Islamic Banking Deposits

(Sources of Funds)

ISF 1101 Foundation of Islamic Finance

Presentation Outline

Wadiah Deposit Products

Mudarabah-based Deposit Products
Profit/Hibah Computation
Negotiable Islamic Debt Certificate (NIDC)
Commodity Murabahah Deposit
Structured Deposit Product
Other Deposit Product Structures
Issues in Deposit Products

Unsuitability of the Wadiah Contract

Displaced Commercial Risk and Income Smoothing
Guarantee of Mudarabah Investment Accounts
Implications of Capital Adequacy
Quasi-guarantee by bank-mudarib

Recap Financial Intermediation

Bank

Surplus Units

Deposits

Deficit Units

Financing

Banks Liabilities

Banks Assets

Sources of funds
Note that deposits are not the only source of funds for a bank

Some banks also access the money market for funding (essentially
short-term borrowings from other banks, investors, the government

Denotes flow of funds

Common Deposit Products and Shariah Concept Used

Demand
Deposit

Deposit Type

Shariah Concept Used

Current Account

Wadiah
Qard

Savings Account

Wadiah
Mudarabah

Time
Deposit

Variable-rate Investment
Account

Mudarabah, Wakalah

Fixed-rate Investment
Product

Bay al-inah, BBA,

Murabahah, Tawarruq

Negotiable Deposit
Instrument

Bay al-Dayn

The Wadiah Contract

Literal meaning
Leave, that is, the thing left with a person (not the owner)
for the purpose of safe-keeping
Legal definition
The authorization of a person to keep the property of
another in his safe custody by explicit or implicit terms
Legal basis
and if one of you deposits a thing on trust with another, let
the trustee (faithfully) discharge his trust, and let him fear
his Lord [Al-Baqarah:283]

Wadiah Deposit Products

In contemporary Islamic banking, the contract of wadiah is combined with the

contract of guarantee (dhaman) to emulate the functionality of the
conventional savings and current accounts
Such a modification in the use of the wadiah contract has been commonly
known as wadiah yad dhamanah
Its use is common in South East Asian countries
Salient features of its application as a deposit instrument
The bank guarantees deposited monies
Depositor can withdraw monies at any time
The bank can use the deposited monies to generate profit
Depositor is not entitled to profits generated by the bank
The bank typically gives a return to the depositor in the form of
discretionary and voluntary hibah (gift)
Usually applicable to savings account only
Bank is allowed is charge a fee for custodianship
Usually applicable to current account only

The Mudarabah Contract

An arrangement whereby the owner of some property (rabbal mal) gives

a specified amount of capital to another person (mudarib) who is to act
as the entrepreneur to trade with the capital
Profit of the venture will be shared between the two parties according to
a mutually agreed ratio
Profit sharing cannot be a fixed amount or a fixed percentage of
capital contribution
Profit sharing must be a percentage of the profit
Losses will be borne by the rabbal mal as the financier
The mudarib bears the frustration of fruitless effort
Types of mudarabah
Unlimited mandate (mudarabah mutlaqah)
Limited mandate (mudarabah muqayyadah)

Mudarabah-based Deposit Products

One contemporary application of mudarabah in Islamic banking
is in structuring a variable-rate deposit
Salient features
Contractually the deposited amount is not guaranteed by the
bank (no capital protection)
Theoretically, in the event of losses, the entirety of any
diminution in value would be borne by the depositor
Rate of return is not pre-fixed (ex-ante) but only indicative
rates (typically based on historical rates of return) are given
Actual rate of return is only calculated and distributed at the
end of investment period (ex-post), which may or may not
differ from indicative rates

Mudarabah-based Deposit Products (continued)

