33C(ii) WHICH IS CHEAPER? ISLAMIC OR CONVENTIONAL BANKING PRODUCTS. CONSUMER POINT OF VIEW

This topic is very subjective. As a Muslim, one has no choice but to take-up Islamic financing irrespective the pricing imposed by Islamic banks BUT for non-Muslims, their decision to take-up Islamic or conventional banking facility would depend on the pricing and benefits that they would enjoy from Islamic financing.

Our issue here (or is it an issue..??), what are the benefits for those who choose to take-up Islamic financing (irrespective of fixed profit rate or the hybrid fixed/variable profit rate pricing)? My reason for asking this question is because from the information provided to the Writer (including from his own experience), in most Islamic banks in Malaysia, their financing customers are non-Muslims (some reported, more than 60%).

Anyhow, from Writer's own experience most non-Muslim who took-up Islamic financing were due to as follows:

1. Natural Hedge - irrespective they take-up a fixed or hybrid financing profit rate, they are actually hedging themselves against possible hike in future interest rate. The 1997 Asian Financial Crisis has made many, especially those in business, aware of the danger of variable interest rate prevailing in conventional banks. Without BNM intervention during the financial crisis, the impact would have been more severe.

2. Sales campaign - most Islamic banks (and most of the existing Islamic banks are a full-fledged subsidiary of conventional banks) are having shared marketing/sale staff (most sale staff are non-Muslims either permanent or on contract basis). The sales people are commission driven and whenever a campaign is launched, for example, to write at least 500 Islamic new financing accounts (or a target of say, RM100 million sale for new Islamic financing account is set), the sale staff force will push the sale as the target will be included in they KPIs.

The Writer remembered introducing a pocket handbook with Q&A on all possible questions by Customers, including how profit is calculated, comparative analysis (basically, benefits of Islamic financing over conventional banking) etc so whenever a sales staff is landed with questions he is not familiar with, he can immediately refer to the handbook for answers. This handbook is a very effective marketing tools and all Islamic banks should made this available for their sale staff. We have to admit that in general sales staff are good in selling but weak in the product knowledge, especially Islamic products.

3. BNM target - the Islamic bank (as a group with their conventional) need to achieve certain targets imposed by BNM. The Writer is not sure whether such targets are still being imposed by BNM but the Writer opine, it is a good move to achieve the MIFC's objectives. By removing this target, the sale staff will prefer to sell products that they are familiar with.

Surprisingly however, prior to my retirement, there were a number of instances, Malays (who are supposed to be Muslims) still prefer to take-up conventional banking, despite  knowing (we even showed to them Sura Al Baqarah - 2:276 that Allah will deprive usury of all blessing...

...part of Al Baqarah (2:276)

Infact, there was one incident when a Muslim customer insisted conventional loan over Islamic banking financing facility just because to him, Islamic banking facility is more expensive than conventional. He further reiterated that it's was a matter of principle NOT religion. Honestly, this was something that the Writer cannot comprehend until today, a Muslim willing to sacrifice Allah's blessing for the sake of principle...?? There are some who said, existing Islamic banks are actually adopting a disguised "riba" so it is okay for them to take-up conventional loan due to 'dharurah" rather than taking disguised "riba". Irrespective of one's opinion, a fatwa has been issued by the National Shariah Advisory Council (NSAC) of BNM. We have to assume they have addressed all issues relating to "riba" as people sitting in the NSAC are reknowned Muslim scholars who are expert in their fields.The Writer hopes that there are NO OTHER MUSLIMS out there having same thinking about Islamic banking.

4. Pricing - in reality pricing is an important element when it comes to making decision to take-up financing or to borrow.! (common terminology used by people on the street).  As a true Muslim, what is most important to him is Allah's blessing. If a Muslim believes this, even if Islamic banking pricing is say, 1.0% higher than conventional bank loan, he will still take-up Islamic financing. What more , under Surah Al-Baqarah (2:279), Allah and his Prophet, declare war on those who takes "riba". Was informed, in the USA, "halal" meat is difficult to get, so the price of halal meat is normally more expensive than the non-halal meat but as a Muslim, one will still buys it because from young, a Muslim has been trained not to eat non-halal food. But when it comes to "riba".....why there are people who said "a matter of principle or they are not afraid of Allah's warning..?? The Writer trained his children from young "pork and riba are haram" although only a certain age they understand what is riba meant ...but most important we instill this saying in their mind from young. Perhaps, it's because "blessing" as promised by Allah to Muslims is something "non-tangible" or something that cannot touch, feel and visualize. We have also heard some said " not to worry, we can repent when older". Please visit my other blog http://alqamar5417.blogspot.com that touch a bit on these subject matters.

Anyhow, let's evaluate whether Islamic banking products are more expensive then conventional. Let's look at customers' point of view first. The Writer, in later topics, shall also discuss as to whether Islamic banking is a loosing business to the banking group (conventional bank plus its full-fledged Islamic subsidiary).

As for this topic, let's look at this comparative analysis..! Some of the points have actually been deliberated under Topic 33C(i).....


a) Comparative Analysis

Now, let's look at Chart 1 below

Late charges in Islamic banking is allowed basically as  a deterrent mechanism against cases of default by customers in discharging their financial obligation arising from Islamic contracts. Islamic banks used to charge only 1.0% p.a. on overdue installment. The side effect, there are customers (having both Islamic and conventional accounts) that placed priority in payment of conventional loans rather than Islamic due to the low penalty charges they will incur compared to delaying conventional loan payments. Due to this (the Writer believe that the pressure comes from conventional bank having Islamic subsidiary) there were banks that seek BNM to review the penalty charges to be imposed on Islamic banking customers.

As a result,  sometime in August 2011 (implemented in first quarter of 2012), the NSCA approved new late charges calculation that comprises both concepts of gharamah (fine or penalty) and ta'widh (compensation). Gharamah is not allowed to be recognised as income, and it must be channeled to specified charitable bodies. However, Islamic banking institutions may recognise ta'widh as income (normally at 1.0% p.a.) on the basis that it is imposed on the customers as compensation for the actual loss incurred by the Islamic banking institutions.  The maximum rate of gharamah and ta'widh that may be imposed by Islamic banking institutions will be determined by Bank Negara Malaysia. 

