35. MONEY CREATION

A simple way to understand how banks create money is through a process called fractional reserve banking. The 'fraction' is the key part.

The Basic Idea

When a customer deposits money in a bank, the bank doesn't just lock it in a vault. It is required to keep only a small fraction of your money on hand (this is the "reserve"). It lends out the rest.

The "magic" happens when the bank makes a loan. It doesn't hand over a briefcase of cash. Instead, it simply adds digital numbers to the borrower's bank account. In that instant, new money is created.

Let's walk through it.

A Simple Example: The $1,000 Deposit

Imagine the "reserve requirement" is 10%. This means banks must keep 10% of all deposits on hand and can lend out the other 90%.

• A customer deposits $1,000 into Bank A.
• Bank A's vault: It holds $100 (10% reserve) and can lend out $900.
• Initial Money Supply: $1,000 (your deposit).

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• Bank A lends $900 to Sarah, who is buying a bike from Tom. The bank puts that $900 loan into Sarah's account.
• Sarah buys the bike and pays $900 to Tom.
• Tom deposits that $900 into his account at Bank B.
• Total Money Supply: Now it's $1,900 (your $1,000 + Tom's new $900).

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• Bank B's vault: It now has Tom's $900 deposit. It holds **$90** (10% of $900) and can lend out **$810**.
• Bank B lends $810 to Martin, who gets a new deposit for that amount.
• Total Money Supply: Now it's $2,710 (your $1,000 + Tom's $900 + Martin's $810).

This process continues, with each new loan creating a new deposit, which is then re-deposited and re-loaned (in smaller and smaller amounts). The customer’s single $1,000 deposit has allowed the banking system to "multiply" it into thousands of dollars of new money.

Key Takeaways

• Banks create money by lending. They don't lend your actual money; they create new digital money (a deposit) for the borrower.
  
  
• This new money is technically debt. The borrower gets a deposit (an asset) but also has a loan (a liability).
  
  
• The reserve requirement. Set by the central bank, it controls how much money can be created. A lower requirement means banks can lend more, creating more money.
  
  
• An important note: In some countries, like the United States, the reserve requirement has been set to 0%. Banks are no longer limited by this rule, but other regulations (like capital requirements) still govern how much they can lend. However, the basic principle of creating money through new loans remains the same.

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The Money Multiplier: How Banks "Gear Up" an Initial Deposit

The number of times a bank can "multiply" an initial deposit is determined by the Money Multiplier.

The formula is simple:

Example: The 10x Multiplier. Let's use the same 10% reserve requirement as an example.

• Reserve Requirement: 10% (or 0.10)
• Calculation: 1 / 0.10 = 10

This "10" is the multiplier. It means that for every $1 deposit, the banking system can eventually create a total of $10 in the money supply. So, with the original $1,000 deposit, the maximum amount the money supply can "gear up" to is $10,000 ($1,000 x 10).

Here is a table showing how the "gearing up" happens:

Round	New Deposit	Reserve Held (10%)	New Loan Created (90%)	Total Money Supply
Start	$1,000.00	$100.00	$900.00	$1,000.00
2	$900.00	$90.00	$810.00	$1,900.00
3	$810.00	$81.00	$729.00	$2,710.00
4	$729.00	$72.90	$656.10	$3,439.00
...	...	...	...	...
Final Total	**$10,000.00**	$1,000.00	$9,000.00	$10,000.00

 

In Reality, the "Fractional Reserve Banking" terminology

In reality, this "gearing up" (or multiplier) based on deposits is a simplified model that is no longer accurate for modern banking. The "gearing" is not limited by reserves. In fact, in many major economies, the reserve requirement is now 0%.

The Plot Twist: The 0% Reserve Reality

In March 2020, the U.S. Federal Reserve (and many other central banks) officially reduced the reserve requirement ratio to zero. (In Malaysia, the Statutory Reserve Requirement (SRR)  is 1.0%. This rate was set by Bank Negara Malaysia (BNM) and became effective on May 16, 2025, after being lowered from the previous rate of 2.0%. The SRR is the proportion of a banking institution's eligible liabilities that it must hold as a balance in its Statutory Reserve Account (SRA) with the central bank. BNM uses the SRR as an instrument to manage liquidity in the banking system.

Anyhow, if the old model were true, a 0% requirement would mean an infinite multiplier. Banks could create unlimited money. This is clearly not the case. This single fact proves that reserves are not what limit bank lending. This leads to the real story.

The Real Limit: Capital Requirements (Basel III)

So, if banks don't need reserves to lend, what stops them? The answer is Capital.

• Reserves (Old Model): A bank's liability. This is the depositors' money that the bank holds.
  
  
• Capital (Real Model): A bank's asset. This is the bank's own money—from shareholders and profits. This is its "skin in the game".

This is how it really works:

1. A bank does not wait for a deposit. It finds a creditworthy borrower for a home loan.
   
   
2. The bank creates the loan ex nihilo (from nothing).
   
   
3. It does this by simply typing numbers into a customer's account. In that instant, new money (a deposit) is created.
   
   
4. The actual limit on this creation is the Capital Requirement, set by international rules like Basel III.
   
   
5. Regulators might say, "For every $100 you lend, you must have $8 of your own capital to absorb the loss if that loan goes bad".

The limit is no longer a reserve limit; it is capital. A bank with $8 million in capital could "gear up" and create $100 million in loans, regardless of its deposits.

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The Fundamental Conflict: Conventional vs. Islamic Banking

This "money-from-nothing" model is the foundation of the conventional banking system. And it is, by its very nature, in direct conflict with the principles of Islamic finance—and the capital requirement rule doesn't solve it. The conflict isn't about safety rules. It's about the very source and purpose of money.

1. Riba (Interest)

The conventional bank creates a $100,000 debt from nothing. Its entire business model is to charge a fixed, guaranteed fee (interest) on that created debt. It is "renting" money for a guaranteed profit. This is the definition of Riba (interest), which is strictly prohibited in Islam.

2. Creating Debt vs. Financing Assets

The conventional bank creates pure debt. The loan is just a digital number, a claim, not tied to any real-world asset.

• A Malaysian Example: In Malaysia, for example, personal loans (via personal financing, credit cards, etc.) can create unnecessary spending, placing many young people in debt.
  
  
• Based on recent data from Bank Negara Malaysia (BNM) and other financial reports, the Malaysian banking system's lending is heavily weighted towards households rather than the business sector. Lending to the household sector makes up the majority of total bank lending in Malaysia, at approximately 55-60%. The remaining 40-45% is directed towards "real economy" sectors, such as businesses, trade, manufacturing, and construction.
  
  
• What is "Household Debt"? This large 55-60% "household" portion is not primarily small personal loans or credit card debt. The overwhelming majority are tied to asset purchases:
  
  
• Mortgages (Home Loans): This is the single biggest component.
  
  
• Vehicle Financing (Car Loans): The second-largest driver.
  
  
• Personal Financing & Credit Cards: This includes unsecured personal loans and outstanding balances.
  