Using the concept of mudarabah, both demand deposits and time deposits can be
structured
Savings Account (demand deposit)
Return to depositor given on the basis of balance held in account calculated at
intervals
Mudarabah investment account (time deposit)
Requires commitment of deposit for specified time periods (for e.g., 3, 6, 9, 12
months)
In the event of early withdrawal, principal usually made available (returned)
to depositor but no return will be given on the deposit
Rates tend to track that of conventional fixed deposit accounts and are generally
higher than savings account rates
Two types are common
General Investment Account (mudarabah mutlaqah)
General mandate given to the bank, standard profit sharing ratio
Specific Investment Account (mudarabah muqayyadah)
Customer specifies constraints on use of capital, negotiated profit
sharing ratio

Profit / Hibah Computation

While numerous variations may exist, common
computation of profit/dividend/hibah for demand
deposits (see Example 1 in handout) is based on either
The Accumulated Daily Average Method, or
The Daily Balance Method
Some Islamic banks offer multi-tiered rates (See
Example 2 in handout)

For mudarabah investment accounts, distributed

profit is based on ex-post quoted rates for
stipulated intervals (See Example 3 in handout)

Computation of Profit/Hibah Rate

All sources of funds (savings and mudarabah investment accounts of

various maturities) are pooled
Deposits of longer duration are assigned higher profit sharing ratios
In Shariah terms, this is operationalized via the following:
Depositors forming the common pool of funds have a musharakah
relationship with each other
The pool of funds, in its collective capacity, enters into a mudarabah
contract
The pool acts as rabbal-mal and the bank serves as mudarib
Any profit generated is shared according to an agreed profit sharing
ratio, between the pool of funds and the bank
The pool of funds share of profit is then distributed among depositors
of varying maturities according to an agreed set of profit sharing ratios
(typically giving longer durations a higher share)

However, sharing of loss would be strictly according to the respective

investment ratio
The computed profit/hibah rate, stated in annualized terms, is then
applied to individual account balances to determine distributed
profit/hibah
(See Handout for an example of the computation)

Negotiable Islamic Debt Certificate (NIDC)

A deposit instrument offered by some Islamic financial

institutions in Malaysia
Classified as a short term (less than 12 months), fixed
rate deposit
Islamic version of negotiable certificate of deposits
(NCD)
Based on the principle of bay al-inah (sale and buyback)
The instrument is negotiable, providing the depositor with
liquidity
Negotiability effected via the principle of bay al-dayn at a
discount

Negotiable Islamic Debt Certificate (continued)

Bay al-inah
RM100,000 Cash
(Deposit)
Share certificates of bank
Bank

Depositor
Share certificates of bank

RM105,000 in 6 months

Debt certificate
(syahadah al-dayn)
issued

Secondary
Market

Possible sale to
obtain liquidity

Bay al-dayn

Commodity Murabahah Deposit-i

Commodities
Broker B

USD1m Cash
Bank
Commodity

USD1.1m
Deferred
Commodity

Commodities
Broker A

USD1m Cash
Depositor
Commodity

Structured based on the concept of tawarruq

Due to relatively high transaction costs, suitable for high net worth
individual (HNWI) deposit accounts only

Structured Deposit Product

Invest $93K

Bank

Depositor
Deposit
$100K

Fixed Return
Instruments
- commodity

QuasiCapital
Protection
for $100K

Bank acts as
agent (wakalah
contract) in
investing
depositors
money & charges
a fee for the
service

murabahah
- sukuk, Islamic
ABS
(at 7.53%)
Invest
$7K

Higher Return
Investments
- equity, derivatives
(at 28.57%)

Gross Expected
(Potential) Return of
$9K

Other Deposit Product Structures

Qard-based Deposits

A creditor-debtor relationship is established between

depositors and the bank
To attract and mobilize deposits, some banks have
been known to offer incentives in the form of:

Prizes or cash bonuses

Exemption from, or discount in, payment of commission and
fees,

Priority in use of banking facilities

Such a practice is common among Islamic banks in Iran

Shariah scholars caution that such gifts must be

completely discretionary and not given on a regular
basis (so as not to lead to depositors expectations of
the gifts)

Other Deposit Product Structures (continued)

Wakalah-based Deposits

Islamic bank acts as wakil (agent/representative) of

depositors/investors and manages funds on their behalf for a
fixed fee
Combination Structures

Deposited monies are split into stipulated portions

Qard / Mudarabah, Wadiah / Mudarabah, etc.

