. For example, if the bank wishes to use a new car value at RM100k, the car will be placed on display at certain location accessable to all Customers, if they wish to see it. Due to depreciation, the said car will be placed on display for only about a year and then disposed-off by tender.

Let's for our example, we are using floor space/plot as the Bank's Asset to validate the Bai Al-Enah contract.

The Bank will sell these plots (after assigning certain value on the plots) and then buy back on deferred payment basis. Graphically, the floors are divided as per Chart 7

Chart 7

For good governance, to use the office space/plots as the underlying assets for Bai Al-Enah transaction, proper Board of Directors' resolution and Shariah Committee's approval must be obtained. On why the Plots are divided into different sizes, it is basically to cater for the different transaction volume. In addition, once the plot is being used for a particular transaction, the same plot cannot be used again unless the Bai Al-Enah transaction has been concluded.

b) Commodity Murabahah (Tawwaruq)

Under Tawarruq, the underlying asset is commodity such as palm oil or metal. Some banks use stocks such as halal tin products that are easily identify and touch. Basically, it is a sales of certain specified commodities, through an exchange, on a cost plus profit basis.

It should be noted that Commodity Murabahah Deposit is a product that gives the investor a pre-determined rate of return (different but akin to conventional FD pricing) via buying and selling of commodities as the underlying transactions. Like Bai Al-Enah, Commodity Murabahah can also be transacted as a deposit taking or a financing instruments.

The transaction flows for Commodity Murabahah where the Bank accepts money from a depositor is as per Chart 8 below:

Chart 8

For the Bank to accept deposit under Commodity Murabahah, it must undertake the purchase and sale transaction of the commodity. Parties involve in Commodity Murabahah transactions, are:-

i)  Depositor (Party A or Investor) who has surplus funds;
ii) The Bank (wakeel or agent) which requires the funds;
iii) Broker 1 (party which transacts or sell the underlying commodity);
iv) Broker 2 (the other party which also transact or buy the underlying commodity from the Bank).

The transaction flows can be read together with Chart 8 above:-

#1 - Bank receives fund from Depositor (Party A) as a Wakeel (under the principle of wakalah).

Note
In practise, the Bank staff who is assigned to transact the deal on behalf of the bank must call the customer, record the customer's name (deal only with authorized staff of the Customer), note the time and payment mode, to be followed by written confirmation by both parties;


#2 - Bank as wakeel uses the fund provided by Depositor to buy the commodity from Broker 1 (through Agent or direct) on behalf of the Depositor (Party A) on SPOT basis;

#3 - Due to the size and volume of the Commodity, Broker 1 shall retain the commodity in its possession (storage yard) as a safe keeper (fully covered by Takaful or insurance etc) but the "beneficial ownership" of the commodity is transferred to the Depositor (Party A). Official letter of confirmation/or Purchase confirmation receipt shall also be sent to Party Depositor (Party A) for purchase of the commodity.

Note
In practise, the Bank (preferably the Shariah Officer of the Bank) will visit and verify the storage place, the transaction documents, confirm the quantity etc so as to ensure the transaction is valid and ensure existence of the commodity. Surprise audit/check may need to be done from time to time.

#4 - Being the beneficiary owner, Depositor (Party A) has absolute right to deal with the commodity. Since the Depositor (Party A) does not to keep the commodity, the Depositor (Party A) sells the commodity to the Bank at agreed sale price comprising original cost plus mark-up on deferred payment basis to the Bank. The beneficial ownership of the commodity is then transferred to the Bank;

#5 - As the new beneficiary owner, the bank has the option to keep or sell the commodity. Since it wanted cash, it then sell the back to Broker 2 (through Agent or direct) at a discount equivalent to the original cost price on SPOT basis;

#6 - Broker 2 will pay the Bank at the SPOT price;

#7 - On maturity date of the deferred payment contract between the Bank and the Depositor, the Bank will pay Depositor (Party A) at the agreed sale price i.e. the original amount plus the profit.

The above transaction flows must be supported by proper accounting entries to ensure the transaction is Shariah compliant.

It should be noted that some Shariah Committee insist that the commodity to be sold to different party i.e. must have two (2) brokers instead of one (1). However based on various practises on Commodity Murabahah, the Writer opines there are still a number of issues that need to be resolved at industry level to ensure the Commodity Murabahah is really transacted in accordance with Shariah requirements. In situation where two (2) Brokers are used, the Brokers are supposed to be a different entity but in practise, they are from same group although on paper they are not connected.  Both Broker 1 and Broker 2 are required to maintain a non-checking account in the Bank. Broker 1's non-checking account will be credited by the Bank (when the Bank purchase the Commodity) and when concluding the transaction, Broker 2 will pay to the Bank (as agent of Party A when it sold the commodity to Broker 2).

The Writer wish to highlight the following issues raised by certain practitioners. Where does Broker 2 gets the money to pay the Bank when it buys the Commodity from the Bank..?

Again in practise, both Broker 1 and 2 will square their positions by Broker 1 instructing the Bank to transfer whatever money credited into its non-checking account to non-checking account of Broker 2, so payment for the commodity purchase from the Bank by Broker 2 can be affected. Is this arrangement acceptable by Shariah? How about using only one (1) Broker i.e. the commodity is sold to the bank and when the transaction is completed, pay for the purchase of commodity using same money earlier credited to its account by the Bank to purchase the commodity. This is more straight forward.

Another issue, why do we need to use Commodity Murabahah when the real intention ("niat atau tujuan sebenar") is "creation of cash". Why the long-winded process as though "Allah" is not aware of one's intention. Under this argument, using Bai Al-Enah contract is more straight forward (Allah knows our intention) without using "back-door process such as commodity murabahah" to validate cash creation transaction although most Shariah scholars argue on its validity.

We hope the Shariah scholars can clarify the above issues.


3. Wakalah Deposits

Another deposit product which is normally transacted by the Treasury Department is Wakalah Deposit (some spell it as wakala). Wakalah is a contract whereby the bank in its capacity as Agent, raises funds from its customers to invest these funds in a Sharia'h compliant good and/or financial assets. The Wakil (bank) has a responsibility to ensure investing in assets will yield certain return greater than as specified by the Principal. The rate of return that the bank normally offers to Wakalah customers is the "expected/anticipated profit rates" and not "guaranteed rates" as these are based on the underlying earning assets performance. The Bank as an agent, receives agency fee for undertaking the job of investing on the Principal's behalf.


Since Wakalah Deposits is more becoming a product of the Treasury Department of the Bank, we shall discuss this product in some more details when we discuss about Treasury products.

Finally, in our next session, we shall discuss on the profit sharing concept and how profits are calculated and distributed with the Bank's depositors.


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