  
• As of recent data, household lending (driven by mortgages and car loans) continues to grow at a faster pace than business loans.

While Islamic finance, in principle, prohibits the creation of pure debt, a common workaround in practice is the Tawarruq contract. This instrument, often justified as a temporary solution based on public interest (maslahah), faces significant criticism for being a 'disguised sale' that synthetically creates debt. This reliance raises a persistent question: For how long can such concessions be made before they undermine the foundational principles of asset-backing and risk-sharing?

It is important that all Islamic financing must be tied to a real, tangible asset or service. An Islamic bank cannot just give you $100,000 in "debt". Instead (in a Murabaha contract, for example), the bank must first buy the house itself. It then sells that house to you at a pre-agreed-upon markup. Your payment is for a real asset (the house), not for "money". The bank's profit comes from a sale, not from lending.

3. Risk-Transfer vs. Risk-Sharing

This is the most critical difference.

• In the conventional model, the bank transfers all risks. If you take a loan and your business fails, you still owe the bank its money plus interest. The bank has a guaranteed profit and takes zero risk in your actual venture.
  
  
• In the Islamic model, this is unjust. Financing must be based on Profit and Loss Sharing (PLS). In a partnership (Mudarabah), if the venture loses money (without negligence), the bank (as the capital provider) bears that financial loss. The bank must share the risk of making a profit.

 Summary: The Core Conflict

Feature	Conventional Model	True Islamic Banking
What is Created?	Debt (from nothing)	A Sale or Partnership (tied to a real asset)
Source of Profit?	Interest (Riba) (A fee for lending money)	Profit (Ribh) (From a sale or a share in a venture)
Risk Structure?	Risk-Transfer (Borrower takes 100% of the risk)	Risk-Sharing (Bank and customer share the risk)
Capital Requirement?	Yes, a regulatory safety rule.	Yes, a regulatory safety rule.

Even with modern Basel III capital rules, the conventional system is still based on creating debt from nothing and charging interest on it. This violates the core Islamic principles of prohibiting Riba, requiring asset-backing, and demanding risk-sharing.

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 These videos on fractional reserve banking provide a simple visual walk-through of this money-multiplying process. 

Another very interesting video is a very open discussion by Mr Zahid from MMJ

Encik Zahid menerangkan berkaitan "Money Creation"  

dalam Bahasa Melayu. Click CC to auto translate to English etc

Another simple explanation. 

 

A Shocking History: The U.S. Bank Failures Where Customers Actually Lost Their Money

When a bank fails, we often hear about government bailouts and how depositors are "made whole." After the 2023 failure of Silicon Valley Bank, the government famously stepped in to cover all deposits, even those over the $250,000 FDIC insurance limit.

This leads to a common misconception: that customers never lose their money.

But history tells a different story. While the U.S. system is designed to protect depositors, it's not foolproof. There have been several painful moments where bank failures resulted in real, permanent losses for customers.

Let's look at the cases where the safety net tore.

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1. The S&L Crisis: When Insurance Wasn't Enough (1980s)

The Savings & Loan (S&L) Crisis of the 1980s and 1990s was the largest-scale failure in modern U.S. banking history, with over 1,000 institutions collapsing. While the federal government ultimately staged a massive $132 billion taxpayer-funded bailout, many customers lost money in two distinct ways.

Case 1: The State-Fund Collapse (Ohio & Maryland, 1985)

• The Banks: Home State Savings Bank (Ohio), Old Court Savings & Loan (Maryland), and 70+ others.

• The Failure: These S&Ls weren't insured by the federal government (FSLIC, the precursor to FDIC). They were insured by private, state-run insurance funds. When a few large banks failed due to fraud, the state insurance funds were drained and became insolvent.

• The Customer Losses:

  • In Ohio, the governor declared a "bank holiday," freezing all deposits at 70 institutions.

  • In Maryland, the governor was forced to limit depositor withdrawals to $1,000 per month to stop the panic.

  • Customers were locked out of their life savings for months, and in some cases, years. State-level bailouts eventually made most depositors whole, but not before they faced the reality that their primary insurance had completely failed.

Case 2: The Lincoln Savings & Loan Fraud (1989)

• The Bank: Lincoln Savings and Loan (owned by Charles Keating).

• The Failure: This was a case of pure deception. Bank employees were trained to sell high-risk "junk bonds" from its parent company, American Continental Corporation, to customers inside the bank branches.

• The Customer Losses:

  • Over 21,000 customers, many of them elderly, bought $285 million in these worthless bonds believing they were safe, insured bank deposits.

  • When the parent company went bankrupt, the bonds became worthless. These customers lost everything.

  • While the bank's insured deposits were covered, the $3 billion federal bailout of Lincoln did nothing for the victims of the bond fraud.

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2. IndyMac: The Modern Loss (2008)

This is the clearest modern example of uninsured depositors suffering direct, permanent losses.

• The Bank: IndyMac Bank, F.S.B.

• The Failure: At the height of the 2008 financial crisis, IndyMac collapsed under the weight of bad mortgages. The FDIC seized the bank.

• The Customer Losses:

  • At the time, the FDIC insurance limit was $100,000.

  • IndyMac had roughly 10,000 depositors with funds over that limit, totalling about $1 billion in uninsured deposits.

  • The FDIC paid these depositors an "advance dividend" of 50 cents on the dollar for their uninsured funds. The other 50% was gone, permanently.

  • Total Customer Loss: Approximately $500 million.

• The Government Cost: The bank's failure cost the FDIC's Deposit Insurance Fund (which is funded by other banks) an estimated $12.4 billion.

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Why Most Bailouts Don't Lead to Customer Losses

It's important to contrast these stories with the "bailouts" we more commonly hear about. In most modern cases, the government's top priority is preventing customer panic and losses.

Year	Bank(s)	Government Action	Customer Losses
2023	Silicon Valley Bank (SVB)	The FDIC invoked a "systemic risk exception" to cover all deposits, even those over the $250,000 limit.	None.
2008	Washington Mutual (WaMu)	The FDIC seized the bank and immediately sold it to JPMorgan Chase. All depositors were fully protected.	None.
2008	The 2008 System (TARP)	The $700 billion "Troubled Asset Relief Program" was a $31.1 billion net cost to taxpayers to stabilise the entire system and prevent a domino collapse that would have wiped out everyone.	None. (This action prevented depositor losses).
1984	Continental Illinois	The government declared the bank "too big to fail" and issued a blanket guarantee covering all deposits, stopping a global bank run.	None.

The 1998 Malaysian Bank Run: When MBf Finance Almost Collapsed

For most Malaysians today, bank runs are something we only read about happening in other countries. But in 1998, during the height of the Asian Financial Crisis, Malaysia faced its own terrifying banking panic—a classic bank run on what was then its largest finance company, MBf Finance Berhad.

This event is a critical part of our financial history, not because of a disaster, but because it showed how a crisis can be stopped.

What Triggered the Panic?