Chart 2

We have discussed the impact on compounding  under Chart 13 of Topic 33C(i)  but to see further impact on "compounding" we shall at end of this topic use the "famous" legal case "Zulkifli Abdullah versus Affin Bank"   to further elaborate the impact of "compounding" on default case.

Chart 2

The impact of fixed monthly installment for conventional Bank is shown in Chart 13 of earlier topic 33C(i)

Chart 3

Likewise, we can see this impact in legal case "Zulkifli Abdullah" versus "Affin Bank" in later section of this topic.


Chart 4

For Chart 4, rather than customer (particularly non-Muslims) seek re-financing from conventional bank (assume in low interest rate regime situation) it would be cheaper in long-run, for them to seek the bank to provide them a rebate (or a discount) on the profit payment i.e. not on profits already earned by the bank but on future profits (termed as unearned income). The Islamic banks on the otherhand, should consider the rebate request if they are to maintain the customer.

b) Legal case to show Islamic banking is cheaper..!

This has been discussed in Topic 15 of this blog. However, in this topic we shall provide detailed explanation on the impact of the Judge's decision if the case is not overturned. Infact, this case is a good example to show the impact of conventional loan when landed in court.

Chart 5

SELECTED FACTS OF THE CASE

• In 1997, the defendant took up a BBA financing of RM346,000-00 from BSN Commercial Bank (which was later taken over by Affin Bank Berhad) for a financing period of 18 years (216 equal monthly installments) under the staff loan [ the word "loan" is used here by court ] scheme at 3.5% profit rate (special staff profit rate) with the Bank’s selling price of RM466,847.28

• At commercial profit margin, the Facility was to be repaid over an 18 year tenure by 216 monthly installments of RM3,582.80  BUT since the defendant is a staff, by the applying Islamic principle of Ibra (for as long as the defendant remained in the Bank’s employee) the staff is entitled for a rebate of  RM1,421.47 per month. Thus, his monthly installment after rebate was RM 2,161.33 per month.

• Formula for calculating the installment:  [ RM3,582.80 less RM1,421.47  = RM2,161.33 ]  (Refer Chart 6 below)

• The total payments as long as he remained an employee of the Bank was therefore, RM2,161.33 x 216 = RM466,847.28

• This RM466,847.28 was described in the Letter of Offer of 26th May 1997 as the Bank Selling Price.

            Chart 6

      Chart 7

e

             Chart 8

                Chart 9

Chart 10

Due to the Judge statement, quote " when the gratification of being able to satisfy the pious desire to avoid financing containing the elements of riba (interest) gives way to the sorrow of default......" Writer felt obligated to explain the "actual calculation method" and took-up challenge then ..to explain how the judgement should be made based on Shariah decision. The Writer presented the facts to 2 universities (UIA and UiTM), bar council members (3 sessions, including one in Sarawak) and also 2-3 other seminars, including that organised by IBFIM. The slides used for this topics were actual sides used by the Writer during the presentation.

Chart 11

Based on the above court decision, the award of RM98.54 per day profit until full settlement is actually "riba". The award was calculated based on at 8.0% p.a. the standard penalty charges imposed by court today. You will notice that the court uses the word loan to imply Islamic financing. 

COMPARISON BASED ON JUDGEMENT

Chart 12

Based on current shariah view by providing refinancing facility, including capitalising the unpaid installments, the transaction is against the shariah principle of bay al-kali bi al-Kali nevertheless, Islamic banking were new then and such principle has not been raised by Shariah scholars at that time.

Nevertheless, based on earlier practises, the customer and the Banks MUST entered into a new contract which means there must be a new agreement entered by both parties  i.e. a new purchase price (principal + unpaid instalments + penalty charges) and a new sale price (total payable based on new profit rate and financing tenor). 

However, for this legal case, there was ONLY the original purchase agreement (when defendant signed as a bank staff) AND there were two (2) sale agreements i.e. the original sale price of  RM466,847.28 (at staff profit rate) and another sale price of RM958,909.21 (at commercial profit rate)

Chart 13

Chart 13 above (unfortunately, we are unable to make the image bigger) provide a single view between the conventional banking calculation determined by the Court and the Islamic Banking calculation where the Banks normally work from the outstanding sale price downwards. To explain, let's look at the chart individually as per Chart 14 and 15 below.

Chart 14

a)  Under conventional banking, all calculation shall begin from the principal outstanding figure as of a particular day and subject to certain validity period. In Chart 15, the principal outstanding was RM394,172.06  [line 1 of formula]

b)  Using daily profit of RM98.40 x standard 30 days per month, the monthly penalty interest due was RM98.40 x 30 days = RM2,952.00 per month.

c)  No. of months overdue was 74 x RM2,952.00 = RM218,765.49  [line 2 of formula]

d) Add penalty charges, miscellaneous charges and also MINUS total installments paid to date then of RM33,454.19, the outstanding balance due as at December 2005 then, was RM582,626.80

Chart 15

Now, lets look at Chart 15 below. Using similar formula, the calculation is actually the same, except the penalty charges awarded is considered "riba".

For BBA, the calculation shall start from the original sale price as follows:

a)  Original sale price (based on so call, new contract) was  RM 992,363.40

b)  To find out the actual outstanding sale price, we need to deduct all installment paid so the sum of RM33,454.19 is to be deducted from the sale price, giving an outstanding sale price of RM958,909.21

c)  The original sale price comprise UNEARNED INCOME NOT YET DUE (income that the bank was not entitled to earn as of December 2005). Using simple profit (interest) formula, the rebate amount due was RM379,425.84 and the principal outstanding equal to RM579,483.36

d) At late charges and miscellaneous charges (RM3,141.44 + RM2.0) the total amount due was RM582,626.80, which is the SAME AMOUNT DUE USING CONVENTIONAL CALCULATION.

