22 - Application of Funds

In next few sessions we shall be discussing on a very technical subject relating to how profits are shared between the Islamic banks and their depositors. For those who have been following my blog just to know about Islamic banking in general, go through the topics to have a surface understanding on subject matter but, for students planning to make Islamic banking as their future career and also to practising Islamic and conventional bankers with intention to move their career to Islamic banking,  my suggestion is for all of you to spend some time on my next few topics to appreciate how the profit sharing mechanics work. It is interesting to note that last two (2) years or so, there was a survey forwarded to all Islamic banks on a new or additional profit sharing method using "deposit bucket" but the same is yet to be implemented.  

Towards the end of this session (which shall be divided into several topics), the Writer will provide a blank Profit Distribution Table worksheet (excel form) with some questions. Those interested to understand this topic in depth,  suggest you complete the said exercise.

Before we discuss about the profit sharing methods, we must understand this simple application of funds comparison between conventional and Islamic bank. Let's examine:-

1. Conventional bank makes money from the interest charges on loan it lent out and the cost of deposits (to be more precise - cost of funds) it has to pay to fund the loan, apart from other auxiliary income such as fees and commission etc. On the otherhand;

2. Islamic bank makes money after it has paid its depositors’ portion of the profits based on agreed profit sharing ratio. Under this profit sharing principle, the depositors are the Bank’s joint venture partners ( also share the risk) thus whatever profits paid out by the bank to the depositors are technically, not an expense item (contrary to what is presented in Islamic bank P&L and Balance Sheet) but the depositors’ share of the overall profits distributed by the Bank (who acts as an entrepreneur) in running the business on behalf or jointly with the depositors i.e. depending on types of funds.

Before we discuss on the more technical part of this topic, lets evaluate the overall application of funds of a bank through this simple chart as follows:-

Chart 1 - Application of Funds (Islamic)

Looking at Chart 1, you will notice that sources of funds comprise mainly from three (3) deposit types namely, savings, current and general investment accounts. Although commodity murabahah is also used to garner counter deposits, it is more popularly used by Treasury Department to secure large deposits at fixed rate.

In Malaysia, savings and current deposits accounted to about 20-30% while MGIA is about 50-60% and commodity murabahah is about 10% or maybe lesser. After setting aside certain portion for statutory reserves (currently 1% set by BNM) and for liquidity purposes (normally ranging from 10-15% but in practise depending on how effective the Bank manages its liquidity), the difference is used for financing and investment activities for the bank to generate income. Whatever income derives from these activities are placed in a General Profit Pool (gross profit) prior distribution. After deducting general provisions or certain provisions as required under IFRS accounting, broker's fee, specific provision, income-in-suspense (most Islamic banks still maintain this treatment) and profit equalisation reserves (PER), the balance will be distributed according to the agreed profit sharing ratio between the bank and the depositors. It should be noted that service charges and commissions which are non-financing related are normally not shared with the depositors thus, it will be treated as full income to the Bank.


Excess funds like liquidity reserves and money not use for financing and investment activities, will be placed in the Islamic Interbank Money Market (IIMM) or for purchase of halal securities, sukuks etc

Likewise, for Specific Investment Account, similar treatment is done but whatever income generated from application of this funds shall be placed in a specific pool where whatever balance after deducting similar allowed expenses under Specific Investment contract, shall be distributed only with the Specific Investment Depositors.

Human resources (HR) costs, administration and other operating expenses are to be borne solely by the Bank thus whatever income distributed thereof to the Depositors is technically on gross basis. Under normal non-banking business activities e.g. Sdn Bhd company, the HR, Admin and other costs would have been deducted first prior distribution of profits. As an Islamic bank, it is mandatory for the bank to pay zakat, in addition to the corporate tax payable to the Inland Revenue Department.

Now, let's examine how conventional bank earns its income.


Chart 2 - Application of Funds (Conventional)

At the glance, you can see that the application of funds by conventional bank is different from Islamic bank. Since most of its deposits cost (interest cost) are predetermined on deposit placement, income to the bank depends on how effective it manages its excess funds. Unlike Islamic bank, expenses such as general and specific provisions, brokers' fee, commission payable etc are direct expense items and borne solely by the Bank. After deducting its operating cost, the pre-tax profit is determined.

For our next topic, we shall discuss on various income recognition methods practise by Islamic banks.

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