Sale and Buy Back Agreement (SBBA)

Essentially a repurchase agreement (Repo)

Bank sells Islamic securities to depositor at an agreed price

Bank makes a unilateral binding promise (waad) to re-purchase

the Islamic securities from the depositor on a specified future
date and at an agreed price

Negotiability of Islamic securities provides liquidity options to the

depositor

Issues in Deposit Products

Objection to the use of the wadiah

contract in structuring deposits
Displaced Commercial Risk and Income
Smoothing
Guarantee of Mudarabah Investment
Accounts
Implications on Capital Adequacy
Quasi-guarantee by bank-mudarib

Unsuitability of the Wadiah Contract

Although return on wadiah deposit accounts by way of hibah is not contractual,

there are arguably widespread depositor expectations of it

Conceptually, the wadiah yad dhamanah savings account is similar to a loan

(qard) by the depositor to the bank

Failure to give consistent and competitive hibah returns is likely to result in deposit
withdrawals
Thus, in practice, hibah returns are somewhat obligatory (by way of market operation)
De facto required hibah returns seem to attach an additional condition to the
contractual arrangement albeit not formally
Some jurists opine that if the hibah is customary (urf), such widespread practice is
tantamount to an implied term of the contract

Thus the communication of the possibility, and likely magnitude, of benefits accruing
to the lender-depositor should be avoided
Banks should not indicate or advertise hibah rates

In practice this is difficult to monitor and implement because counter personnel

may indicate hibah rate verbally to the customer

Hence many (including IFSB standards) feel that the wadiah contract is not
suitable for the structuring of savings accounts, and should be replaced with the
mudarabah contract

Displaced Commercial Risk

Market pressure to pay investment account holders (IAH) a rate of return

higher than what should be payable under the actual terms of the
investment contract
Non-adherence to such pressures risks withdrawal of funds by
depositors
Divergence between actual returns and depositors expected returns
may arise due to:

Banks underperformance for a given period

Increase in benchmark rates

To address this situation, banks can waive their portion of profits to
bolster rates of return
An extreme example of such self-imposed practice

International Islamic Bank for Investment & Development (Egypt)

distributed all profits to IAH with shareholders receiving nothing from
mid 1980s to late 1980s
Recognition of the need to mitigate this risk has led to the standard
industry practice of income smoothing

Income Smoothing
Profit Generated
from Investment
Account-financed
Assets

Set aside

Mudarabah Profit
to be distributed
As per profit sharing ratio

Bank (mudarib)s
share of profit

Profit Equalization
Reserve (PER)

Buffer /
cushion to
smoothen
income

Investment Risk
Reserve (IRR)
Set
aside

Investment
Account Holder
(rabbal-mal)s
share of profit

Actual profit
distributed to
Investment
Account Holder

Issues in Income Smoothing

A number of issues may arise from this practice of income smoothing

1. Investment account holders unawareness of such adjustments in
returns
2. Investment account holders not having direct influence in the
manner of such adjustments thus possibly raising doubt and
uneasiness
3. Possible subsidization of returns by short-term IAH vis--vis longterm IAH (see illustration on next slide)
To address such concerns, the following can be done
1. Adequate communication to investment account holders and
obtaining of their express consent (waiver of rights to profits)
2. Transparency in the method of adjustments and existence of
standard guidelines or requirements specified by supervisory
authority
3. Applying adjustments to long-term investment accounts only

Illustration of Subsidization of Returns

Jan

Feb

Mar

Apr

May

Jun

Average/Net

Actual Return

9%

10%

7%

5%

5%

6%

7%

Adjustment

- 2%

- 3%

+ 2%

+ 2%

+ 1%

Distributed Return

7%

7%

7%

7%

7%

7%

7%

Investment account holders investing in the months of Jan and

Feb could have actualized an average return of 9.5%
Instead, they have to settle for a reduced average return of 7%

