Real Cost of Tawarruq

Recently, the topic of Tawarruq & Commodity Murabahah has been popular in the industry as both BNM and Shariah scholar have been asking operational questions on the implementation of Tawarruq arrangement in the industry. It seems, even with the Policy Documents, there are still some divergence in terms of operations and understanding of the minimum Shariah requirements for Tawarruq. Each financial institutions have their own operational abilities and processes that differs from one another; to have a standardised platform may be a bigger challenge than imagined.

The rise of Tawarruq in recent years should really not be a surprise to many observers. We are seeing that most financial institutions in Malaysia now consider a Tawarruq structure a “must have”, because there really is no options as other Banks deal in it. It has become norm, and while scholars might take a view that Tawarruq should be a “last resort” option, the truth is there is so much effort invested into making Tawarruq an efficient machine. Just take a look at the Bursa Suq Al Sila and what it is capable today.

What has been circulating today?

The latest consideration of Tawarruq is on the treatment of Tawarruq funds after the transaction. What is it exactly and how is it been managed within the Bank, with the Capital Adequacy Framework for Islamic Banks (CAFIB) implementation a few years ago (latest update this year 2017). In particular, when a customer is approved a certain limit (let’s say $1,000,000) and a singleTawarruq is done for $1,000,000 for the line (instead of multiple small Tawarruq for each usage of the amount within the $1,000,000 limit), where does the money goes?

To clarify, upon the completion of Tawarruq, real money of $1,000,000 is generated. Cash. It is not a “line” in the conventional terms, but it is money now belonging to the customer. He can draw out the money anytime.

But the practice is that the money is kept in the Bank’s books unless requested by the Customer, and by keeping this the Bank will give a “rebate” on the money kept in the Bank, similar treatment as if a “principal payment” is made (although it is re-drawable). In the meantime, the Bank utilises the money (taken as principal payment made) for its own banking business activities.

The question that I believe we will have to eventually address are on the following:

  1. the Tawarruq is done on a single transaction for the full amount, therefore it is a full release of capital (i.e. fully funded). As such, it should have a “capital charge” consideration if it is not fully utilised by the customer. Bank has released fully the funds to customer (therefore Bank should be entitled to earn a full profit on the amount). The formula for profit would be $1,000,000 x Profit Rate – Cost of Capital. Note the Cost of Capital is on the full amount.
  2. Then, the subsequent mechanism instead is as follows: since the customer did not fully utilise the funds, the customer is given a “rebate”. For example the customer only uses $50,000 of the $1,000,000. The formula for rebate is that ($1,000,000 less $50,000 = $950,000) x Profit Rate. Banks earn full Profit Rate on $50,000 and gives rebate based on $950,000.
  3. Of course, Banks will utilise the $950,000 meanwhile but at what I imagine on short-term instruments because the $950,000 is customers money (i.e. committed amount) and can be requested at anytime. So the Bank do not earn a lot from this.
  4. Also, there is concurrent discussion as to when the amount is kept and used by the Bank, what is the underlying contract used for this “unutilised, principal payment which is drawable on demand” amount? Is it kept by the Bank as Qard (loan), Wadiah (safekeeping), Amanah (trust) or can it be taken as Tawarruq deposit (monetised obligation) or Mudharaba (investments)? Different Banks have differing views on this, but I suspect BNM is trying to standardise this understanding and practice.
  5. But more importantly, while the Bank is giving customers “rebate” on the amount they do not utilise (but committed by the Bank), is there also “rebate” on Cost of Capital then? It seems unfair, because Tawarruq proceeds are deemed fully drawdown (full amount) and incurs full Capital Charge but is earning returns based on only the utilised amount. The rebate formula is very specific, and do not contain the amount for “rebate” Capital Charge.

In the conventional Banking world, this is not so much of an issue. Their approach is simple: if the amount is “committed” to the customer, 2 things will happen:

  1. Once the amount is drawdown i.e. utilised by the customer (lets say $50,000 utilised of the $1,000,000), then full price is charged on the $50,000
  2. On the amount unutilised i.e. $950,000 the Bank will charge a “Commitment Fee” of 1.0% per annum (or any negotiated rate) on the unutilised (but committed) portion. While 1.0% per annum do not usually cover the full Capital Charge on the $950,000 it somewhat compensates the charge as the Bank (because $950,000 is still a “limit” and not Cash payout) can still use the unutilised amount in its day to day banking activities i.e. investment in short term financial instruments.

