18 - Funding in Islamic Banking

Similar to conventional banks, 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. In addition, to avoid co-mingling of the funds, separate accounting books are maintained by the Islamic banks.

The original source of the Islamic funds has to be ascertained to ensure it come from a “halal’ sources. Under a dual window banking operation, the initial paid-up capital is normally given on al-Qard basis (benevolent loan which is free of interest) from the conventional counterpart thus there should not be any issue in regards to the source of the funds.

Deposits from customers are collected from various contracts, which can be briefly described as follows:

1. Al-Wadiah Deposits

   a) 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. Deposit can be withdrawn through issuance of cheques, automated teller machines or over the banking counter during banking hours.

  b)  Savings Account-i : similar to current account except it does not have cheques facility. Under strict principle of Al-Wadiah, bank cannot give any return for Al-Wadiah deposits. Nevertheless, in practise (particularly in Malaysia), Islamic banks are giving certain return as hibah (or gift) due to mas'lalah (public interest) reason as they need to compete for deposits with the conventional banks

2. Al-Mudharabah Deposits

There are two (2) types of Al-Mudharabah deposits namely a) Al-Mudharabah General Investment Account (MGIA) and Al-Mudharabah Specific Investment Account (MSIA). The features of these deposits are as follows:-

a) MGIA - This is an investment account with pre-determined profit sharing ratio and maturity period. General investment deposits are contracted under the Mudharabah principle where depositors and the Islamic Bank agree at the time of placement, the profit sharing ratio and the placement duration. To subscribe to the principle of fairness, depositors that place funds under longer placement tenures will be paid higher profits then depositors that places funds under shorter tenures. Brief understanding of the formula used by Islamic Banks in Malaysia in the distribution of profits shall be discussed in latter session.

b) MSIA - This 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 return and the adherence risk that come with it. Generally, returns on specific investment account are very much higher however there are not many depositors that are keen to place their funds under this type of deposits. Any losses from the project shall be borne entirely by the specific depositors. Generally, depositors for this type of deposits are by invitation basis and common projects that bank will use for this type of funds are real estate related.

3. Commodity Murabahah-i (CM)

CM is also another unique deposit contract. Under this contract, the Customer will purchase commodity (normally crude palm oil or metal) from a broker, say Broker A who will sell the commodity to the Bank on deferred payment (including profit margin). Once the ownership of the commodity has been transferred, the Bank will then sell back the Commodity at at discount for cash through another Broker, say Broker B. On maturity of the deferred payment term, the bank will pay the Customer the agreed deferred payment price. Technically, this product is a fixed profit rate deposit account.

4. Islamic Interbank Money Market(IIMM)

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 a loss to the bank) there will be an immediate need to cover its position (say also due to certain unexpected withdrawal by its large depositors or it has to make a large financing drawdown), it will normally call another bank (say, Bank X) with excess fund to invest (technically, under conventional banking it is termed as borrowing) by making placement with them. On maturity, Bank X will be paid as per agreed sale price of the Commodity.

Apart from the above deposits products, we shall also discussed other types of deposits that are also been offered by Islamic Banks.

The rate of return on deposits depend 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 bank performed.  Depositors of Islamic Banks will earn higher returns when profits on investments ventured by the Islamic Banks are higher or vice verse. Infact, most Islamic banks offer profit rates declared on a month-to-month basis where if a customer placed his deposit under 12-month placement 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 return compared to if they are to place the same funds under longer tenure in conventional banks. The situation however may be reversed if the interest rate trend is on reducing trend. The writer is of the opinion that when the Islamic deposits accounted to more than 50% of the conventional bank, deposit performance of Islamic banks may no longer be influenced by interest rate trend. Currently, to avoid commercial displacement risk (depositors moving from Islamic to conventional or vice verse for better interest/profit rates), most Islamic banks are still using conventional interest rate trend to plan its deposit strategy except for longer tenure deposit (usually 15 months and above) where Islamic banks’ profits are generally higher than conventional banks.

One very important selling point, Islamic bank does 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. However for MSIA, the Bank reserves not to pay any profit .

One major issue where depositors are still not accustomed is the in availability of return figure on the certificate of deposits for General Investment Account-i. What will appear on the deposit certificate is profit sharing ratio (PSR). 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, depositors 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.

In our next topic the Writer shall highlight the detailed description of the deposit products together with its comparative analysis.