The year was 1998. The Asian Financial Crisis was tearing through the region. Currencies were collapsing, businesses were going bankrupt, and public confidence was at rock bottom

Amid this economic turmoil, rumours began to swirl that MBf Finance was in deep trouble, holding massive bad loans and facing insolvency.

For depositors, these rumours were a terrifying prospect. Fearing the bank would collapse and take their life savings with it, they did the only logical thing: they ran to get their money out.

The Bank Run

What happened next was a scene straight out of a history book.

• Mass Withdrawals: Thousands of panicked depositors lined up at MBf branches all across the country.

• A Classic Bank Run: The lines grew longer, and the panic fed on itself. News of the bank run only caused more people to join the queues, demanding their cash immediately.

• The Liquidity Crisis: This is the critical weakness of any bank. MBf, like any bank, didn't keep all its deposits in a vault; the money was loaned out. It simply did not have enough cash on hand to pay all its depositors at once.

MBf Finance was on the brink of collapse, not necessarily because it was worthless, but because it was illiquid. It could not meet its commitments, and confidence was completely broken.

The Government Steps In

Before the bank could completely fail and trigger a catastrophic domino effect across the entire Malaysian banking system, Bank Negara Malaysia (BNM) stepped in with decisive and powerful action.

1. BNM Took Control: In 1999, the central bank officially took control of MBf Finance to manage the crisis.

2. The Blanket Guarantee: Most importantly, BNM issued a blanket guarantee for all deposits. They publicly assured every single depositor that the government would cover 100% of their money, including both principal and interest.

The Outcome: A Crisis Averted

The effect of the government's guarantee was immediate. The panic stopped.

Why? Because the run was driven by a fear of loss. Once the government—a "too-big-to-fail" entity—publicly guaranteed all deposits, that fear vanished. There was no longer any reason to line up and pull your money out.

In the end, not a single depositor at MBf Finance lost a single cent.

This event was a powerful lesson in financial stability. It demonstrated the critical role a central bank plays as a "lender of last resort" and a protector of public confidence. It was this crisis, and others from that era, that led to the creation of Perbadanan Insurans Deposit Malaysia (PIDM) in 2005, ensuring a formal, automatic insurance system is now in place for all Malaysians.

A Deeper Takeaway: The Bank Run and the Fractional-Reserve Problem

These historical failures highlight a fundamental vulnerability at the heart of our financial world: the fractional-reserve banking system.

The main critical weakness in this system is liquidity.

The bank's promise (its liability) to you is that your $1,000 deposit (for example) is "liquid"—you can withdraw it at any time. But its assets (the $900) are "illiquid"—they are locked up in a 30-year mortgage. This system works perfectly as long as everyone has confidence.

The "systemic withdrawal" you mentioned is what's known as a bank run. It's a crisis of confidence. It's not that the bank is worthless (it still has that $900 mortgage as an asset), but it is illiquid. It simply does not have the cash on hand to give all its depositors their money back at the same time.

When a bank run starts, the bank can't "fulfil its commitment." This is the moment a bank fails.

This is precisely why the U.S. government created the FDIC and has stepped in with "systemic risk" guarantees (like for SVB). These measures aren't just to protect money; they are to protect confidence and prevent the bank run that would expose the inherent instability of the fractional-reserve system.

Islamicbankingway
ONLY ALLAH KNOWS BEST
 

 

34(B) DMF Shariah Concept

DMF Shariah Concept

In describing the Shariah Concept, the Writer will be using certain terminologies that may or may not be used by Islamic banks offering DMF.

Principally, DMF is structured on two types of contracts, as follows:

#1 Musharakah – For the joint ownership of an asset;

#2 Ijarah Muntahiya Bitamlik (leasing ending with ownership) – For the rental of property belonging to the joint-owners (it should be noted under the Tax Neutrality Act in Malaysia, the rental income is tax-exempt). In this case, the customer is normally the partner who shall rent the property from the Bank.

Thus, DMF can be re-described simply as a purchase of an asset by two or more partners. In this case, both the customer and the Bank will each contribute cash towards the purchase of an agreed property, but prior to that, they have to agree on the quantum of contribution by each party and also who shall use the property. In practice, the property will be used by the Customer.

DMF Process Flow – completed property

DMF process flows outlined under this section (if it is different from existing practices) are suggestions of the Writer. The Writer invites both Shariah scholars and practising lawyers to comment and share their experiences and research findings, with one objective in mind: to come up with a standardised DMF model for Islamic banks.

In Malaysia, for the purchase of a completed property, the Customer would have paid the down payment before signing the Sales & Purchase Agreement (SPA). Technically, the Customer had already established a beneficiary interest in the property, although the full purchase price has not been settled. In common practice, the Customer will go to the Islamic Bank to seek financing with a copy of the signed SPA.

In a BBA contract (irrespective of bilateral or tripartite agreement); the Bank normally signs a Novation Agreement (some banks discard this requirement) with the Customer. Somehow, there are Shariah scholars who think that although Novation may meet the contractual requirements, it however, does not meet Shariah requirements. Most importantly, is the intention or “niat" for example, an issue on commodity murabahah. What is the main purpose? The customer "wants cash". So, why make a circle by buying and selling commodities, although the intention is to give cash to the customer? Like the Writer said earlier, let's let the Shariah experts argue on this. So, to avoid this type of argument, the Writer feels that we can do away with the Novation Agreement, but we should impose one condition: the Customer must not pay in full the intended down payment, but just pay the booking fee first, normally RM1,000, before seeking DMF from the Islamic Bank. The balance of the down payment has to be paid directly to the Bank, and the Bank will use that amount to pay the balance of the down payment directly to the Vendor on behalf of the joint-venture partner.

[Novation is defined by Lectlaw as a substitution of a new debt for an old debt. The old debt is extinguished by the new contract in its stead; basically, it is a legal document that formalises an arrangement to substitute one party for another in a contract.]

Wikipedia defines:

Novation, in contract law and business law, is the act of –

1. replacing an obligation to perform with another obligation; or
2. adding an obligation to perform; or
3. Replacing a party to an agreement with a new party.

for example,

Let’s assume the Customer applies for 90 per cent (%) margin of financing and has paid a booking fee of RM1,000. In addition, the Bank had also approved the Customer’s request for DMF.

To formalize the DMF transaction, the Bank need to undertake as follows (take note that whether these processes are acceptable under Civil or Contract law is immaterial as the Writer thinks that, if current civil or contract laws cannot cater for the processes proposed, the laws should be revised to meet Shariah requirements rather than structuring the Islamic banking products to meet existing civil or contract laws, which are non-Shariah compliant. Thus, the process:-

#1. Write to the Customer an invitation letter for his/her agreement:

a.   To purchase the said property on a joint-venture basis, and

b.   To obtain the Customer’s agreement to rent the property from the Bank (co-partner).

c.   To get the Customer’s agreement to pay the balance of the Customer’s down payment directly to the bank, and the Bank will undertake to pay the same to the Vendor.

d.   The Bank agrees to appoint the Customer to sign the SPA on behalf of the partnership

e.   The bank to acknowledge that the booking fee advanced or paid by the Customer to the Vendor shall be treated as a booking fee or an amount paid by the Customer on behalf of the partnership.

f.   The bank will then advise the Vendor that it shall pay the down payment (on behalf of the customer or, rightly, the partnership and then release the full sum upon satisfaction of all legal requirements (similar to an undertaking to pay).