Main reason for the misunderstanding by both all the parties concerned i.e. defendant's lawyer, the Bank and the Court was that they are not aware of the calculation method in default situation.

c) Shariah view of the above case.

Some pertinent questions raised as a result of the above case.

i)   Is the daily profit of RM98.54 award by court permissible under Syariah ?

ii)  Irrespective of Court decision then, if balance remained unpaid.. Can a Islamic Bank, continue to earn profits at RM98.54 per day until sale price of RM958,908.21 is fully exhausted…?


Now, let's look at the above case based on Shariah decision.!

a)  Outstanding sale price should be RM466,847.28 will apply i.e. sale price stipulated in the original agreement signed when the defendant was under employment of the Bank.

b)   No new agreement executed for the 2nd contract although letter of offer accepted by defendant. Since there is no new purchase price and new sale price executed, there is no "akad".

c)  Daily profit awarded is considered "riba". 

d) Any judgement amount in excess of original sale price i.e. RM466,847.28 is considered 'riba" and cannot be earnedd as income to the Bank to avoid other income as "tainted income" but whatever amount in excess awarded by Court, can be given to charitable organisation.

e) To resolve this issue, OK to stipulate in claim that a "rebate based on agreed formula...show the formula...will be granted if the account is full settled" prior expiry of the original financing tenor.

INTERESTING FACTS ABOUT INTEREST COMPOUNDING EFFECT!

As commented by Judge. Islamic financing is more burdensome..?
Is that statement true..?.

Chart 16

Bigger view of the chart

Chart 17

Assume that Court decision was right. Customer thereafter diligently pay his monthly installment based on the 2nd contract. In 25 years, the whole sale price of RM992,361.60 will be fully settled.

On the otherhand, in a similar situation but assume it is a conventional loan, the total payable shall be as follows:

Chart 18

Due to the "compounding effect" on the loan, those who took-up conventional bank loan under similar situation will only finalize the loan at 31years + 8 months and will end-up paying a total sum of RM1.312 million. Additional about RM320k vis-a-vis Islamic financing.

The case when through an appeal process but the Writer will stop his discussion on the above case up to here. What is more important, customer will be able to distinguish the benefits of fixed rate financing versus conventional in situation of default.




ALLAH KNOWS BEST
www.islamicbankingway.com

33C(i). COMPARATIVE ANALYSIS

Under this comparative analysis topic, we shall discuss according to the followings Sub-Topics, namely:

1. What makes BBA/Murabahah different from conventional loan?
2. Brief comparison between Islamic and Conventional Banking.
3. Is BBA fixed rate financing better than a variable interest rate conventional term loan?

    i)    Impact of Asian Financial Crisis on Islamic Banks in Malaysia;
    ii)   Brief understanding of Islamic Interbank Money Market (IIMM) that has impact to (i) above;
    iii)  Fixed or variable instalment (in relation to movement of interest rates).

4. Which is cheaper, Conventional or Islamic Banking financing facility? Customer point of view (we shall discuss  this under Topic 33C(ii) )

This comparative analysis topic shall be reasonably long and also a bit technical in nature. The Writer will try to write as simple as possible  so all readers would be able to understand and benefit from this topic.

Now, let's talk about Sub-Topic 1.


1. WHAT MAKES BBA/MURABAHAH DIFFERENT FROM CONVENTIONAL LOAN?

A person with conventional banking background will say, "There's nothing special about Islamic Banking (referring to BBA) financing as it's just like a modified term loan at fixed rate".

Looking at Islamic perspective, the above assumption is wrong. Under Islamic banking, although BBA is also a debt based financing somewhat the same to the conventional term loan,  what make it different from conventional loan is that for BBA, it involves trading transaction i.e purchase and sale of an Asset. What the Islamic Bank does is to purchase (buy) the asset and then sell the asset to the Customer. This comply Sura Al Baqarah (2:275).

Chart 1

The Sura above (just a brief translation of the full ayat), distinguish what is trade and what is usury ("riba". 

 

From the Writer's own understanding, in normal trading transaction, the seller's sale price will include profit amount (above his original cost of acquiring the goods) so he can make profits.  Allah clarifies that although in trading there is a marked-up amount for seller's profit,  Allah has permitted trade BUT in a loan transaction (where one is expected to repay the cash obtained as a loan or amount owing), any additional amount in excess to the original loan amount, is considered "riba"(usury) and riba is strictly prohibited in Islam.

Like normal trading, BBA Financing facility (most common Islamic financing during Islamic banking early years till today) is structured where the bank will purchase the asset or sell its own asset, at a marked-up price. However, in normal trading transaction, we would normally not aware (the seller will not tell us) of the seller's purchase price (assume the seller purchase the goods from a wholeseller) BUT in BBA financing facility, it is offered in such a way that the customer is aware or know the Bank's purchase price (the financing amount the Bank has approved to the customer) and sell it at a higher price (inclusive profits agreed between the bank and the customer for the whole duration of the agreed financing period. For example, if the financing period is for 10 years, the whole profits (calculated at agreed formula) for the 10 years is added to the original financing amount as then referred as "sale price".

Why the Writer kept repeating about the BBA transaction but explained in different way? Analysing the above, the Writer opine that there are actually two (2) types of trading transactions:

(a) normal trading, for example, sale of grocery goods; and

(b) buy and sell transaction involving a banking product, 

.....some people argued that the relationship of a customer in normal trading transaction is different from a relationship between a bank and its customer.

For the later relationship, both the bank's purchase price (financing amount) and the sale price are known to the Customer. What more if the bank actually purchased the asset not from a third party (like a wholeseller), but from the customer himself at a cost price (equivalent to the amount financed) and then sold it back to the customer at a marked-up price.

The two types of trading about has create Syariah issue until now ! Some scholars said BBA is "Elah..!" And there are those who said, BBA is not a Murabahah contract BUT a Bai Al-Enah contract.  As a practitioner (now retired..!), Shariah scholars must reach consensus as this continuous arguments are confusing the Muslims. Issues on why Shaikh Imran N. Hosein said that Islamic banks are operating "back-door riba" and why Shiekh Umar Vadillo, known as the father of modern day Islamic gold dinar said that Islamic banking is "triple riba" should be countered and should not be left, unanswered !

