GE20803 DEPOSIT & FINANCING OPERATION OF ISLAMIC BANKING

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1 GE20803 DEPOSIT & FINANCING OPERATION OF ISLAMIC BANKING DEPOSIT MOBILIZATION BY ISLAMIC BANKS Updated version 21st October 2015 BY DR. HANUDIN AMIN LABUAN FACULTY OF INTERNATIONAL FINANCE UNIVERSITI MALAYSIA SABAH

2 BRIEF INFORMATION ON DEPOSIT MOBILIZATION BY ISLAMIC BANKS Like conventional banks, customer deposits are both sources of funds and liability products in Islamic banking In Islamic banks, deposits are used to finance the purchase of assets such as houses, vehicles, land and building Factors like philosophical, moral legal and economic play a role in differentiating the management of deposits in Islamic banking from that of conventional banking Major source of funds for Islamic banks besides shareholders funds Unlike Islamic banks, deposits in conventional framework is explained by liquidity preference theory explains why people need money for transactions, precautions and investments - making demand deposits, savings deposits and investment deposits are of utmost importance

3 TWO MAIN FUNCTIONS OF ISLAMIC DEPOSITS Transaction function Wadiah dhamanah current and savings account Current or demand deposits do not pay any return both in conventional and Islamic banking But conventional savings pay interest while Islamic savings do not Transaction function of Islamic deposits is conducted via the contract of wadiah dhmanah has no profit motive Benefits ease of cash withdrawals on call & protection of deposits Current account is used to make payments to third parties while savings account is intended for safekeeping and convenience purposes Investment function Al-mudarabah investment account Al-ghornm bil ghonm no profit can be gained without taking risk (no reward without risk) The incentive to place money in mudarabah deposits should revolve around profits Subject to systematic risk Subject to operational risks Mudarib can abuse his responsibility (thus moral hazard is a serious factor to account for in decision making when people plan to place their savings in the mudarabah deposits

4 MICRO LEVEL OF MUSLIM BEHAVIOR ON SAVINGS 1. In Islam, savings will always means surplus income to be placed for investment purposes thus keeping money in circulation. All savings must be invested again in the economy. Otherwise, it is hoarding (ihtikar) 2. Hoarding money is prohibited in the religion of Islam. Why it is so? 3. Does hoarding money better? Hoarding: 1. Idle cash 20, Zakat x 20,000 = Cash balances = 19,500 Savings: 1. Cash invested 20, Profit 10% 2, Wealth 20,000 +2,000=22, Zakat 22,000 x = Wealth after zakat = 21,450

5 WHY DEPOSIT NEEDED IN ISLAMIC BANKING? DEPOSITS ARE THE MAIN SOURCE OF FUNDS DEPOSITS PROMOTE CREDIT CREATION (e.g. Islamic mortgage) DIRECT LINK TO ECONOMIC GROWTH AND PROSPERITY DEPOSITS ALLOW TO CATER THE FINANCIAL NEEDS OF SURPLUS UNITS

6 Transaction motive Current account What are purposes of different types of deposits? Precautionary motive Savings account Investment motive Islamic fixed deposit

7 Does penalty impose by an Islamic bank when a current account holder has an insufficient fund for payment to a third party, but the check has been issued?

8 LECTURETTE #1 TRUE/FALSE QUESTIONS: 1. Both Islamic and conventional savings deposits are considered as a major source of funds for both banking systems, therefore, the savings deposits are similar -FALSE 2. Liquidity preference theory explains muslim behavior to hold money in an Islamic bank - FALSE

9 TYPES OF DEPOSITS Demand deposits Savings accounts Investment deposits Negotiable instruments of deposits

10 DEMAND DEPOSITS Definition a bank account that entitles the account holder to receive his or her funds on demand using checks Common features of demand deposits facilities offered by Islamic banks: 1. Customers who have the capacity to enter into a contract (i.e. 18 years old) 2. For businesses, clubs, societies and associations, certificates of registration and documents such as MAA and minutes of meetings relating to the opening of the account must be presented (i.e. as evidence of the establishment) 3. Banks are of their discretion to determine the minimum amount required during the opening the account 4. A cheque book will be supplied by the bank to the account holder 5. Withdrawals can be made with the issuance of cheques or other written instructions given by the account holder 6. The cheques issued by the account holder will be honoured by the bank but is subjected to the availability of funds of the account holder 7. Islamic banks may impose a service charge for servicing and maintaining the account 8. Account holder can terminate the account provided a notice is given in advance