Scholars generally do not agree with the concept of Commitment Fees, and there is specific BNM guidelines prohibiting the charge of Commitment Fees in these specific scenarios.

The Capital Charge factor

I still think there is a disconnect somewhere that while we aim to achieve the same end result by the practice of Ibra’ i.e. “Rebate”, but with Capital Cost coming into play, it may eventually seem that the cost of running an Islamic Banking business can be higher than a conventional Bank. It really depends on how we interpret the guidelines and the treatment on Tawarruq especially the single Tawarruq structure where the full amount is transacted i.e. whether it is a full Capital Charge or otherwise.

I know what BNM usually advise i.e. it is a full Capital Charge. But this concurrently means, without Commitment Fees on the unutilised Customer portion, it may result in extra costs for the Bank. Now I am not suggesting we introduce Commitment Fees for Islamic Banking; this idea of Commitment Fees is a conventional banking concept for recovering opportunity costs, which may not sit well under Shariah consideration.

But in the world we operate today (where each $$$ is risk weighted to a cost), this translates to “Actual Costs” incurred by the Bank, based on the interpretation for the “single full amount Tawarruq transaction”. And Shariah may want to consider this as it is a real “Actual Costs” and not opportunity costs. By letting the money sit still, the Bank incur real, actual costs which is not recoverable as per guidelines. It may have started as “recovering opportunity costs” but if you really think about it, this is above opportunity costs. Maybe in the conventional space, they may even revise Commitment Fees to recover BOTH Opportunity Costs as well as Capital Charge.

So, my question is this: should both the industry and Shariah scholars re-look at the basis of Commitment Fees (in the context of how Tawarruq works), or re-think about the “Rebate” mechanism and perhaps have an adjusted formula to factor in a “Rebate on the Capital Charge”?

Can Shariah consider this mechanism to recover a real cost incurred by an Islamic Bank?

In the meantime, Happy Ramadhan to all, and may you have blessed month ahead.

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Islamic Banking Operating Model

For the past few months, there have been some earnest discussions on whether Islamic Banking is operating under the right model or type of institutions. Comments by prominent scholars on the suitability of certain Islamic contracts in a financial institution sparked debate on the types that are suitable for operating Islamic contracts. Before I attempt to also put my piece in the mix, there were also questions asked to me on which of the existing models can actually be the right fit. There is still confusion on the types of institutions operating in the market.

Before we look deeper, it is worthwhile to recap the available models in Malaysia.

THE ISLAMIC WINDOW OPERATING MODEL

We  have to start somewhere. Islamic Windows as a starting point, provides the best opportunity to build capabilities at the lowest costs while the business is being developed. The intention is to identify the requirements for system and invest minimally to assess feasibility and operational gaps. This allows the Bank to build the infrastructure at an acceptable pace. This is also a pre-cursor to further/larger infrastructure investments if there is a decision to expand the business into a subsidiary.

This model relies on the existing conventional infrastructure where all the processes, operations, sales, channels, finance, branches, compliance, audit and all functions are provided by the conventional bank. It is a leverage model where the Islamic Banking Windows are more like a “manufacturer” of products. Islamic Banking Windows churn out the products and services (like a factory), and delivers them to the conventional team as part of the suite of products offered by the conventional bank. In such structure, Islamic Banking Windows are just a “segment” of products on offer. Just like Corporate Banking products. Commercial Banking products. Wholesale Banking products. Private Banking products. Retail Banking products… and Islamic Banking products.

The advantage of this model is the low set-up cost. The business rides on existing infrastructure and hires specialists in each function. There is no need to set up a different branch as those Islamic products are sold directly by the existing branches and channels sales team. Balance Sheet discloses Islamic Banking Window performance as part of the Notes to the Account. Shareholders’ Capital, however must be separately allocated, accounting ledgers managed separately and the Single Customer Exposure Limit (SCEL) will be 25% of the allocated Capital. A head of Islamic Banking Windows will report directly to the conventional banking CEO, where business decisions are made.

Not many banks operates under the Islamic Banking Windows model. The main reason is the lack of product range i.e. competing with conventional banking products of the same branch, and the small scale of business limited to its SCEL, and no autonomy of business decision which must be aligned with conventional products.