#2. Among other standard terms, to issue the Letter of Offer (LOF) to include the following terms and conditions:

     

a.   The monthly lease rental (refer to the next section for types of rental payment)

b.   Determine the “Equity buy-back period” (EBBP) or simply, the financing period. For this example, let’s assume the financing period is 20 years. The LOF should stipulate the formula to determine how

i) The monthly rental is calculated

ii) profits that the Bank can earn, and most importantly

iii) the “Equity purchase-portion" (EPP) to be embedded in the monthly rental. During the EBBP, the customer will use the EPP of the monthly rental to purchase additional equity over time (with the option to purchase more equity without prior notice) from the Bank’s original 90% equity when the joint venture was originally formalised. Thus, for each rental payment made by the Customer, the Bank’s equity stake in the property diminishes while the Customer’s equity correspondingly increases.

c.   Once the Customer has fully bought the Bank’s equity, the Bank will release its rights over the property.

Customer’s Relationship With The Bank

Under DMF, the relationship between the customer and the Bank is different compared to debt financing.

#1. In a conventional mortgage facility, the customer is a borrower (debt financing).

However, in a DMF structure, the customer is a co-owner and also the Bank’s tenant. This different relationship between the Bank and its customer presents the Bank with different risks and requires different remedies to problems/issues that might occur (we shall discuss further on this in a later session)

#2. As a joint owner of the property, the Bank faces risk associated with the property ownership.

This situation does not exist under an “interest-based mortgage” nor a BBA contract, where the bank never owns the property, as it normally takes a charge over the property.

#3. Insurance on Property

Since the property is rented under the syariah principle of Ijarah Muntahiya Bitamlik, it shall be the responsibility of the partnership to take up Fire Takaful (Islamic fire insurance policy), and the premium is to be shared in accordance with the equity position (in practice, banks require this to be paid by the Customer) at the time of purchase. In addition, the Quit rent cost shall also be shared according to the partner's equity stake. However, the Customer shall be solely responsible for paying for the assessment fee to the Local Council for service rendered and also other services such as Utility bills (where applicable) since the Customer solely enjoys the benefits of using the property.

Despite the above identifiable differences, unfortunately, in Malaysia, Islamic Banks still take charge of the property, akin to a debt financing like BBA. By right, if the property is jointly owned, the bank should not take a charge? It should be noted that if the Bank takes a charge over the property, when it comes to foreclosure proceedings, the Bank has to undergo the normal National Land Code legal process commonly used for debt financing, which is totally against the principle of DMF. Anyhow, based on market findings, there is one international bank that secures its DMF via a Trust Agreement, but currently, there is no test case yet in a foreclosure situation. The Writer supports the use of the Trust Agreement (to be discussed further in a later session)

Diagrammatically, the DMF can be described as follows:-

Figure 1

Figure 2

Note: We shall discuss the DMF structure of the incomplete property later in this session.

How to determine the monthly rental? 

After entering the DMF Agreement, the Bank will give the customer the first option to rent the house under a Tenancy agreement. Before entering this tenancy agreement, both the customer and the Bank need to agree on the “monthly rental” using various rental calculation options to cater for the risk profile of a particular customer. In determining the calculation of the monthly rental, the Writer can only think of three (3) possible options at the moment, as follows:-

A. Rental Value Method (RVM)

#1. Under RVM, the Bank will seek rental quotations from various parties (if need be, to obtain in writing or verbally from a registered valuer), as a benchmark to determine the monthly rental. Of course, the best method is to use the rental index. However, the rental index may not be reliable in certain countries, e.g. for Malaysia, the writer opines that the rental index may not be reliable. One reason, a project developed by a good developer may command a higher rental value and another project, although adjacent to the earlier project,  may not be able to command a similar rental value. This is the reason why the Writer thinks that the rental index in Malaysia is not reliable.

#2. In addition, the Customer is encouraged to provide his/her own rental quotation for comparison to justify any dispute in deciding the monthly rental under the tenancy agreement.

#3. The rental will be reviewed periodically, e.g. annually or say, once every 2 years, etc, as agreed between the Bank and the Customer.

It should be noted that one disadvantage under RVM is that the tenant may end up paying a high monthly rental due to exceptional appreciation of rental value in the surrounding locations. Nevertheless, this can be addressed if the rental is also benchmarked against, say, a certain margin above the Islamic base financing rate (which is normally benchmarked against conventional BLR).

The Writer thinks that the method used by Lariba Bank, i.e. the Commodity Indexation Rule and Marking-To-Market Rule are good alternative for Islamic banks. These rules were applied successfully since 1989 in the United States by the author Dr Yahia Abdul-Rahman, considered to be the father of Riba-free banking in America, with proven results. However, the rental index in Malaysia is yet to be developed. You should also visit http://www.bankofwhittier.com/ and http://www.islam-in-usa.com/  for more information on the two rules and on Dr Yahia Abdul Rahman.

B. Effective Rate Method (ERM)

#1. Monthly rental is calculated based on ERM, where the rental will be determined based on the prevailing cost of funds or a certain rate of return (margin above the Islamic cost of funds or base financing rate) expected by the bank. In practice, the formula for calculating the Islamic cost of funds is the same as the conventional calculation of the base lending rate. That is the reason why, whenever conventional banks change their base lending rate, the Islamic banks will follow suit.

Note:

Islamic Shariah scholars have permitted Islamic banks to use a conventional interest rate as a benchmark since that rate is well known to everyone (transparent), and also, currently, there is no acceptable formula to calculate the Islamic cost of funds. The Writer knows Dr Hassan (an actuary),  who designed a formula for the Islamic cost of funds. However, when we use this formula, the cost of funds turns out to be very expensive,  especially if the Islamic bank is a new set-up. The Writer will publish this formula upon obtaining permission from Dr Hassan.

Under the ERM method, the monthly rental is determined based on a certain margin plus the prevailing base financing rate; however, since we structure the DMF together with Ijarah Muntahiya Bitamlik, revision of the rental cannot be totally benchmarked against the base financing rate. Instead, the Bank has to agree with the Customer on the rental renewal period, which can be monthly, quarterly, bi-yearly, yearly or any other period as agreed by both parties. Since we have to send prior notice (the DMF agreement needs to be worded in such a way that the Customer agrees to auto-renewal of the rental period and the notice is an advice to the Customer without the need for his consent), prior renewal of the rental period (this allows the Bank to change the monthly rental). Based on the Writer's experience, it would be very costly if we were to structure the pricing based on a monthly or quarterly rental period since the mailing stamps need to be borne by the Bank. Bi-yearly is more acceptable, but administratively it is still cumbersome (although this can be done by the system). Yearly basis will be more reasonable. This means that, although the base financing rate changes within the rental period, the price can only be changed after the expiry of the prevailing rental period.