11 DEMAND DEPOSITS Wadiah current accounts guarantee the paying back of money but not any return: The bank s responsibility is in the form of guarantee and therefore it is compulsory for the bank to return the fund as and when requested by the customer If the bank earns high profit the depositor, but to compulsory, to receive hibah At a loss, the bank will not give any hibah to customers Shariah Principle used: Wadiah yad dhamanah the bank pools and utilizes the fund Shariah Principle used: Qard hassan deposits are treated as qardh or a benevolent loan by the depositors Qard hassan current account a benevolent loan: The bank is free to utilize these funds at its own risk The depositor in its role as the lender is not entitled to any return as this would constitute to riba The bank owes the depositor only the principal amount borrowed Less popular commercial consideration that any profits gained by the bank cannot be given (i.e. hiba) to depositors Mudarabah current account profit sharing basis: The depositor brings capital, the bank brings a personal effort At a profit, it is distributed according to PSR ratio At a loss, the depositor borne the loss The depositor has no control over the management of the project Customers entitle to earn dividends based on the profit made by the bank from the investment Shariah Principle used: Mudarabah the depositors contribute capital (deposited funds) and the bank is a mudarib

12 WADIAH CURRENT ACCOUNT DEPOSIT FUNDS ~safe-keeping ~CUSTOMER GIVES PERMISSIONS TO THE BANK TO UTLISE ANY SUM OF MONEY DEPOSITED ~ Wadiah yad dhamanah (an Islamic bank is a custodian) ~ The principal amount is guaranteed by the bank 1 CHEQUE BOOK 5 Hibah at the bank s discretion 4 100% 3 PROFIT 2

13 QARD HASSAN CURRENT ACCOUNT Depositors give a benevolent loan to the Islamic bank. The Bank is free to utilize the funds at its own risk. The depositor serves as a lender and is not entitled to any return as this would constitute riba Banks find it difficult to market such product as there is no return for account holder 1 4 CHEQUE BOOK 100% 3 At a bank s risk PROFIT 2

14 MUDARABAH CURRENT ACCOUNT INVESTS FUNDS FOR TRANSACTIONS USING CHEQUE AND INVESTMENTS. PSR= 30 % CUSTOMERS 70 % AN ISLAMIC BANK 1 CHEQUE BOOK % 30% 70% LOSS PROFIT 3

IN THE MARKETPLACE Thank you to promote us Maybank Islamic Berhad offers an Islamic checking account based on al-wadiah yad dhamanah and mudarabah Current account-i a current account based on the

15 IN THE MARKETPLACE Thank you to promote us Maybank Islamic Berhad offers an Islamic checking account based on al-wadiah yad dhamanah and mudarabah Current account-i a current account based on the Shariah concept of Wadiah Yad Dhamanah (safe custody), with checking facility. Flexibility of making unlimited withdrawal s at home branch and outstation withdrawals of RM10,000. Protected by MIDC Premier mudarabah account-i A Shariahcompliant current account that pays indicative dividends, plus premium banking and takaful benefits. A combination of safe custody (al-wadiah yad dhamanah) and profit sharing (mudarabah). Provides a cheque book

16 Islamic banks offer products for savings, checking (demand) and fixed deposits, structured to comply with Shariah principles

17 SAVINGS DEPOSITS Definition a bank account that offers to account holders who seek safe custody of their funds and wish to save money as well as to earn an income from that savings Common features Islamic banks: of savings deposits facilities offered by 1. Customers individual account, minor account, joint account, club and associations 2. A passbook will be supplied by the bank to the account holder 3. Withdrawals can be made either over the counter or ATM 4. Islamic banks may impose replacement of ATM card etc a service charge for withdrawal, 5. Account holder can terminate the account in writing and must sign necessary documents 6. Hibah is given at a bank s discretion (i.e. not compulsory) 7. The savings account facility has no profit sharing characteristics except for contracts under the concept of al-mudarabah 8. As for minors below the age of 15 years, the savings account must be under the name of their guardian (i.e. trust account)

18 SAVINGS DEPOSITS Wadiah Yad al-damanah (Safekeeping with Guarantee): Banks guarantee the deposits Banks can use the deposits Banks replace or compensate whatever gets lost Banks are expected to give the deposits whenever they are requested by the owners According to many scholars, this category is most suitably termed as qard loan. Some do not even consider this type in Islamic law. Wadiah Yad al-amanah (Act of Trust): By definition, keeping with trust. No compensation in case of loss or damage No reward for keeping No right at all to use the property This type of wadiah is also called Amanah The Apostle of Allah (P.B.U.H) said: he who accepts a trust property (as a trustee) has no liability

19 WADIAH SAVINGS ACCOUNT DEPOSIT FUNDS ~safe-keeping ~convenience ~ Wadiah yad dhamanah (an Islamic bank is a custodian) ~ The principal amount is guaranteed by the bank 1 4 Hibah at the bank s discretion 100% 3 2 PROFIT