THE ISLAMIC SUBSIDIARY  MODEL

Islamic Subsidiary rides on the strength of the Parent Bank, which is the conventional bank. The model used is still a leveraged model, but the Islamic Subsidiary can choose which services or function they want to “outsource” to the conventional bank (at a fee chargeback, of course). The idea of a Subsidiary is to be independent, so all cost consideration must be taken into account. Decision to open Islamic Banking Branches can also be made, and BNM supports this expansion via Islamic Banking Branches.

However, being a Subsidiary Bank can also be a burden to set-up. A differentiated system or process or operation team requires cash for its set-up. At the early stages, such investment cash will be limited, and when cash is available for investment, the development of the Subsidiary Bank must then align with the conventional bank. So it can be a chicken and egg situation where to expand you need to earn but to earn you need to expand (and spend).

Most of the conventional banks offers Islamic products via Islamic Banking Subsidiary. The main advantage is that decisions are autonomous in a Subsidiary, there is more control of marketing and sales and branches, and the Bank (as an independent entity) can chart its own course. However, there will still be influence from the parent (as the majority shareholder) and the products and services offered are generally aligned to the products and services offered by the parents. The SCEL for Subsidiaries are also dependent on the strategy of the parent Bank, where it can choose to invest heavily or adequately for the operations of its subsidiary.

FULL FLEDGED ISLAMIC BANKS

These are standalone banks that generally are not under any conventional banking influence. The products and services may be consistent with the offerings in the market, but it is not an obligation to follow. In theory, Full Fledged Islamic Banks have the capacity to offer new-to-market products, based on the approvals obtained from Shariah Committees and BNM.

There is room for innovation and experimentation of new structures via Full Fledged Islamic Banks, although they must still governed by the financial ratios and controls for other types of banks and financial institutions, using conventional measuring tape which could lead to a “penalty” cost for doing business.

For example, a debt based home financing based on Tawarruq will incur a capital charge of 50%-100% but in a Musyaraka Financing, that capital charge will cost 100%-400% which will be an “expensive” proposition simply because it is measured against conventional financial ratios.

Personally, I believe Full Fledged Islamic Banks should follow a different set of financial ratios catered to reflect the type of risks an Islamic Bank CAN take, should the Islamic Bank look to offer products such as Mudaraba, Musyaraka, Istisna’ or even Salam. To allow for pure innovation, the financial ratios and treatment of capital and assessment of risks should be differentiated to reflect the nature of the products offered. While Basel requirements can be used as benchmark to ensure stability, an “Islamic” Basel will be even more meaningful where it can fully address all the real risks faced by Islamic Banks deploying Profit Loss Sharing (PLS) and equity-based structures such as Mudaraba and Musyaraka. Slowly, BNM is recognising these differences for measurement and has taken small steps to differentiate, such as the introduction of treatment of Investment Accounts (IA), the Liquidity Coverage Ratio (LCR) treatment, Capital Adequacy Framework for Islamic Banks (CAFIB), and the removal of Reserve Funds (reserves from paying of dividends) from Islamic Banks recently. It is my sincere hope to one day see an “Islamic” section in future Basel releases as well.

The main challenge for a Full Fledge Islamic Bank, is the costs of building the franchise from ground zero. To compete with a conventional bank, the Islamic Bank must invest similarly in its infrastructure and achieve operational efficiency and scale as soonest as possible. The payback period and Return on Investment and Return on Equity remains important for long term sustainability. SCEL is dependant on how big the Bank intends to grow. Another key consideration is the ability for the Islamic Bank to build a strong source of cheap deposits for the funding requirements.

NOTE

Of course there are other structures that can be attributed as Islamic Financial institutions such as cooperatives, development banks, and investment banks. But the most common are the above variations and these structures fit into strategies identified by the bank. In most cases, BNM prefers to see development coming from the Full Fledged Islamic Banks and Subsidiaries. These should be the drivers for the growth of Islamic Banking.

Wallahualam

Is Islamic Finance Suffering from the Wrong Model of Implementation?

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One of the things that attract me to maintain this website on Islamic Banking is the opportunity to interact and share ideas with the various practitioners and academicians in the industry. There are many discussion topics and we intend to bring such discussions to the open table as constructive as possible. Interaction with Ms Rosana is always interesting as she dare explore the Islamic Banking model itself, making comparison to other similar models in the market across geographies. And I do share some of her views on the industry, and I have written about it to some extend in my earlier postings. What is interesting about Ms Rosana is that she is taking the discussion a necessary step further in evaluating the existing Banking model, as to whether it is the right model to begin with. She has written a short discourse on this topic and looking to explore in-depth its implication in the near future.