How to determine the monthly rental under ERM?

For example, the ERM required by the Bank is 7.00% per annum. Using the formula below, the monthly rental for a DMF for RM 90,000.00 is RM517.81 (or rounded up to RM518.00 - see illustration in Figure 3 below)

Figure 3

Using the above formula, the frequency for the rental period renewal is as per Table 1

Table 1

From the table, you can see that if the renewal period is on a bi-yearly basis, the new rental period shall be Aug 2010, although during the period,  the base financing rate changes every month.

Some viewed using the ERM as little different from conventional mortgages because under both methods, the monthly instalments are calculated using a similar formula to determine the amortised portion of the principal and profit. However, unlike a conventional mortgage, where money is lent to help customers to purchase a property, e.g. a house (paying interest for money lent), an Islamic bank offering DMF makes profits through the house’s physical use by the Customer’s occupation as a tenant. This is one of the fundamentals of Islamic banking, whereby customers can be charged for the use (usufruct or benefits) of something physical, like renting a house, but customers cannot be charged for the use of the money, which is considered “interest or usury” under Islam.

C. Mutually Agreed Method (MAM) 

This is an alternative instalment formula that the Writer would like to propose!

The Writer would like to promote the MAM as the payment mode for DMF mainly because the amortisation of the principal amount (or Equity Purchase Portion) and profits is determined based on the prevailing or month-to-month profit-sharing ratio of the co-owners.

Although initially, the Bank can determine the effective return it wanted (and agreeable by the Customer), any changes on the monthly rental thereafter, maybe due to (i) Customer's request to lower or increase his monthly rental (ii) restructuring process etc, the amortization between the principal amount and profits, has to be determined based on profit sharing ratio until next rental renewal period.

How to determine the monthly rental using the MAM method?

#1. The monthly rental can be decided based on any reasonable amount requested by the customer and agreed upon by the Bank. 

Before considering the Customer's request, the Bank may use the internal rate of return (IRR) formula to determine whether the monthly return to the Bank is acceptable. Otherwise, the amortisation of principal and profits shall be based on the prevailing profit-sharing ratio. For this example, we shall use IRR to determine the monthly rental.

Example :

(a)  The Bank requires an IRR of 7.0% and based on the MAM formula, the monthly rental that the Customer is required to pay is RM575.00 per month. This formula is normally applicable at the beginning of the transaction, but of course, subject to the agreement of the Customer. Thus, if both parties do not agree, the Bank may refuse to provide the DMF.

A view on the formula revealed that although the IRR appears to be 7.77%, due to the profit allocation based on the profit-sharing ratio, the actual return to the Bank is only 7.0% per annum.

Figure 4

#2. The customer must be advised that the monthly rental is subject to review, but to be agreed upon by both parties.

It should be noted that although Option C is the best option for the Customer however based on simulation, any changes in the monthly rental (especially if the rental amount is lowered),  it will take a longer period to acquire the equity from the Bank since the amortisation of principal and profits is based on profit sharing ratio. For example, the monthly rental is reduced from RM575.00 per month to only RM350.00 on the 7th month.

Figure 5

Once the monthly rental is changed, the effective return to the Bank is reduced to 4.26%. As earlier mentioned, a reduction in the monthly rental should be considered in situations to avoid the Customer from defaulting and indirectly giving time to the Customer to recover from whatever situation (ensure it is genuine) rather than allowing the account from becoming non-performing.

True Spirit of Shariah Law

If the management of the Islamic Bank and its Customers believe in the true spirit of Shariah Law, lower return to the Bank and equally lower return to the Bank's depositors does not necessarily mean lower income to the Bank or its depositors. The problem in today's Muslim world, many want to see and touch something tangible. Some are willing to place their excess cash in non-halal investments, basically to earn a higher return.

Allah's promise of "blessing" is something intangible (cannot be seen nor can it be touched). Let's look at these two (2) surahs:

Al Baqarah (Surah 276)

Allah will deprive Usury of all blessing, but will give increase for deeds of charity; For He loveth not Creatures ungrateful and wicked.

The writer remembered when giving a talk on Islamic Banking to a group of trainees in Tenaga Nasional Training Centre about 15 years ago, a non-Muslim trainee asked the Writer about the concept of "bless". At that time, the Writer gave the following examples:

Assume you received a very low 3% return from a "halal and non-usury related investment" of RM1,000. If the return is halal (if you believe in Surah 276), you can probably save or double your return in some other investment without any unforeseen hindrance.

Now, let's assume you received 6% return from a non-halal investment (higher by 3% from halal investment) but on the next day, your car broke down, one of your children fall sick and you have to pay high medical fees, and towards end of the month, you even have to use your credit card due to shortage of cash. This is the intangible part where Allah promised to deprive usury of blessing.

There is one investment here in Malaysia where there are arguments among the Muslim Scholars (sorry.....the Writer is unable to disclose the name of the investment. Maybe you can guess?...). Shariah scholars from Islamic Banks commented that the investment is "haram", but a fatwa was made that the investment is "harus" because most of the investors are Muslim, and we need this to go on, to raise the economic standard of the Muslims. Islamic banking and Islamic investments have been introduced in Malaysia for more than 30 years. There should not be any excuses that certain investments can be considered "harus" due to the investment being participated in by a majority of Muslims. What the Writer can comment here is that if you think you are a "Malay", then the investment is "harus", but if you think you are a "Muslim", then the investment is "haram".

Was informed reasonably that, to circumvent the issue of a halal or haram fund, the investor (non-halal fund) transfers its fund (intended to be invested in the same investment) to a fund manager, who in turn transfers the fund to the original intended investment. The writer still remembers, when asked why the fund comprises non-halal sources, the answer was, they are operating not to promote Islamic funds but the agenda of Bumiputra.


Al-Baqarah (Surah 280)

And if someone is in hardship, then (let there be) postponement until (a time of ) ease. But if you give (from your right as ) charity, then it is better for you, if you only knew.

Being a business entity, the Writer does not believe that the Bank will stop their recovery process in case of default and write-off as charity, but there is one method which the Writer is proposing that will meet the true spirit of Shariah on a "win-win basis" for both the Islamic Bank and the Customer. This will be discussed in a later session.

IslamicBankingWay.Com

ALLAH KNOWS BEST

34(C) EQUITY ACQUISITION PERIOD

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 Equity Acquisition Period (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.aminuddin2@gmail.com

IslamicBankingWay.Com
ALLAH KNOWS BEST.

34(D) SECURITY RECOVERY PROCESS

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).

Allah Knows Best.

34(E) RESTRUCTURING & RESCHEDULING

This was also another article which was not published. I am not sure whether this is still relevant but those who studies Islamic Banking or existing Islamic bankers,  may use this as reference and improve the structure so this type of financing facility can be introduced or implemented by Islamic banks.

Start here...