Nevertheless, based on current trend, most Syariah scholars are of the view that both types of trading transactions i.e. (a) and (b) described above, are acceptable trading transaction or in another word, for (b) the transaction is considered as Syariah compliant.  Main reason why both types of trading are acceptable is because both transactions involve movement or exchange of asset from one to another i.e exchange of an asset for money or can also involve exchange of asset for another asset i.e. barter trade (as long as it is not an exchange of a "ribawi" items) and most importantly, agreed or consented by both parties (basically all the five (5) tenets relating to trading are satisfied).

 

As for a loan, the customer normally receive cash (as amount borrowed) and the customer can use the cash for whatever purpose, including purchase of asset and interest is charged on the outstanding balance until the loan is fully repaid.

The Writer wrote the various views above for the sake of argument to open the minds of Followers of this Blog. Now, let us think out of the box. Why the BBA issues still not resolved? The Writer opine that there are two (2) main issues still not resolved ?

1. Why the Bank's sale price differs? If the customer plan to pay over 5 years, the sale price is say, RM120,000 BUT if the customer, plan to pay over 20 years, the sale price is higher, say RM220,000..? In banking the answer is simple, profit or unearned income for 20 years is surely higher than unearned income for 5 years! This is why some Syariah scholars do not agree! There should only be one sale price!

2. Why the Bank buy the asset from the Customer and then, sell back to the Customer? Normal trading does not work like this !?

Ok, LET'S THINK OUT OF THE BOX ! Perhaps (alot of deliberation still need to be done by Muslim scholars) BUT perhaps, this example can be reviewed by existing practitioners and Shariah scholars:-

The Writer in his previous topic (described under Chart 4 of topic 33B) had suggested Islamic Banks to adopt alternative ways of offering BBA financing products, like selling its own asset (say, from unit of houses obtained in lieu of cash profits from a joint-venture housing project the Bank JV with a developer or make a bulk purchase of houses directly from a developer). When the Islamic bank has stock of completed houses, it can sell the houses by quoting " one lump sum sale price" (say, price equivalent to 30 years deferred payment, which is inclusive of profits (internally priced as say,  1.50% + BFR).

The above suggestion, MAY actually solved issue (1) and (2)..!? 

Let's continue...The Bank can sell the houses using the following options:

a) The Islamic Bank should joint venture with a Developer. Instead of taking its share of the profits in cash, they can convert the same into unit of houses. So, the Bank does not need to buy the houses from the customer although the houses are actually new houses bought from a house developer. Infact, the Islamic Bank can make additional profits compared to selling at a normal developers' price. i.e. when the Islamic Bank hold a completed unit on completion, the price would actually appreciate..its quite common for a house under construction when completed, appreciates by at least 10% and some as high at 30%. 

 

The houses hold by the Islamic Banks should not be sold at cash price (that would be the role of normal developer or the developer that partner with the Bank). The bank's unit of houses, shall only be sold on deferred payment basis.  

 

b) The Bank ONLY QUOTE ONE (1) SALE PRICE (calculated at maximum years the Islamic Bank is willing to finance the house, say 30 years). However, if a customer indicates that he wants to full settle the account within 20 years, the monthly installment is calculated based on "20 year financing tenor" BUT the sale price shall remained the same i.e based on the original 30 years period. When the customer full settle the house on maturity of 20 years or pre-maturely within 15 years (assume he sold the house), the Bank will give him a rebate (to be provided for under "Wa'ad unilateral promises + formula stipulated in the Sale Agreement).

 

There may be some (or perhaps most), those who do not understand Islamic banking will say the sale price quoted using above method is expensive BUT if the customer is explained with example (like using Chart 2 below) plus some comparative analysis statement, its not that difficult to understand. Overtime, customer will accept that how's Islamic banks priced their fixed rate products..

 

...or perhaps, BNM should issue guideline for Conventional banking to make transparent in their documentation on the "Total Payable" or "Total Instalment Amount" rather than just indicating 'Loan Amount" and the interest rate to be charged. By showing this, eventually Customer will understand what sale price under Islamic banking stand for.! My suggestion, the practioners should propose this requirement to BNM so Islamic banking can compete on equal ground. Honestly, until today, I still heard Muslims said, " Islamic banking financing products are more expensive than conventional " basically because they do not understand the components of the sale price.

The above suggestions are something for all of us TO THINK ABOUT..!? especially Islamic bankers that are involved in product development...! The Writer opine, if the land laws need to be changed (since dealing other than with developer, will have some impact matters relating to issuance of new land title, property gain tax and also, stamp duties),  the relevant authorities should change the laws so there are no more arguments among the Syariah scholars in relation to BBA/Murabahah.

On the Bank's side:

 

i)  If you get comments from Risk Officer like " Banks are not supposed to hold properties for trading purposes..!" ....then why Islamic Banks are allowed to do trading on the first place for financing facility like BBA/Murabahah financing?  

 

ii)  If investing in property development project affects the Bank's shareholders funds, then invite depositors who can provide Specific Mudharabah Deposit (capital charge for financing secured by specific mudharabah funds,  is zero...so, there should not be any issue?.) 

 

iii)  Stock of houses will not depreciate, infact, in most situation, property price appreciates. If a Bank partner with a developer, public confidence on the project is better.  In addition, there should not be any issue on cash overrun. Assume if that happens, the Bank as a partner can inject extra cash to ensure completion of the project.  

 

iv)  In addition, only completed house will be sold (one way of resolving cases of abandon projects).

Sorry Readers, the Writer got carried away with BBA issues so now let's go back to our original topic i.e. comparatively analysis.

As earlier mentioned, under Conventional Banking, in a loan transaction, there is no BUY and SELL transaction. It's just a loan (borrowed money) and the borrower will be charged interest over the agreed loan period or as long as the loan remained outstanding. Chart 2 is a simple example of a "loan" versus " Islamic debt financing".

