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.

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