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)
- 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.
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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