She welcomes constructive feedback, comment and discussion points for this posting and hopes to decide on the next step forward gauging from your kind response. Do read and give us your opinion and comments. Thank you.

Is Islamic Finance Suffering from the Wrong Model of Implementation?

By Rosana Gulzar Mohd

In this blog’s latest post ‘Disruption: Islamic contracts’, there holds an imminent danger. The Islamic banks in Malaysia are not so much inching towards becoming just like the interest-based conventional banks they were supposed to replace but in fact, running towards them. Even as the industry celebrates its trillion size assets and formerly astronomical growth, there lies a darker truth. In a recent class I taught on the dichotomy between Islamic banking theory and practice, a participant, a new ‘Islamic’ banker, came up to me and wanted to discuss commodity murabaha. She said her team had just tabled the product for the bank’s approval but she did not feel comfortable. The head of the Shariah committee also seemed disappointed. His comment, according to her, was that we no longer need Shariah advisers. The industry only needs commodity murabaha experts now.

Post-IFSA 2013 which fines and jails CEOs and everyone above and below for any wrongdoing and a flurry of policy documents telling banks how to implement Shariah contracts, ‘Islamic’ banks in Malaysia are seeking refuge in tawarruq. Musharakah and mudarabah? All that is left of profit and loss sharing contracts, which some scholars say are at the heart of the ideal Islamic financial system, is the policy documents by Bank Negara Malaysia (BNM). I would be pleasantly surprised if anyone can show me a bank which is genuinely implementing them. The supposed mudarabah-based products brought on by IFSA, namely the investment accounts and the IA platform, are currently being mutilated to look almost like any guaranteed and fixed return deposit. The IAP, I believe, are unlikely to be successful for laughable reasons.

When commercial banking, with its inherent tendencies for excesses, profit maximisation and desensitisation to social welfare, is the problem, how does crowdfunding through commercial banks become the solution? Won’t the banks still look for credit-worthy companies with an almost guaranteed future to fund? Who then takes care of the small and medium-sized entrepreneurs who are also seeking financing? Are not the SMEs the backbones of the economy? Not to mention, where is the upholding of Islamic values such as justice, equitability and social well-being? Granted there are other organisations in Malaysia meant to help the lower incomes and SMEs but why do ‘Islamic’ banks call themselves ‘Islamic’ if they are far from embodying the ideal values in Shariah? Unfortunately, this sad state of affairs extends to other parts of Islamic finance such as takaful (apparently ‘Islamic’ insurance), sukuk, the other beauty pageant contestant in this parade, and other capital market products such as interest rate, oh wait, ‘profit’ rate swaps.

How did BNM envision the success of IFSA with no changes to the current environment? We are still in a dual system where ‘Islamic’ banks are pitted head-to-head against interest-based conventional banks. ‘Islamic’ assets are still only a quarter of the entire system despite the country allowing all sorts of controversial contracts such as bai al dayn, bai al inah and the one that takes the cake, tawarruq. Where are the educational campaigns to explain to customers this shift in the industry that the central bank expects to happen?

When customers, including ‘Muslims’, have been accustomed to deposit guarantees and fixed returns their whole lives, how do banks suddenly sell them an ‘investment account’ that promises neither? Is it any surprise that conventional bankers are using this as a selling point? They are telling customers to avoid ‘Islamic’ products because there are no guarantees. Theirs still do. When the chiefs of ‘Islamic’ banks themselves seem cloudy in their understanding of the new regulations, how did BNM envision people on the street, who are banking with its ‘Islamic’ banks, to embrace the changes? A deputy director unfortunately got defensive when I asked. Other central bankers claimed ignorance because they “are not from that department”.

While BNM seems keen to reform the industry, perhaps the answer it has been looking for is that the Islamic finance industry, and within it, Islamic banking, has been built the wrong way. Trying to make it work in the commercial banking space is what has led to the frequent comment that it is like squeezing a square peg into a round hole. Commercial banking, with its profit maximisation mantra and desensitisation to social welfare, is antithetical to the Shariah ideals of justice, equitability and social well-being as embodied in the maqasid. And isn’t it the one that has been leading the world from one crisis to another? Why then are we so busy emulating them? Isn’t it time the powers that be wake up and face facts?