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 (please look at the new 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 (there is a controversial issue on this from the remarks by Presiden Mahkamah Timbangtara.

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 (amortization 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 maintain 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.



IslamicBankingWay.Com
ALLAH KNOWS BEST

NOTE

Due to many requests via personal emails received by the Writer, here onward 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.

34 (A) MUSYARAKAH MUNTANAQISAH

This is a reproduction of an earlier article on Diminishing Musyarakah (or Musyarakah Muntanaqisah) with some updates to look at the product based on current practices. The Writer has not been writing for many years due to some personal reasons but when he glanced through this blog somehow, a few articles were left as a draft. So, he was not sure to what extend the Islamic Banking Act has change and this article is published, just to complete the article. The write has no intention to update this product, to meets its current guideline, if any (year 2020).

Diminishing Musharakah Financing (DMF) can be readily use as the alternative product for Al-Bai Bithaman Ajil (BBA). 

A number of Islamic Banks in Malaysia are currently offering DMF but what Writer plan to write in this Section is to propose an ALTERNATIVE Musyarakah structure (probably not yet implemented by any Banks in Malaysia). Personally, the Writer feels that this alternative structure can be considered as "Real Musyarakah" rather than a DMF contract by name but pricing wise, it is comparable to the conventional floating interest rate facility.

Current DMF contract is advantage of those who are interested to seek short term financing facility but for long term financing (e.g. for home financing), it would be more advantage to go for fixed profit financing like the BBA or Murabahah (if this facility is still available, as Islamic banks are more keen to promote DMF due to the floating rate nature of the facility). Fixed profit rate financing facility is better for the consumer as they do not need to worry about the conventional  "interest rate" trend that may influence the DMF's profit rate due to its floating pricing structure.

Why the Writer says this? Malaysian (particularly the Malays), prefer long payment tenor i.e. 30 years or longer (some banks offer up to 40 years). When they signed-up for long payment tenor, they are actually exposing themselves to profit rate risk (akin to interest rate risk). Fixed profit rate (even though most Islamic banks are offering hybrid profit rate where  maximum profit margin (usually about 4.0% p.a.)  + base financing rate equal to sale price), the Customers are technically entering into a "natural hedge contract" where the sale price is fixed (at a glance its look very high) but what is important to the customer, the Islamic Banks cannot charge profit rate higher than the maximum contracted ceiling sale price.

If we are to look at current DMF structure, there is no ceiling profit rate or maybe if they do, it would be structure similar to the floating financing rates akin to BBA. If the profit rate is not fixed in DMF, when the conventional interest rate moves up to say, 15% or more per annum (this has happened before), the DMF pricing, may also moves up since Islamic base financing rate (BFR) is very much influence by the conventional BLR. Even though now, we have full fledged Islamic Banks, most of the Islamic banks are owned by conventional banks thus, they would not want to expose the group to what BNM termed as "Displaced Commercial Risk" i.e. moving of funds from Islamic deposit to conventional banking and vice versa.

Although BNM National Shariah Council has no objection on floating profit rate pricing, why can't the Islamic banks offer another alternative pricing or do away with the floating price benchmark? Although the Writer admit that under current trend (effective 14 March 2014), Mudharabah investment account (floating investment profit rate deposit) are preferred by Islamic banks BUT due to the new BNM classification of Mudharabah Investment Account (no PIDM insurance cover  and it is also treated as part of bank's investment vis-à-vis capital charge),  Commodity Murabahah is now preferred (with PIDM insurance cover) by Islamic Banks.

For social reasons, Writer's proposed DMF structure should be considered for offering because there is one special feature that is not available in any other type of financing i.e. Islamic banks can avoid potential non-performing financing.  Under current situation, where the Banks had to offer six months payment moratorium period, the DMF structure that the Writer would like to propose, would be benefits to both parties ie. to the Banks and the customers.The Writer feels that this type of structure is suitable for low cost housing financing and for those who prefer short term payment period, of say 3 - 5 years (it can be a special structure for high net worth customers).

Perhaps, the Islamic Banks can still offer fixed profit rate (using Writer's proposed  DMF structure) and backed by specific Mudharabah investment deposit (perhaps, there are depositors out there that still prefer Mudharabah deposit structure) to fund it. .

Before, we touch further on DMF, let's define again (this already defined in earlier article) what is Musharakah?

Investopedia defined Musharakah as a joint enterprise or partnership structure with profit/loss sharing implications that is used in Islamic finance instead of interest-bearing loans. Musharakah allows each party involved in a business to share in the profits and risks. Instead of charging interest as a creditor, the financier will achieve a return in the form of a portion of the actual profits earned, according to a predetermined ratio. However, unlike a traditional creditor, the financier will also share in any losses.

Actually, Musharakah plays a vital role in businesses. Formation of a limited company (Sendirian Berhad) between two (2) individual is actually a Musyarakah contract. For example "A" wants to begin a business but has limited funds; and "B" has excess funds, and is willing to finance the venture. When the two (2) enters in a JV agreement and begin the business, both are subject to profit and loss sharing. This negates the need for "A" to receive a loan from "B"{. Of course, if "B" is willing, he can still help "A" by giving a loan but it has to be non-profit/interest bearing (al Qhardul Hassan)

On the other hand, Diminishing Musharakah is defined as "a partnership between one party and another, to jointly purchase an asset". For non-banking transaction, the partners are most likely buying the asset to make money from rental or eventually capital gain from the sale of the asset. However, in banking perspective, when the Bank enters into a partnership with the Customer to purchase an asset, the bank real intention is not to jointly own the asset for longer than the agreed financing period as the Customer is expected to eventually purchase the entire shareholding/equity or control (hereafter to be referred to as "equity") over the asset. How the Writer wishes the bank can be a partner in a real property purchase contract as this would be the best way to avoid non-performance in the Bank (more explanation later).

Once the asset is purchased, the asset will be rented to the Customer. The rental amount is "to be agreed upon by both parties" (...will explain this later)  and the Customer’s portion of the rental based on its current equity holding, shall be used to increase its equity on the said asset. The rental amount after deducting the Customer’s "equity purchase portion" is to be treated as profits to the Bank.

Technically in Malaysia, DMF should ONLY be offered by Islamic banks i.e. Islamic banks are allowed under Islamic Banking Act 1983 (this Act i.e. the Islamic Banking Act 1983 has been repelled by Bank Negara Malaysia and replaced by the Islamic Financial Services Act 2013 effective 30 June 2013). I have not check whether there are more changes made since then. Musyarakah financing is provided under Interpretation 2 of the FSA 2013 (Act 758), under the term "provision of finance" which means entering into, or making an arrangement for another person to enter into, the businesses or activities which are in accordance with Shariah including - (a) equity or partnership financing, including musyarakah, musyarakah muntanaqisah and mudarabah (page 23 of the new FSA 2013) if there is no revision since 2013.

