Islamic Banking Deposits

(Sources of Funds)

ISF 1101 Foundation of Islamic Finance

Presentation Outline
Wadiah Deposit Products
Unsuitability of the Wadiah Contract
Mudarabah-based Deposit Products
Guarantee of Mudarabah Investment Accounts
Displaced Commercial Risk and Income
Smoothing
Profit/Hibah Computation

Recap Financial Intermediation

Bank

Surplus Units

Deposits

Banks Liabilities

Deficit Units

Financing
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

Issue: 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

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

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 Customer
(Entrepreneur)

Bank
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

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%

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)