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17- Growth In Islamic Banking

The Islamic Banking system can attain significant growth if the value proposition is better understood. Any misconception about Islamic banking, once eliminated, will certainly encourage and entice more Customers (irrespective of race and religious believes) to switch from existing conventional to Islamic banking. Perhaps, the true value propositions have been not been fully revealed by conventional banks with Islamic subsidiaries, fearing that Islamic banks will cannibalize their existing conventional banking businesses. One key misperceptions until today (although Islamic banking has been introduced in Malaysia since 1983), is that Islamic banking is exclusively for Muslims. With the affixing of an "i" to Islamic banking products rather than applying the Arabic contract name,  has to certain extend make the product more acceptable to non-Muslims.

The Writer's concern is that till date, Islamic subsidiaries are more comfortable to emulate whatever products currently offered under their conventional counterparts rather than do more complex products like Specific Investment and Musharakah financing. One or two Islamic banks (not Islamic subsidiary) have shown some effort but the offering are not openly marketed.

Islamic banking products and services address the requirement for all, regardless of race and religious belief. For Muslims, it will fulfil their religious obligations where they must refrain from taking usury (or interest). For non-Muslims, it provides viable alternatives to their conventional banking products. Comparatively, the latter is predominantly driven by floating interest rate system, as opposed to Islamic banking that offering more flexibility from fixed, hybrid of fixed and variable profit rate mechanism, thus promoting certainty, clarity and predictability in its financial transactions. In addition, Islamic banking also offers profit-sharing contracts for example, Diminishing Musharakah financing which we discussed in previous Topic 16.  Customers, particularly the Depositors (or investors in the true sense of risk and reward arrangement), can enjoy higher returns (at agreed profit sharing ratio) from profits generated from the bank's investment in financing and other ventures as opposed to conventional banking model where profits generated from the bank's business is not shared but predetermined on placement of the deposits. Technically, in a rising deposit rate trend, depositors who place funds under a long tenure conventional fixed deposits will lose out while depositors of Islamic banking deposits will continue to enjoy uptrend movement of the profits rates (irrespective of their placement tenure) which is normally benchmarked against the "interest rate trend" due to competition.

With regards to Islamic banking financing products, particularly debt financing. the pricing is determined as a fixed selling price which incorporates and predetermines the profit levels that the Islamic bank will charge for the whole financing tenure. This will enable the Customers (or the borrower as termed under conventional banking) to better manage their cash flow, unlike conventional banking loans where the interest rate is on a floating basis.

The 1997 financial crisis taught us a great lesson where floating interest rate pricing had caused hardship to both businesses and consumers alike. We have to accept the fact that our whole economy is still driven based on conventional economic theory. On top of that, the "interest upon interest" or compounded method used by conventional banks, is strictly prohibited under Islamic banking. Late charges on overdue installment is normally charge as a deterrent and whatever income derived from late charges are given to charity unlike conventional banking, late charges shall be part of the bank's income.

Effective next couple of sessions, we shall focus on Islamic banking funding system covering various Islamic banking deposits (for consumer, corporate and interbank money market) and how profits are shared between bank and the depositors. We shall also make comparative analysis between Islamic and conventional deposits for better understanding on the differences.


 

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16E - Restructuring & Rescheduling

While servicing the monthly rental under DMF, the Customer may request (if agreeable by the Bank) to lower his/her monthly rental due to unexpected situation such as sudden out of job, economic crisis, business failure etc. As long as the Islamic Bank is agreeable with such requests, the Bank can change the monthly rental at any time to suit its Customers' payment capabilities. If this is adopted, issue on non-performing financing will be resolved or at least reduced. The upside for both parties, the Customer will take longer time to finalise the facility and the Bank's effective return will be reduced.

The above proposal may not follow the GP3-i guideline issued by Bank Negara Malaysia but the Writer believe this is one way to avoid non-performing. In adverse situation, the Bank can still opt for Put Option Default but since the Bank is a joint venture partner, it is also subject to risk if the market value of the property is lower than the outstanding balance of the DMF facility. Any losses incurred on disposal of the property, shall be borne by the Bank accordingly. However, if the property is sold through a panel real estate agent and not at forced sale price but at best market value, the risk will be mitigated.

To consider lower rental amount, the Bank should consider the following actions:

1. Rental Value Method – the profits and buy-back portion will be distributed based on the equity position of the JV partners.

2. Effective Rate Method – when the rental is re-computed at lower amount while the profit rate remained unchanged, the profit portion (amortisation based on original rental) will result lower principal payment and possibly, the lower monthly rental cannot fully cover prevailing profits due. In such situation, whatever amount collected should go to profit first to maintan the Bank's IRR. This can also result, lower or temporary suspension of the principal payment which will also result extension of the payment period. 