Chart 2

In Chart 2 above, the interest rate chargeable under CB is variable i.e. percentage (% ) spread pegged against BLR. On inception of the loan, if the interest rate is, say 2.0% + BLR of 8.0%, the applicable interest rate will be 10.0% per annum. Should the BLR moves to say 9.0 % per annum, the new interest rate applicable on the loan is 11.0 % per annum.

 

It should be noted that MOST Banks in Malaysia now do not advise customers to increase their monthly installments when the interest rate moves (especially when it moves up). The impact -whatever ADDITIONAL INTEREST AMOUNT  (i.e. the difference of 1.0% per annum when BLR moves from 8.0% to 9.0% as per chart 2 example)  NOT paid (since monthly installment remained unchanged) will be compounded and become principal for the following month. This is the 'killer factor" in CB. Those who defaulted their loans and had to undergo long foreclosure proceedings.......ended up their loan outstanding balances higher or double and some triple (depending on how long the legal process will take!) due to compounding interest on their loans.  Under CB, the Total Installments noted in Chart 2, it will increase or decrease depending on the interest rate movements over the duration of the loan. We shall discuss further on this in Sub-Topic 3 (iii).

Under IB in Chart 2, the total installments is treated as the "Selling Price"and that amount will remained fixed throughout the financing period (for this example, is 3 years). The principal financing amount shall be referred to as "the purchase price" (loan amount under CB). When you look at the Total Installment amount in Chart 2, it is the same with the total installment under CB i.e.  of RM11,617.20 but under IB, that amount is fixed. As for total instalments under CB, the interest movement will have impact as to whether the loan can be finished earlier or later, as earlier explained.

2. BRIEF COMPARATIVE ANALYSIS

Now, let's us compare what are the main differences between Islamic and conventional banking products. At this stage, we shall only discuss on the structure/features.

Islamic Financing

1. Debt financing, secured or non-secured. If non-secured, can use Syariah financing concept of Tawarruq  (can also considered this as "structured financing product") or Commodity Murabahah to validate the“buy/ sell” transaction. *¹

2. Profit rate is fixed (although can be structured using hybrid pricing i.e. fixed + variable*²) throughout the whole financing tenor;

3. Since profit rate is fixed, the selling price is also fixed and no additional charges to be added on top of selling price once the contract has been signed. The purchase price (or the acquisition cost) on the otherhand, may include direct expenses which refer to cost incurred to enable the acquisition of goods to the Customer and this includes expenses such as transportation, storage, assembly, taxes, Takaful (insurance) or any valid expenses established by customary practise. Once the selling price has been agreed upon, it shall remained fixed until maturity;

4. Offers natural hedge (since pricing is fixed) irrespective whether the financing period is short or long or the base financing rate (BFR - Islamic version of the BLR) is on increasing trend;

5. Compounding of unpaid profit (i.e. account in arrears) is strictly prohibited("haram") and is considered as "riba". In Malaysia, BNM allows Islamic Banks to charge compensation charges ("ta'widh") or some preferred to term it as penalty charges ("takzir"), which principally (irrespective it is a compensation or penalty charges) should not to be treated as income to the bank (some Islamic banks are still treating  these charges as income...) BUT to be given solely to CHARITY.

6. If monthly installment is paid diligently on due date by the Customer, financing facility will be settled (paid) as scheduled.

7. The selling price comprised principal amount and profits due for the whole financing period (or in banking, the profit portion is termed as "unearned income"). Thus, on paper the sale price looks very expensive (due to this, some Muslims still prefer to use conventional banking as they say, Islamic banking facility is more expensive than conventional)*3. On early settlement, the Bank will normally gives rebate (or in arabic, "ibra' or most prefer to refer it as "muqassah"). What it means here, all profits not due yet to the Islamic Bank, will be reversed from their book (not refund as cash to customer i.e. some also misunderstood this treatment).

Conventional Loan

1. Loan (debt based facility), secured or non-secured.

2. Mostly priced at base lending rate (BLR) + credit spread %. Thus, customer is exposed to interest rate fluctuation (risk to them) throughout the loan period. However, one fixed interest method available under conventional banking is hire purchase loan where interest rate is calculated using interest calculation known as "Rule of 78".

3. Total amount to be repaid cannot be determined up-front as the final amount depends on the BLR movements. Monthly installment can be structured as fixed throughout the loan period or variable subject to the movement of interest rate. However, common practice now in Malaysia is fixed monthly installment unless the interest rate disparity (example, during interest rate hike situation) is wide.

4. Customer is exposed to “interest-rate” risk (due to potential movement of BLR)

5. Unpaid interest due to movement of BLR (and where monthly installment remained unchanged during interest hike situation as a result, the interest portion of the current monthly installment is higher, thus current installment is insufficient to cover the actual payment due) will be compounded as principal balance for the following month. Interest on the following month, will be calculated on the new principal balance (including unpaid portion of the previous month). This situation contributes to what is known as "Interest Upon Interest" calculation and this type of income recognition can be huge to conventional banks as its quite common for people to pay their monthly installment after the 1st of the following month (although their instalment for example, is due on 25th of the current month). This type of calculation i.e. compounding, is prohibited under Islamic Banking.

6. Loan may not be repaid on maturity of the loan period due to the compounded interest amount. In situation where the interest rate is on the decreasing trend (and remains low throughout the loan period), the loan will normally settled earlier.*4

7. Interest is calculated based on month to month basis, so on early settlement the Bank may charge certain amount of interest, for example, one (1) month interest in lieu of notice in addition to the month's interest due.

8. In case of special pricing loan i.e. low interest (applicable to housing loans), which is normally below BLR for the first 3 to 5 years, the Bank will recoup (claim back) the interest loss (business strategy to build loan asset where the bank is supposed to recover the interest loss due to low interest rate on the 6th year onward). The conventional Bank will recoup this amount, if the customer settle the account within the special pricing loan period.