20 IN THE MARKETPLACE Bank Muamalat offers an Islamic savings account account based on alwadiah yad dhamanah principles BSA Al-wadiah yad Dhamanah. Basic features minimum initial deposit is RM 20.00, withdrawal can be made using ATM, MEPS throughout the country WSA Al-wadiah yad Dhamanah. Minimum deposit RM Withdrawals can made as similar as BSA That s great! We are progressing over the years

21 NORMAL CALCULATION OF HIBAH Daily Average Balance x (number of days/365) x hiba rate = Profit (RM, hiba): For example, hiba rate from 16 Jun until 15 July is 2.0%, daily average balance is RM 5,000, the deposit is kept for one month (Jun 2012, 30 days) so the hiba will be; and RM 5,000 x (30/365) x 0.02 = RM8.22 In essence, the amount of RM8.22 will directly be credited into the current account-i holder after the rate and the calculation for the profit has been made. The computation of the hibah rate is anchored in the performance of the bank, size of the deposit, period of the saving and the policy of the bank, which may differ from one bank to another

22 CALCULATION OF HIBAH WHEN TIER MATTERS Given the following information on En. Dollah s Wadiah savings at Mutli- hibah rates (effective 16/12/ /01/2016 and 16/01/ /02/2016) Examples Tier Range Rate (% p.a) Tier 1 Up to RM 1, % Tier 2 RM 1,001 to RM 5, % Tier 3 RM 5,001 and above 2.54 % Hence compute WSA with a balance of RM7,000 for whole of January (31 days), 2016 based on the above hibah rates: 31/365 x 1.05% x 1,000 = RM /365 x 1.85% x 4,000 = RM /365 x 2.54% x 2,000 = RM 4.31 Total Hibah = RM 11.48

23 LECTURETTE #2 Given the following information on En. Matlan s Wadiah savings at Multi- hibah rates (effective 16/12/ /01/2016 and 16/01/ /02/2016) Tier Range Rate (% p.a) Tier 1 Up to RM 1, % Tier 2 RM 1,001 to RM 5, % Tier 3 RM 5,001 and above 2.34 % Hence compute WSA with a balance of RM10,000 for whole of January, 2016 based on the above hibah rates

24 INVESTMENT DEPOSIT Definition a bank account that allows customers to keep money for investment motives, be it short-term or be it long-term Common features the following are among the common features of the investment deposit: 1. Minimum amount of deposit (e.g. 5,000) 2. Types of customers who can operate an investment account (i.e. individuals, joint individuals, firms and corporations & societies, associations and clubs) 3. Withdrawal and renewal process 4. Distribution of profits (i.e. Profits are distributed between the owner of the capital and the entrepreneur based on PSR such as 70:30 Islamic banks: Customers)

25 Mudarabah Al-Mutlaqah Al-Moqayyadah

26 MUDARABAH ACCOUNT INVESTS FUNDS PSR= 70 % CUSTOMERS 30 % AN ISLAMIC BANK % 70% 30% LOSS PROFIT 3

27 ELABORATION Key elaboration: Suppose you deposit RM20,000 with a bank and the PSR is 30:70, 30% is to the bank, 70% is to you The bank takes the money to invest in a project. It does not guarantee that the investment will be profitable Now suppose there is a net profit of RM1,000. The profit is shared as follows 30% x 1,000 = RM300 for the bank, 70% x 1,000 = RM700 for you. Your account would then show a balance of RM20,700 (RM20, ) In the even of a loss, say, RM500, you as depositor will be the only one to bear the loss. The loss is 100% for you (100% x RM500=- RM500) while the bank is 0%, Your account would then show a balance of RM19,500 (RM20,000 RM500=RM19,500)

28 CALCULATING DIVIDEND FOR MUDARABAH ACCOUNT If Aly places RM10,000 in MGIA on 20/1 until 20/4, with declared rates as below: rates 16/1-15/ % 16/2-15/ % 16/3-15/ % 16/4-15/ % Dividend computation RHB Bank Based on daily accrual basis on the prevailing declared rates. (20/1-15/2 = 27 days) 27/365 x 3.30 % x 10,000 = (16/2-15/3 = 28 days) 28/365 x 3.25% x 10,000 = (16/3-15/4 = 31 days) 31/365 x 3.20% x 10,000 = (16/4-20/4 = 05 days) 05/365 x 3.12% x 10,000 = Total dividend RM 80.79

29 IN THE MARKETPLACE FIRST OF ALL, BIMB, surely we are the best BIMB introduces a first in Islamic banking, that is, al-awfar investment account-i. NOT CIMB ISLAMIC. Minimum initial deposit is that of RM1,000 1 month tenure. RM months tenure: PSR=70 Bank: 30 Customer Are you sure?