3. Mutual Agreed Method – the treatment is similar to Rental Value Method.

Upon re-assuming the normal or reschedule monthly rental, there is no necessity for customer to update all the back dated rental (due to rescheduling to lower the monthly rental) unless original payment method is based on ERM, where customer need to observe the original payment tenor (or EAP). Under ERM, all back dated payments should be updated before the expiry of the original maturity period.

Non-performing situation will only be triggered if customer totally cannot pay AT ALL and the bank had to exercise the Call Option Default. The option is triggered as follows:

• Customer defaulted in paying the monthly rental for 3 consecutive months;

• Customer did not take effort in rescheduling or lowering his monthly commitment downwards to resolve his default position;

• Bank has to write to customer advising the Bank will exercise PUT OPTION DEFAULT. Upon expiry of the said notice, the Bank will appoint immediately a panel real estate agent to dispose-off the property.

• Any capital gain or losses from sale of this property shall be shared by the Bank and the customers after deducting all sale expenses and charges/debits due to the Bank.



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NOTE

Due to many requests via personal emails received by the Writer, hereonward we shall go back to Writer's original proposed contents before we continue our discussion on financing products.

Actually there are two (2) more sessions to be discussed under DMF but we shall temporarily hold both sessions, namely (a) purchase of property under construction and (2) legal documentations, until we reach the session on financing contract of Ijarah Muntahiya Bitamlik or leasing ending with ownership.

16D - Security Position & Collection

Currently, the National Land Code does not cater for Equity JV property financing thus, most Islamic banks offering DMF in Malaysia (with exception to 1 international bank) will take a charge over the property to be financed. As earlier argued, the ambiguity appears when the property is to be auctioned as though it is a debt financing.  Although, there are arguments that overdue rentals can be considered as debt when due but not yet paid, the the spirit of Musharakah should be observed under DMF. Thus, to maintain the spirit of Musharakah, disposal of the property should also follow the Musharakah way.

The Writer is of the view that the DMF facility should be documented using a Trust Agreement. Although for administration purposes, the property may be registered in the name of the Customer (due to current land laws in Malaysia), the Customer merely acts as the proxy of the joint venture partners or on behalf of the beneficiary owners who are actually the joint-venture partner. As the Writer is still not sure on the detailed legal implications using Trust Agreement, the Writer seeks Legal and Shariah practitioners to explain implications of the same, if used to document DMF. If there are loopholes or hindrances in our current land laws, how this can be revised to support the implementation of DMF in Malaysia. Anyhow, from Writer's little knowledge on Trust Agreement, it can be used but when we want to dispose-off the property, we need to go back to the Customer for consent. If this is so, perhaps, we can incorporate some kind of "pre-consent clause" allowing the Bank to take unilateral action when it comes to default situation.

The joint venture contract is considered terminated once the Customer has fully subscribed (through rental payment) the remaining equity previously owned by Bank including payment of whatever dues such as shared quit rent, Takaful and other administrative charges, where applicable.

Thus, the way DMF contract can be terminated are through the following options:-

1. Put Option Cash

Under Put Option Cash, the customer would like to terminate the Tenancy Agreement (and the DMF Financing) by acquiring balance of the equity still holds by the Bank at par value of RM1 by cash. Under this situation, the Bank is obliged to accept full payment from the Customer. By cash include receipt of redemption amount from other Bank on assumption that the Customer is refinancing the facility only.

2. Put Option Sale

Customer intends to sell the property for capital gain. Under this arrangement, the Bank can exercise the followings:

(a)  Customer to give consent to the Bank (should be incorporated in the Diminishing agreement) to arrange sale of the property through a registered real estate agent or any party introduce by the Customer at price most beneficial to both the Bank and the Customer. A “without prejudice” clause must also be incorporated in the Agreement to protect the bank and Customer from any dispute on sale price once sale is concluded through whichever mode agreeable by both parties.

(b) Customer will be allowed to suspense (if he wishes) to pay the monthly rental.

(c) Capital Gain from the sale of this property will be shared by the JV partners in accordance with the relevant share equity prevailing at time of receipt of sale proceeds.