As for item 8 above, there are also Islamic Banks that also structure similar "special pricing" for Islamic home financing. When the customer early settled within special pricing period, the Bank will give lower rebate amount to cover the differences similar to conventional banking. However,  action of the Islamic Bank can be considered as non Syariah compliant, if in providing the rebate, it shows the customer the amount recouped on paper (in trying to be transparent) which can be considered as additional amount or can be tantamount to "riba"*5. This is one shariah issue that need to be resolved.

As for rebate formula, BNM has set rule that Islamic Bank can provide rebate under "Unilateral Promise Principle of Wa'ad") and if such promise is provided for by the Islamic Bank, it has to stipulate the rebate formula to avoid future conflict.

NOTE

1. There are arguments when it comes to the principle of Tawarruq. Is it a true sale or just to facilitate the "buy" and "sell" transaction?. If the intention for using Tawarruq is just to validate a transaction, which on the onset is non-Syariah compliant, then the Tawarruq transaction can be considered as "elah" (or excuse) which may not be acceptable in Islam. Currently, there are many transactions that are using this structure especially for structured products (we shall discuss more on this later).
 

2. Fixed pricing (say 4% + base financing rate or BFR) but actual earning is based on say, 2.0% + BFR. The difference will be rebated on full settlement (this has been discussed in Topic 23-26).
 

3. More expensive? Under conventional banking, the interest rate amount over the loan tenor is not shown but under Islamic banking, it has to show the total profit amount to determine the selling price. Some customer do not understand this. A good example is in Chart 2 above that shows - Total Installments equal Selling Price BUT under conventional banking, the total installments is not fixed, that amount can change depending on the "interest rate" movements.
 

4. Assume on signing the agreement, the BFR is 6.0% per annum but due to "low conventional interest rate trend" (unfortunately, currently Islamic BFR is somehow directly or indirectly based on conventional BLR), the BFR is say, 4.0% so there is a difference (in banking term of called this as "negative carry") of 2.0% in favour of the Customer. This difference will be rebated. Under conventional banking, the customer will enjoy the lower interest rate directly BUT since the monthly installment is fixed. The lower interest charge will allow the difference (higher amount will be allocated to principal) to repay the principal amount faster.
 

5. Syarially, rebate is actually at the discretion of the Islamic Bank but since BNM requires the Islamic Bank to be transparent - resulting application of the principle of Wa'ad, the Writer opine that the Islamic Bank can structure their rebate formula something like this " Common Formula Used + SPD (or Special Profit Differences or whatever terms suitable), implying the "amount to be recouped in case of early settlement" during the special pricing period. (kindly take note that this is just the Writer opinion, some Shariah Advisors may think differently). The best solution (Writer's opinion) is of course, no rebate formula is mentioned (since rebate is at discretion of the Islamic Bank i.e. we revert to old practise)  BUT operationally BNM, to issue operational guideline with "full settlement formula" where ALL Islamic Banks must adhere irrespective the rebate is at discretion of the Bank. The guideline, should further imposed that Shariah Audit department shall be responsible for enforcement of this guideline. This rebate issue was resulted from the famous legal case of Zulkifli bin Abdulalh vs Affin Bank (29 Dec 2005), so to avoid legal issues, most Islamic banks now adopt this "Wa'ad" principle but till today, there are still "opinions" against it. (This will be discussed later)
 

3. IS BBA FIXED RATE FINANCING BETTER THAN A VARIABLE CONVENTIONAL TERM LOAN?

To evaluate whether Islamic banking is better (The Writer prefers to termed it as safer where Customer is actually hedging himself) than conventional banking, it would be fair if we are analyzed this not based on "risk assumptions" but based on "actual events". For this, the Writer will use impact of the 1997 Asian Financial Crisis on Islamic banking system although at that time (except for Bank Islam Malaysia Bhd),  all other Islamic banking activities, were operated under "dual banking window operation".

i) Impact of Asian Financial Crisis to Islamic banking business in Malaysia

When we talk about actual events, let's look back at the actual BLR of most commercial banks between the year 1991 and 2009 (see Chart 3 below).

The year 1997 to 1999 was known as the Asian Financial Crisis period. In 1997 Ringgit Malaysia plunged from RM2.40 to a low of RM4.90 to USD 1.  From one article that the Writer read, net portfolio investment shrunk from positive RM103 Billion in 1996 to negative RM12.9 Billion in 1997. This crisis led to the collapsed of the stock market, ballooning of foreign debt, massive corporation defaults and non-performing resulting banking crisis.

In 1998 to counter recession, BNM loosened the monetary policy by reducing interest rate gradually from 11% in July 1998 to 6.0% in May 1999 and further reduced to 3.0% in December 1999. Ringgit was pegged to US dollar in September 1998 at RM3.80 to US1 and remained at that price for almost 7 years (up to 2005)

Chart 3 revealed that during the initial stage of the Asian financial crisis (sometime in August 1997), the gap on the interest rate (already on rising trend then) were between point 10 to 40 basis point but effective 5th November 1997, the interest rate differential became wider and by 3rd June 1998, the interest gap between the initial stage of the financial crisis was 2.65%. The continuous rise in interest rate caused panicked among the bankers, interbank money market rose over 40% (see Chart 5) as a result, most or almost all banks, charged the escalating cost back to the borrowers and FD rates were as high as 15% per annum for long-term tenor of 15 months (some were of the opinion that the financial crisis was going for long haul so most banks offered high interest rate for long-tenor FD).

When BNM reduced the interest rate abruptly in 1999, most conventional banks were caught by negative carry due to large exposure on 15 month FD deposits thus, Islamic banking Division/Unit Unit at that time contributed considerable profits to the Banks as a whole. Also, since its financing assets were not much but financing rates were fixed thus, in general (especially home financing customers), default rate under Islamic Banking were low. If effected, it was because the Customer also had high exposure (mostly relating to their business account) under conventional banks thus their loan repayments as a whole were affected.

Talking about interest rates,  let's us review the actual BLR trend for Commercial Bank (record of the Bank the Writer used to work with) from 1991 to 2009. You will notice that the BLR before November 1998 were on the high sides. In later years (after 2009 to now in 2012), BLR were quite stable hovering at about 6.50% per annum.