In the old Islamic Banking Act 1983; there was a BNM subsequent issue (the Writer has forgotten on its sources) relating to Asset own for trading (which include buy, sell and lease) while under BAFIA, assets can only be owned by conventional banks for their own banking premises and business related activities such as training centre and the like. This validate the buy and sell of Asset for trading-liked facility such as BBA (I think most banks no longer offer this structure anymore) and Murabahah.

Anyhow, let’s continue with our discussion on DMF. Why should Islamic banks also offer DMF as alternative to the existing fixed profit rate debt financing contract?

#1- Most Risk Managers are of the opinion that the fixed profit rate (commonly used for BBA financing) MUST be hedged to protect the bank’s profit margin. Under BBA; once the sale price is fixed, it cannot be changed until the facility is fully paid. This place the bank in situation where its income will be reduced or in a loss position vis-à-vis higher deposit cost compare to the profit (at the agreed fixed rate) that it received from the BBA contract. This argument make sense for example, if BBA fixed price is 6.0% per annum while prevailing deposit rate is 7.0% per annum, the Islamic bank will suffer negative variance of 1.0% per annum. That is why Risk Managers are not in favour of fixed profit rate financing. However, in order to comply with BNM aspiration in making Kuala Lumpur as an Islamic financial centre (if they still do...), the strategy of most banks (based on Writer's experience while working with Islamic subsidiary of a local conventional bank) is to achieve the target imposed by BNM on Islamic Banks. Most will go along with the requirement but imposed strict approving criteria just to meet the target with no real push to increase their Islamic banking business.

#2- Assume Islamic banks decide to hedge. This can be done as follows:-

a) Sale of debt (BBA receivables) can be done with Cagamas or the Islamic bank creates Negotiable Islamic Debt Certificate (NIDC-i). However, both products are not internationally acceptable Islamic hedging instruments since both are structured using the contract of Bai Al-Dayn (sale of debt). In Malaysia, Bai Al-Dayn contract is Shariahlly acceptable, I think so as per this link..

b) Hedging using Profit Rate Swap (PRS). Likewise to Bai Al-Dayn, PRS is structured using Commodity Murabahah. Again, this product also received mixed views from both local and international Shariah experts.

If we are to examine the above carefully, both the above products are structured to emulate conventional hedging products. If we are to question this, the arguments will never stop. So, let's not argue about it!

#3- Under BBA fixed rate financing, the contracted selling price (total installment payable) represents maximum amount that the Bank can claim (apart from other charges/debits) from a Customer in a foreclosure proceedings. In addition, Shariah only allows maximum amount that can be claimed from Customer in a foreclosure situation, NOT EXCEEDING outstanding sale price and maximum compensation charges accumulated; ALSO CANNOT EXCEED the outstanding principal balance. In addition, accept for 1% p.a. (this is an old structure, to know the latest please click this link...) whatever compensation charges collected are to be given to Charitable organizations (bank cannot treat compensation charges as income) although BNM has allow under the latest late charges method. So due to these restrictions in making claims (...leading to opportunity loss of income to the Bank), Risk Managers are also against the Banks having too much exposure on fixed rate financing.

The writer remembered a friend from one of the active commercial banks offering Islamic hire purchase facility (i.e. AITAB- Al Ijarah Thumma Al-Bai) commented that despite his boss being a Muslim, the instruction was to reduce AITAB’s exposure since the compensation charges allowed for AITAB was only 1.0% per annum while under conventional hire purchase, the Bank can charge up to  8% per annum as allowed under the Hire Purchase Act. My only hope here is, Allah will show him (i.e. the boss) guidance...! (anyhow this happen in early year 2000 ago but the Writer still share this story to describe attitude of bosses where conventional heads are still giving instruction to a Islamic subsidiary due to Group strategy). Infact, I think (if this has not change) now, sales people parked under Islamic banks, are required to cross-sell conventional banking products.

#4- In the conventional bank’s “letter of offer”, the loan amount and interest rate are clearly shown but in letter of offer normally issued by Islamic bank, only the purchase and sale price are shown. However, in practice, most Islamic banks will indicate the profit rate charge and set the profit margin above certain benchmark or base financing rate (derived from base lending rate). This is where the confusion starts. This situation became more complicated when CJ Dato’ Wahab Patail made controversial High Court decisions in the Affin Bank vs Zulkifli case (among the earliest controversial Islamic Bank legal case) where he commented that Islamic banking is more burdensome than conventional when a property is subject to foreclosure proceedings. Although that decision has been overturned, it nevertheless, creates an eye opener to BNM and the Islamic banks to  review its BBA product exposure. In fact on June 7, 2010,  Bank Negara made a bold decision on basis of maslalah (public interest) where Islamic Banks are to stipulate the rebate (ibrar’) clause in the agreement to ensure such arguments are no longer raised in the court. The writer is of the opinion that we should maintain the "status quo" where rebate is at discretion of the Banks but instead, BNM issue an operational guideline or perhaps, this can be done by AIBIM (Association of Islamic Banking Institution Malaysia) regulating Islamic banks to use standard rebate formula on finalization of the account. As explained in Article 15, one of the reasons why Islamic Bank should claim the outstanding sale price is that they are not sure when the case can be settled thus, when the rebate amount kept changing from time to time (..statement of claim need to be changed from time to time in the foreclosure proceedings until the case is resolved) and this is common for BBA financing. Since the Shariah has deliberated over this issue and made a decision, no point arguing over it. What is important, is to expedite collective introduction of DMF.

With DMF, customers shall be able to differentiate clearly the value propositions between Islamic vis-à-vis the conventional mortgage/term financing. The writer is of the opinion that DMF can be a killer product compare to conventional loan if the same is structured properly and collectively offered by Islamic banks

In next article the writer will talk about the various method of structuring the DMF.



ONLY ALLAH IS MOST KNOWING.
IslamicBankingWay.Com

Original article 14 March 2014
1st revision May 25, 2020
2nd revision, 31 July 2020

34. WHAT IS MUSYARAKAH.?

Article 33C(ii) is the last section on debt financing. At first the Writer thought of writing on other financing related matters such as legal documentation, risk ...etc on debt financing (including other financing products such as Ijarah, Salam etc.,)  however due a number of requests, the Writer agreed to write about Musharakah first.

In earlier Article 16A-16D, the Writer had explained about Diminishing Musharakah Financing (DMF) and this product is repeated under this Section 34 but with more details or with an updated version to meet requirement under the new BNM Islamic Financial Service Act (FSA) 2013 that replaced the old Islamic Banking Act 1983.

Before we start, let us define what is Musharakah or Musharakah financing?

Musharakah is a partnership agreement entered by at least two (2) parties or best to be described as partners, for a particular business venture (must be "halal" venture). In banking perspective, the business partners shall comprise the Bank (acting as a Financier) and the Customer (supposed to be the expertise in the venture or in reality, the person who needs the funding). The Writer really hope that one day, Islamic banks will readily to offer Musyarakah financing to replace or perhaps, to complement the venture capital companies that have been active in this area (especially in the Western countries), to certain extend. Capital charge issue is the main reason why Musyarakah financing is not yet readily accepted by banks but there are other ways of structuring Musyarakah, which we will discuss later.