Guarantee of Mudarabah Investment Accounts

An important feature of the mudarabah contract is that there is

no capital guarantee for the rabbal-mal
In the event of loss, the rabbal-mal must bear any capital
loss
While Islamic banks, as mudarib, contractually do not
guarantee mudarabah investments, it is common for
mudarabah investment accounts to have a third party indirect
guarantee, by way of,
Implicit guarantee from the government, or
Operationalization of a deposit insurance/takaful scheme
In Malaysia, such guarantee takes the form of a national
deposit insurance system managed by government-endorsed
Perbadanan Insurans Deposit Malaysia ( PIDM )
The issue is, should mudarabah investment accounts be
guaranteed, albeit indirectly?

Arguments Against Guarantee of Mudarabah Investments

1.

Provision of such a guarantee would result in mudarabah

investment accounts to detract from having the economic
substance of a mudarabah arrangement as originally
intended by the Shariah
Mudarabah funds are meant to represent risk capital
and should have equity finance characteristics
2. Given that mudarabah investment accounts typically
have positive returns, guaranteeing the capital sums may
entail riba
3. Deposit-side guarantee when not coupled with an assetside guarantee produces a risk-profile mismatch, which
hinders the realization of the Two-tier Mudarabah Model

Guarantees Complicate the Two-tier Mudarabah Model

Third Party Guarantee
First-tier mudarabah
Rabbal-mal

Mudarib

Mudarabah
investment
account holder

Bank

Bank Customer
(Entrepreneur)

Rabbal-mal

Mudarib

Second-tier mudarabah

Minimal Risk

Substantial Risk

Risks of mudarabah financing cannot be passed on to

mudarabah investment accounts
Banks typically respond by shying away from
mudarabah-based financing

Arguments Supporting Guarantee of Mudarabah Investments

1.

Mitigation of the systemic risk of contagious collapse and

its social costs
To provide comfort to mudarabah investment account
holders and thus containing the effects of isolated
investment failures or atypical occurrences of
financial distress
2. Protection of interests of investment account holders
against moral hazard-related mudarabah financing
3. Paradigm shift in the depositor mindset to understand
and accept the true nature of mudarabah requires time

Implications on Capital Adequacy Profit Sharing Investment Accounts (PSIA)

Tier 1 Tier 2 Capital

Capital Adequacy Ratio (CAR)
Total Risk Weighted Assets

Theoretically, mudarabah investment accounts are not

liabilities but rather can be seen as limited term, nonvoting equity
Losses incurred on PSIA-financed assets passthrough to investment account holders
Thus no regulatory capital needs to be maintained
in relation to such risk assets

Implications on Capital Adequacy (continued)

However, in practice, due to the following factors, such PSIAfinanced assets do have capital adequacy implications

Displaced commercial risk

Guarantee via deposit takaful scheme

Fiduciary risk

The risk that bank (mudarib) negligence or misconduct

caused losses, in the event of which such losses would
have to be borne by the bank
Thus the envisioned pass-through feature is impracticable
Accordingly, IFSBs Capital Adequacy Standard provides an
alternative CAR where a proportion (alpha) of the risk-weighted
assets financed by PSIA is included in the denominator of the CAR

It would be up to the respective regulatory authority to determine

the proportion for each Islamic bank in its jurisdiction

Quasi-Guarantee by Bank-Mudarib

Some regulatory environments require that deposits offered by financial

institutions (including Islamic banks) are guaranteed by the institution itself

E.g., UK Financial Services and Market Act, Singapore Deposit Act

This would contradict Shariah stipulations pertaining to mudarabah-based
deposit instruments, where contractually, the bank (mudarib) cannot
guarantee the deposited amount
To address this legal impediment, additional clauses are inserted in the
memorandum and articles of association of the bank, to the effect that, in the
event of loss,

The bank will forego fees or its share of profits

The bank will draw upon available balance in the profit equalization
reserve account

The bank will abstain from distributing profits to shareholders

The bank would advise the depositor that the above is carried out to meet
local (secular) regulatory requirements, and that if the depositor accepts any
of the said amounts, such action is not in compliance with Shariah principles