To determine whether Islamic banking is safer than conventional banking, let's talk about hybrid  BBA facility where the ceiling profit rate for this example, is fixed  4.0% + BFR of say, 6.5% per annum. The applicable fixed profit rate for this comparison is 10.50%. (we briefly explained about hybrid pricing financing products in earlier Topic so I shall not provide further example on this)

From Writer's record, BLR from April 1991 to Feb 2009 were as follows:-

Chart 3

Based on the BLR trend, you will notice that the interest rate  from Aug 1997 (there's when the financial crisis started to impact Malaysia) abruptly rise and from 7 Feb 1998 onwards, the BLR level crossed the threshold of the ceiling profit rate level of 10.50% (assume the BBA pricing is structured using hybrid pricing) until 7 September 1998 (9 months period), when BNM intervened by reducing the interest rate and BLR was reduced abruptly from 11.90% to 9.50% (a drop by 2.85% per annum). From Writer's own calculation, due to this 9 months financial crisis period, people who took conventional loan, loss equivalent to three (3) years interest payment i.e. in simple words, whatever interest paid last 3 years before the crisis period, were as though not been paid, due to the compounding effect and high interest rate prior BNM intervention.

From Chart plotted from BLR registered in 1980 to 2004 (based on Writer's training slide),  you will notice that if  a BBA financing facility (instead of using hybrid profit rate pricing) is priced at fixed rate of 8.0% per annum, the actual gap compared to average conventional BLR of 8.49% was only 0.49% per annum. The Chart actually tells us that if a Customer took up Islamic financing facility at fixed rate of 8.0% per annum (during the earlier years of Islamic banking prior introduction of hybrid pricing), customers actually enjoy lower financing cost compare to those who took conventional loan that is pegged against BLR.

Chart 4 below, will provide a schematic view of how the trend looked like when we combined the BLR for commercial banking, finance company (now, merged with commercial banking) and Islamic fixed rate financing. The trend also showed interest rate movement changes to high, low, high low for every 3 years but currently for the past many years i.e. since 2004, we were at about 8 years, consider low-medium position.  Also based on historical trend, BNM seems to intervene each time, the interest rate is on the rising trend so if Islamic banks dare (do not think your Risk people will agree) to take this a a trend, they should not be worry about offering fixed rate financing especially, for hybrid profit rate products.

Chart 4

 

Brief explanation of the above Chart 4, other than the average BLR (8.49%), the average lending rate were quite high then i.e. about 10% p.a. while for Finance Company (average BLR at 9.53%),  the average lending rate was 12.53%. BLR changed more frequently (infact, 65 times within the trend period) compared to last few years.

During the same period, the Interbank money market rates were as follows:

Chart 5

Conventional interbank money market (IIM) rate recorded as high as 40.43% per annum during the financial crisis period but the Islamic interbank money market (IIMM) profit rate recorded highest,  at only 8.7% per annum. So, those who took Islamic banking facility then, were not affected much during the financial crisis period because when they took fixed rate financing, they have actually "hedged" themselves against possible interest rate hike situation. Some Islamic bank today, were talking if such situation reoccur, they will give "hibah" as standby in case of huge movement of funds to conventional banking BUT honestly, if the Writer could recalled, no "hibah" were given by Islamic banks during the crisis period. However, Bank Islam that was affected initially by the huge movement of funds (some said more than a bilion) launched Islamic Negotiable Instrument (INI)  known as Negotiable Islamic Debt Certificates (NIDC - based on sale of debt concept) and Islamic Negotiable Instrument of Deposits (INID -based on Mudharabah principle). Within two (2) months (if the Writer is not mistaken), they managed to recover their deposit position. Today, Islamic Banks will use Commodity Murabahah rather than the INI.

How does IIMM works? We shall explain this in later part of this topic.

Chart 6 (BNM statistic after BNM interest rate intervention) showed the impact of financial crisis on Islamic Bank's deposit and financing position. 

Looking at Chart 6, you will notice that the financing to deposit ratio (or loan to deposit ratio as termed under conventional banking) only went up to 109.09% during the month of December 1997 but thereafter, the financing to deposit ratio dropped to as low as 44.8% in Jun 1999

Actually, impact of the financial crisis to conventional bank was so severed that many have to undergo large write-off exercises BUT Islamic banks financing portfolios were not affected. In addition, during that time (before profit equalisation reserve or PER was not introduced yet), all Islamic banks are required to declare their profits based ACTUAL profit ratio, so higher income means higher return to the Depositors, resulting Islamic banks paying higher deposit rates (the gap was as high as 1.0% per annum compared to conventional banks). 

The conventional banks on the other hand, had to reduce their deposit rates since their BLR was reduced due to BNM intervention.. Thus, the impact was that there were large movement of funds from the conventional banks to Islamic Banks (infact, some within its own bank window operation) from RM16.4 billion as at December 1998 to RM26.1 billion in June 1999 (period of just 6 months).  In addition, during the financial crisis, the conventional bank suffered high percentage of non-performing loan compared to Islamic window operations thus Islamic windows at that time, were able to provide higher profits to the Banks' bottom line and also to the Depositors.

Why is this so? To further explain, when BNM intervene by lowering the BLR, conventional Bank had no choice but to reduce their loan interest rate BUT since MOST (infact, all) Islamic financing at that time built their financing asset at fixed profit rate i.e. mostly at around 8.00% per annum or slightly higher at that time, they were able to declare higher profits (at that time, the accounting treatment of "profit equalisation reserve" (PER) was not introduced yet). Due to the movement of funds within the two systems, the situation became so intense that the Islamic Banks were somehow accused of canalising their conventional bank's business. Due to this frequent movement from conventional banks to Islamic banks (worst within the window operation and its own conventional counterpart) and vice verse (termed as Displacement Commercial Risk), the banking players had no choice at that time but to introduce PER sometime (if I got the date right)  in January 1999. By introducing PER, the banks as a whole were able to better manage their deposit rates for both systems (Islamic and conventional) thus, that solved the displacement commercial risk issues within the dual banking systems. However PER had resulted (especially last 2-3 years) issues on why Banks should set aside profits which is actually due to current depositors. PER was supposed to be a temporary instrument to cushion Displacement Commercial Risk effect but (as discussed in earlier topics), PER can also be abused, if not check properly by the Regulator. Currently, the Writer was made to know that some Banks are doing away with PER (its a good sign) as the Writer opine that in order for Islamic banks to compete, it should be allowed to declare actual profit just like during the 1997 crisis period. Most may not agree with Writer's opinion but if the Islamic banks survived during the 1997 crisis, why do we doubt they cannot survive in the next? (let's pray such crisis do not recur)

 Chart 6

Looking at Chart 7, instead of deposit moving out of Islamic banks, it turned out differently, more funds entered the Islamic banking system.