So why did all the big organisations in Islamic finance, from the global standard-setters such as AAOIFI and IFSB to each country’s central banks and each ‘Islamic’ banks’ Shariah committees condone these practices? Perhaps because they were the easiest thing to do and allows for a fast build if the intention is to grab fame and fortune through one’s achievements in Islamic finance. The countless Islamic finance awards and conferences and the effusive back slapping there are testaments to this. Bankers are such happy people.

So what is the solution? I believe it is cooperative banking. The true, genuine type practiced in Europe and not the ones in Muslim countries because they are largely used to fund political cronies and thus suffer from questionable management and corruption. My next article will thus explain cooperative banking, how the model works and why they are a better fit for Islamic finance than the current commercial banking model. In the meantime, I look forward to your thoughts. Students of Islamic finance intuitively get it when I explain these arguments while some practitioners acquiesce (quietly agree). Another group reminds me of this statement in a book by Upton Sinclair, who ironically was also an investigative journalist (uncovers scandals and corruption) as I was in my former life and whose solution to the 1930s Depression in California is to create cooperative ventures for the unemployed. The idea, to his surprise, received wide support but his bid to run as governor was waylaid, according to him, by the oppositions’ “dirty tricks”. He wrote this statement in his book about the political adventure, “It is difficult to get a man to understand something, when his salary depends on his not understanding it.” The reaction of the other group of bankers brings to mind this quote.

What do you think about her assessment and commentary on the Islamic Banking model? Do give us your feedback in the comment box. Thank you.

Check out her other contributions in the following page : Writings Rozana Gulzar Mohd 

Disruption : Islamic Contracts

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Under IFSA 2013, it is no longer about Product Innovation. It is about Product Compliance.

2 weeks ago I had a session with some bright individuals discussing the Islamic contracts commonly used in Corporate Banking financing structures. We went through almost all the available Islamic financing contracts such as Murabaha, Ijara, Musyaraka and Mudharaba, where I highlighted that all these contracts now have their own Policy Document issued by Bank Negara Malaysia (BNM). The Policy Documents, in my opinion, are a concise version of a lot of Sharia regulations and great reading source. It becomes a reference point where management roles and responsibilities are outlined, operational behaviour laid down, and theoretical basis is justified and explained.

It is a matter of time, I told the participants, that these Policy Documents are taken in their full context and finally developed into a comprehensive structure with clear compliance to Sharia requirements. We, as Islamic Bankers, are in for an exciting period of development where we will have a chance to develop “real” Islamic banking contracts.

The moment I said that, I realised it is NOT TRUE!!!

THE IMPACT OF IFSA 2013

The popular belief is that IFSA 2013 is meant to realign all the Islamic Banking regulations in the Islamic Banking Act, Takaful Act and various major guidelines into a single overarching Act. IFSA 2013  consolidates the various practices into more clarity and re-classification of concepts. However, the perception that Islamic Banking in Malaysia as an innovative development hub would no longer hold true. “Innovation” was the key thinking and pride-point prior to IFSA 2013; now I believe the right word is “Compliance”.

163170_477596024332_7522334_nWhen we first started the Islamic Banking journey in late 1990’s and early 2000s, BNM encouraged a lot of product innovation from Banks as there were no existing guidelines. We looked at the various structures that provides the desired outcomes and discussed with Shariah Committee on the design and component of products without breaching Sharia rules. BNM was supportive on us developing these “innovative” products. Some may have been controversial (such as Bai Inah, Bay Ad Dayn, Wadiah and Bai Bithaman Ajil) but it encourages discussions alongside the mantra that “whatever is not explicitly prohibited, is permissible“. Sometimes we were forced to think outside of the box, especially for sophisticated products mirroring conventional. We also received support from Sharia Committees whom temporarily approved “innovative” products with the understanding that over time, a better solution were developed as replacements.

Now with the issuance of the Policy Documents, such innovation becomes limited. Innovation is now ring-fenced around compliance to Shariah rules (either from regulators or internal Shariah Committee), and the Banks are expected to follow these rules to the letter. Breaches to these rules becomes the responsibility of the Bank’s Shariah Committee and detailed deliberation is greatly expected to provide the solution. Compliance first; if it is not covered in the documents, it probably cannot be done without a lot of effort.

CHOOSING THE SIMPLEST ALTERNATIVE

With compliance now being the vogue vocabulary with BNM, Banks had to look hard to the Policy Documents to ensure the requirements are identified and gaps filled for fear of breaches or fines. The gap analysis falls into the line whether “are we complying to the requirements?” and not “how do we do this without it becoming a gap or compliance issue?”. Both Shariah and Bank’s Product teams would now look on how to comply with Policy Documents instead of using the Policy Documents as a reference to develop a product.

