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 Deposit can be withdrawn through issuance of cheques, automated teller machines or over the banking counter during banking hours.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