 Chart 7

In short, historical trend has proven that the Islamic Banks were not affected much during the Asian Financial Crisis as compared to the Conventional counterpart which is exposed totally to interest rate risk. The Writer opine that as long as Islamic banks continue to transact their IIMM activities using Mudharabah principle, if similar situation re-occur, it would be able to withstand BUT if commodity murabahah funds are used more in IIMM activities, then the impact would be the same with conventional Bank. Why is it so? Under Mudharabah IIMM transaction, the MGIA "r" rate creates a ceiling or threshold limit for Islamic banks that are no so lucky when a crisis occur BUT if the Commodity Murabahah IINM is used, there is no threshold limit, the counter party will demand profit rate that will have adverse impact on Islamic banks bottom line  especially when profit rates are quoted using conventional interest rate as benchmark.

ii) Brief understanding of Islamic Interbank Money Market (IIMM) that has impact to (i) above

To explain why Islamic Banks were not that affected during the Asian Financial Crisis, the Writer would like to provide a brief understanding on how the IIMM works.

The IIMM is structured using the principle of Al-Mudharabah and Malaysia is probably the only country in the world (the Writer is not sure of this facts now unless readers can provide new facts about other country offering similar interbank arrangement) that has IIMM in its Islamic financial system. With availability of IIMM, the Islamic Banks can maximize their investment and also manage their funding position.

The Writer would like to say that the IIMM method used by Islamic Windows during the Financial Crisis has really saved the system from what happened to the conventional interbank money market.

Now let's understand how it works !

Looking at Chart 8 below,  the conventional terminology "inter-bank lending" (when the Bank has excess cash) and the term "inter-bank borrowing" (when the Bank is short of cash and is borrowing from another bank) are used in their daily interbank money market transactions. Interest rates would be based on demand and supply but generally, the BNM Overnight Policy Rate (OPR) will be used as benchmark.

Under IIMM, the term 'Inter-Bank Investment"(for better understanding, let's use conventional explanation - excess fund is lent out) while "Inter-Bank Placement" (similar, when it is short of funds, it borrow from the money). 

Chat 8

NOTE: Take note that inter-bank placement is also referred as Interbank Acceptance.

 

It is interesting to note that Islamic Banks also has its own benchmark for this Mudharabah IIMM system ! Every month, all the Islamic Banks are to provide to BNM what we call the "R" rate derived from 12-month gross MGIA deposit rate. What this "R" apply to? Some termed it as just RATE but some also referred to as Reference Rate, whatever..!.

 

Every Islamic Bank will have its own "R" rate. The higher is the Islamic Bank's "R" rate, the more efficient is the Bank's in managing its fund (technically, more profits). Take note that this statement is true prior introduction of the Profit Equalisation Reserve (PER) but once PER was introduced, we no longer able to tell (without having to look at the Bank's financial) how efficient is the Bank. Using PER, the Islamic Banks are allowed to move some of its profits (in accordance to BNM guideline) to PER as precautionary measure to cushion the profit rates in case the banking system is hit by another financial crisis. PER has been explained in earlier Topic 27.

 

Chart 9 to Chart 12 below are self-explanatory.



Chart 9

 

Chart 10

Chart 11

Chart 12

 iii) Fixed or variable instalment (in relation to movement of interest rates)


In this topic, we shall discuss on what is the impact of fixed instalment for a conventional term loan where interest is pegged against BLR.

Chart 13 (Assumption 1) is an extreme case where the monthly instalment is RM615.72 per month (calculated at 6.25% per annum). Using simulation, up and down over the period of 30 years but the average rate over the 30 years is 9.0% per annum, we will notice that at end of 30 years, the loan outstanding is at RM288,597.12. Basic reason is because when the interest is high, the monthly instalment remained unchanged. So whatever interest portion not paid due to monthly instalment not increase in accordance to the higher interest rate, will be compounded. Overall impact, loan cannot be settled on maturity, infact the outstanding amount.

As comparison, for a BBA priced at fixed 9.0% instalment, is settled on maturity. Actual instalment at 9.0% per annum profit rate is RM786.70 compared to the conventional of RM614.72

As earlier mentioned, this is an extreme example, just to show the impact of compounding interest rate.

Chart 13

 

In Chart 14 (Assumption 2), the initial interest rate is 6.25% per annum and the monthly instalment is as per the interest rate i.e. RM615.72. But, on the 3rd year, the interest rate has moved up to 8.0% per annum and the instalment is revised accordingly BUT based on 8.0% per annum interest rate. BUT using similar simulation, the average interest rates over 30 years is 9.0% per annum. Again, you notice that on maturity of 30 years, there is still outstanding of RM123,744.88 mainly due to compounding effect unpaid interest due to instalment not yet to reflect actual interest rate charged.

Chart 14

 

Chart 15 below (Assumption 3), the monthly instalment is changed as interest rate changes. Using similar simulation, you will notice that on maturity the whole conventional facility is fully settled although when you compare with Islamic banking fixed rate, the conventional total payments is slightly higher i.e. about RM1,000 then the Islamic facility.

Chart 15

In next topic, we shall discuss on which is cheaper, Islamic or Conventional banking. The writer will provide one real example, as comparison.

 

 

ALLAH KNOWS BEST

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