30 NEGOTIABLE INSTRUMENTS OF DEPOSITS Definition refers to a sum of money deposited with the bank and repayable to the bearer on a specified future date Common features of the instrument: 1. Two Shariah principles used, BBA and Mudarabah 2. A certificate of investment will be supplied by the bank to the account holder 3. Equivalent to the conventional certificate of deposits (CDs) 4. A bank-issued short-term security that documents a deposit and specifies the profit rate and maturity date 5. As bearer instruments 6. May be issued based on BBA or Mudarabah as above

NEGOTIABLE INSTRUMENTS OF DEPOSITS Negotiable Islamic Debt Certificate (NIDC) Islamic Negotiable Instruments of Deposit (INID) The Islamic bank sells the bank s asset to the depositor at an agreed

31 NEGOTIABLE INSTRUMENTS OF DEPOSITS Negotiable Islamic Debt Certificate (NIDC) Islamic Negotiable Instruments of Deposit (INID) The Islamic bank sells the bank s asset to the depositor at an agreed price on CASH BASIS. The Islamic bank, in turn, buys the similar asset from the depositor at PRINCIPAL VALUE + PROFIT and done at an agreed FUTURE DATE The depositor places money with the Islamic bank and REPAYABLE to the depositor (THE BEARER) on a specified future date at the NOMINAL VALUE + DIVIDEND

32 NEGOTIABLE ISLAMIC DEBT CERTIFICATE 1-SELL ASSET, RM50K MOP: CASH - ISLAMIC DEPOSIT BUY BACK ASSET, RM50K + PR% MOP: DEFERRED OVER A PERIOD OF SAY 4 YEARS The bank sells its asset to a customer for immediate cash, whom simultaneously sells back the asset to the bank for a credit price. The deferred marked up credit price, is re-paid by the bank to the customer within a period from overnight up to 365 days The bank issues a Certificate of Debt (Shahadah al-dayn) as evidence of the bank's debt to the customer NIDC is done on an inah transaction & may be subsequently traded as a debt to a third party

33 NORMAL CALCULATION OF NIDC Bank sells an asset to its customer Selling Price (SP) RM1,000,000 Profit margin ( r ) 7.5% p.a Tenor (months) ( t ) 6 or, days to maturity Bank purchases from the customer SP x [ 1+ (r* t / 365 ) ] 1,000,000 x [ 1 + (0.075 x / 365) ] = 1,037,500 Customer s profit 37,500

34 ISLAMIC NEGOTIABLE INSTRUMENTS OF DEPOSITS 1- CONTRIBUTES 100% CAPITAL REPAYABLE TO THE BEARER ON A SPECIFIED FUTURE DATE, NOMINAL VALUE + DIVIDEND The maturity is from 90 days up to 60 months Similar to a MIA Can be sold or traded in the IMM Profit or declared dividend rate depends on the PSR Return is equivalent to the time value of the depositor s money

35 NORMAL CALCULATION OF INID Profit Sharing ratio in favor of customer (PSR) 80 : 20 Deposit placement (D) RM1,000,000 Declared dividend rate ( r ) 7.5% p.a Tenor (months) ( t ) 6 or days to maturity Proceeds D x [ 1+ (r* t /365 ) ] 1,000,000 x [1 + (0.075 x / 365) ] = 1,037,500 Customer s profit 37,500

36 IN THE MARKETPLACE Bank Muamalat offers a Negotiable Islamic Debt Certificate (NIDC) Done on BBA principle The bank sells the NIDC to the customer at an agreed price on cash basis The bank buys back the NIDC at principal+profit at an agreed future date Tenors of issuance vary from 1 mth 5 years Minimal nominal amount issued is RM10,000,000 in multiples of RM 1,000,000 Fixed return over the entire tenor of the investment We are again!

37 THANKS TO ALLAH AZZA WA JALLA FOR EVERYTHING

6/10/2015. Trust & confidence. Convenience. Quality services. Excellent brand. Interest pay-out WHY NEEDED? HOW DOES IT MOBILISE DEPOSITS?

6/10/2015. Trust & confidence. Convenience. Quality services. Excellent brand. Interest pay-out WHY NEEDED? HOW DOES IT MOBILISE DEPOSITS? GE20803 DEPOSIT & FINANCING OPERATION OF ISLAMIC BANKING MOBILIZATIONS BY CONVENTIONAL BANKS WHY NEEDED? 1. Deposit mobilization is one of the crucial functions of conventional banks it is a requirement