(d) Real Property Gain Tax (if any) will be borne by the relevant parties in accordance to the country's tax structure;

(e) The “First Right of Refusal” clause will also be incorporated in the Agreement conferring the Bank the right to buy the property from the customer directly at price agreed by both parties. This is necessary if there is urgency to dispose of the property or somehow, there is no buyer for the property. On the other hand, this will give flexibility to the Bank to temporarily own the property on assumption that there is potential upside on the property value, if it dispose it later.

(f) If the property is bought over by the bank (on anticipation that the price can hike further), it would be treated as an investment and whatever Bank Negara rules regarding investment or property own by Islamic banks shall apply. Unless the Islamic Bank Act has been revised recently, current Acts allows Islamic banks to own, rent, lease and trade the properties. Unlike under BAFIA (for conventional Bank), the Bank can only own property for its business use only e.g. for its own business premises.

Note

Some propose the signing of Wa'ad requiring Customer to purchase the equity in situation of default since when monthly rental remained overdue, a debt is created. Yes, the Islamic Bank can claim the overdue rental which can be considered as debt when not paid but the Writer opine that when the Customer is already unable to pay the monthly rental, asking the Customer to acquire the balance of the DMF equity, is also against the spirit of Musharakah.

3. Call Option Default

When Customer is unable to service the monthly rental for more than 3 months it will trigger a situation of default. To have a "win-win" situation for both parties, the property will not be auctioned but instead sold through a panel of real estate agents (similar to Put Option Sale except, under this situation, the Bank has more say in handling the disposal of the property).

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16C- Equity Acquisition Period (EAP)

In all types of financing, it is important for Customers to know the total amount that they are required or expected to pay before they can fully own the property normally charged to the Bank. Under BBA financing, a Customer is able to know immediately the total amount payable since the sale price is fixed (with exception to hybrid fixed and variable pricing BBA facility) throughout the financing period. But for a conventional loan, the Customer will only know the total amount payable on maturity of the facility since the interest charge is on floating basis (pegged against base lending rate or BLR which moves up and down), although he can also know the potential amount payable on inception of the loan, by multiplying the monthly installment due with the total repayment period in no. of months.

For academic purposes, the Writer will provide comparative analysis table to determine whether DMF is cheaper than BBA financing. Comparison with conventional loan will only be done in later session on debt financing.

Simulation 1 – DMF (MAM)

• Monthly rental based on effective return of 7.0% to the Bank throughout the financing period;

• Distribution of principal payment and profits to the Bank is totally dependent on profit sharing ratio (PSR) except, during inception of the facility where the monthly rental is calculated based on effective return wanted by the Bank (if the Bank needs to maintain certain internal rate of return for its profit);

• Any changes in monthly rental thereafter, the distribution of principal payment and profit shall be  based on prevailing PSR.

Simulation 2 – DMF (MAM)

• Monthly rental amount and effective return to Bank is similar to Simulation 1 except Customer pays optional amount (without prior notice) to equate the actual monthly rental payable based on 7.0% profit rate used for calculating BBA monthly installment for similar financing period.

Simulation 3 – BBA

• Monthly installment based on actual calculation at profit rate of 7.0% which is RM697.77 instead of RM575.00 for Simulation 1. The reason for higher amount payable for BBA although the profit rate is the same; is because Islamic Banks are using same formula for calculating conventional loan monthly installment. We will learn more about this formula in our session later on BBA.

Simulation 4 – BBA

• Monthly installment is determined based on similar calculation under Simulation 1 and same amount is payable throughout the financing period;

• Non compounding on profit due but not yet paid.

Results of the above four (4) simulations are as follows:-

Explanation

Based on Simulation 1, the facility will be matured within 33.08 years and profit payable to the Bank is 156.58% above the original financing amount. However, for Simulation 2, with additional payment of RM122.77 monthly, to equate actual monthly installment of RM697.77 for debt financing, the facility will be matured by 19.83 years. In addition, total profit payable to the Bank is only 83.01% above the original financing amount compared to Simulation 3 which is 86.01% (maturing at almost similar time to Simulation 2). But when we use RM 575 instead of RM697.77 as the monthly installment under Simulation 4, the facility will be settled by 35.08 years and profits payable is 168.10% above the original financing amount. 

If we are to compare the EAP, the differences between Simulation 1 and Simulation 4 is only about 1 year but under DMF-MAM model, the Customer can pay optional payments without notice and this will help Customer to buy the equity earlier.

Take note that this simulation does not mean anything if Islamic Banks do not adopt or offer MAM for their DMF but use ERM instead.

Those interested to have the excel version of the simulations, can email to the Writer at ismail.aminuddin@gmail.com

 

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