We shall touch on Shariah requirements for Musyarakah under Article 34(B) but our focus later shall be on the Writer's proposed structure (particularly on Musyarakah Muntanaqisah or Diminishing Musyarakah) which is contrary to the current practices offer by Islamic banks in Malaysia and it's possible features.

Brief common features for Musharakah Financing?


a) Both partners shall together raise the joint venture working capital and they need to decide on the working capital contribution ratio prior commencement of business;

b) Both shall manage the business but they have option to allow the other partner to run or lead the venture instead. If they decide to do this, roles and responsibilities of each partner shall be defined in the shareholders' agreement;

c) Profit sharing ratio (PRS) to determine the allocation of profits from the business, need to be decided by the partners, prior signing the joint-venture agreement;

d) Losses this business venture shall be based on actual capital contributed by each partner and NOT based on the agreed profit sharing ratio.

e) The venture can either be an incorporated joint venture (setting-up a new company - for Malaysia this requires BNM approval and there will be a lot of regulatory requirements) or the simplest way is to set-up a loose joint-venture where the venture can be entered via a joint-venture agreement (couple with other agreements, if it need be) between the partners. Since the Bank is the financier, it can have control over the flow of funds (they can do this via a designated current account to control the inflow and outflow of funds).

What is most important in this venture is that the Bank as financier should not treat Musyarakah akin to debt financing especially in situation when there is a cost overrun (or in case of a loss situation) but to act as responsible partner especially under loose JV structure, by injecting new funds (of course, not in situation where good money to cover a hopeless venture) and renegotiate on the terms of the profit sharing distribution i.e. to resolve, it would be best for the customer to agree for profits reduction in lieu of the new capital injected (if they are unable to contribute more capital) or by other ways, subject to Shariah's consent on the revised structure.

To protect both parties, the joint venture agreement should be prepared to cover all possible eventualities especially since Musyarakah is something that have not been tested in court between the Bank as Financier and the Customer.

If the joint venture is set-up using a new entity, the cost overrun issue would be easier to handle i.e. the Bank as Financier can issue new shares and if the other partner (Customer) cannot subscribe to the new shares, it's current shareholdings will be diluted.

So before entering a  Musyarakah Financing arrangement, the Bank and the Customer need to study deeply on the type of JV they need to set-up i.e. either an incorporated JV (this will take sometime) or just enter a loose JV.

How to differentiate Musharakah from debt financing?

Musyarakah is akin to a "Venture Capital " financing where risk is borne by both parties. This is contrary to the one sided debt financing structure where profits are charged by the Bank (irrespective the customer is making a profit or a loss) and the terms of the debt financing is generally structured to minimize risk to the fullest benefits of the Bank. Infact, to lower the risk further, the Bank will requests for collateral as added security.

In Musyarakah Financing or specifically for Mudharabah type (where only bank provides the capital), collateral can be only be requested to cover possible negligence of the Customer in running the business.

Under debt financing, the Customer is required to pay the principal and profit portion due to the Bank on due dates and if the Customer defaults, the Bank will recall the facility (stop the customer from utilizing the facility) and sue the Customer to recover total amount owing to the Bank, and if need be, the collateral is auctioned when the Bank cannot recover the full amount owing to the Bank. Under Musyarakah financing both the Bank and the customer will jointly bear the losses according to their capital contribution and NOT based on agreed profit sharing ratio.

Under this topic, the Writer shall illustrate a number of possible Musharakah structures that can be considered by the practitioners, particularly the Bankers.

However before we discuss further,  it is necessary to highlight why Banks are reluctant to provide Musharakah financing. Put aside the risk aspects, the main reason for Banks not interested to venture into this type of financing is mainly because of the Bank Regulatory capital charge. What is it? It's simply the amount of capital that the Banks are required to hold against their assets. Generally, though the concepts have been evolving with various Basel Accords, regulatory capital for various debt financing instruments is 8% on the Bank's risk-weighted assets.

Surprisingly enough, there are actually lots of different answers. Many believe that it should cover a bank's potential losses in a portfolio with some cushion. There are opinions that say that this is wrong. Why? In reality, no banks will ever gets the luxury of seeing  whether over the long run,  the capital is enough to cover actual losses. The real world doesn't work like that.

Bank runs (people will start withdrawing their deposits on ground that the bank will go bankrupt etc..) start when people become concerned that if a bank had to liquidate its portfolio, there wouldn't be enough money to pay the deposit place by the customer in the Bank. So no matter what style of accounting method a bank uses, at some basic level, investors react to the perceived value of the assets, not eventual value. This is a key distinction.

Depositors reacting that way are the biggest threat, because if they pull deposits, then banks have to sell assets even though they hope to hold until maturity. If the bank isn't relying on the short term funding, the run is less likely, as they have more ability to weather the storm.

So regulatory capital or capital adequacy or just plain capital, actually needs to address the worst of eventual loss i.e. potential "mark to market loss issue". Since mark to market loss risk is almost always worse than eventual loss risk, that has to be the key focus. The way a bank funds itself is also important, the less it has "demand" deposits, the more control they have over the asset side of the balance sheet (no forced selling), so the liability side has to play a role in capital determination.

Therefore, not to be concerned over capital charge issue, the best sources of funds for a Musyarakah financing is a SPECIFIC OR RESTRICTED FUNDS where a the Bank uses money from depositor or a group of depositors whom are willing to fund partially (Bank still has impact on capital charge as per IFSB's Risk Weight of 400% under the Simple Risk Weight Method or between 90-270% under the Slotting Risk Weight Method) OR provide 100% funding to back the joint venture project i.e. able to absorb 100% of the losses, where the Risk Weight is supposed to be Zero % i.e. nil. For the this later structure, the Bank should be agreeable to earn less as no specific or restricted depositor would like to take-up risk if his return does not commensurate with the risks that he is willing to take-up. As a rule of thumb, return of above 15.0% per annum, would be considered a reasonable good return to a restricted depositor. Of course, there are those who are talking about a return of more than 20% per annum. Most importantly, both partners (under joint effort of the Bank and the Customer) are able to come out with a viable proposition to a potential restricted depositor.


To write this article, the Writer too need to undertake research and continued support by readers, who have been contributing opinions and related articles on Musyarakah. The Writer's own practical experience in dealing with Musyarakah Financing was a few years ago when he structured one (1) Musharakah financing using restricted funds and had involved in providing free consultancy services to a Credit & Leasing company that offers Musyarakah Contract Financing mainly for government contracts. The Writer will share both experiences with the readers of this blog.


Last but not least, there is an interesting article about debt and equity financing that the Writer would like readers of this blog to read. The Writer proposed the first article that you should read is an article on Bank of International Settlements leading to the issue of Basel Accord and indirectly to the issuance of the Islamic Financial Service Board (IFSB) standard. Please visit this link http://zahidsay.blogspot.com




ONLY ALLAH IS MOST KNOWING
www.islamicbankingway.com