What I noticed since 2014 is the obsession to comply with Islamic contract requirements, and if the team feels it is difficult to comply, the next logical step is to avoid such contract altogether and seek an alternative contract which is easier to comply with. For example, the Murabaha Policy Document issued in 2014. I have to say it is a beautiful document, and outlines the requirements for Murabaha Purchase Orderer (MPO) that reflects the full Sharia requirements of ownership transfers, risk taking, profit and management of actual assets.

These requirements, which in the eyes of many Banks, may be difficult to fully comply with due to many reasons: shortage of expertise, systems infrastructures limitation, people understanding, complicated processes, operational risks, credit issues and fund management requirements. Instead of the risk of breaching the Policy Documents, Banks opt for something less “complicated” which offers “similar” structure. The default solution is Tawarruq Arrangement i.e. Commodity Murabaha.

Or, the teams looks at Ijara Policy Document. It outlines further the roles and responsibilities of lessor and lessee, while the asset remained in the Bank’s ownership throughout the lease tenure. Again, if a roadblock occurs where a Bank cannot fully comply… Tawarruq Arrangement provides a quick solution. With very defined rules outlined in Tawarruq Policy Documents, the Banks are confident that offering Tawarruq will not breach any guidelines.

Tawarruq, therefore becomes the default Islamic contract in the market. When I asked the participants during case-studies to the question “What contracts should be used for this structure?”, the answers are unanimous “Tawarruq”. And they are not wrong.

DISRUPTION IN ISLAMIC CONTRACTS

155228_469014969332_6259944_nMaking Tawarruq as the “all-problems-solved” structure is having an unfortunate result to the industry. While the issuance of the Policy Documents as a reference was to galvanise the development of various Islamic contracts, the Banks have an easy way out in Tawarruq. Now, the rest of the contracts are in danger of being sidelined in favour of continuous development in Tawarruq.

For example, the Home Financing product which had evolved from BBA in the 1980s to Diminishing Musharaka in the 2000s. When BBA was introduced, practitioners and Sharia teams identified several practical issues that over a period of time needed to be resolved such as ownership transfer, rights to sell, and sale of properties under construction. These issues led to the development of Diminishing Musharaka as an alternative solution.

But with Diminishing Musharaka, there are still operational and legal issues that have yet to be resolved until today. For example, the “right” contract to be used for period of construction, the application of Ijara and the extensive outlining of Wakalah roles and responsibilities. Failure to understand the issues and provide real solutions puts the Bank at risk. There are also legal infrastructures that have yet to be addressed such as land joint-ownership by the Bank (as a partner), and different practices of land offices for the registration of Bank as a partner. These are roadblocks (and credit risks) to the Banks to take the structure further.

THE DOUBLE-EDGE SWORD OF TAWARRUQ

25547_378676189332_2665364_nMalaysia is in danger where I foresee that one day the industry itself will became the absolute global expert in Tawarruq and Commodity Murabaha. With Bursa Suq Al Sila as the leading commodity trading platform for the country, backed by the government (as a national bourse), the Tawarruq structure is expected to evolve into an efficient Islamic-structure engine. The processes of Commodity Murabaha will become seamless, and may even integrate into a Bank’s core banking system, the operation for buying and selling commodity will become commonplace and familiar, and this will result in effective processing, awareness of Shariah risks, compliance to trading requirements and well as reduction in overall operational risks.

Banks will one day become so well versed in Tawarruq, they will question the need for other types of Islamic contract, where they may not able to fully comply with.

With such development, more and more:

  1. capital investments will be made into perfecting the Tawarruq infrastructure, and Banks will also be able to comply with BNM requirements by investing in human capital familiar with Tawarruq.
  2. product structures will be developed around Tawarruq and once these products are established, it will be difficult to unwind as a prefered product simply due to the ease of the Tawarruq contract requirements.
  3. variations and hybrid products will be introduced based on Tawarruq, or containing elements of Tawarruq to solve “difficult scenarios” for compliance.

We will one day have an innovative and world class Tawarruq product, but no development in the other major Islamic contracts. Innovation will stall and Banks will choose quick returns and operational ease of Tawarruq. It is a dilemma of the industry where it is heading to “one” major solution for almost all “sale-based products”.

It is unfortunate if Banks chose to abandon the other contract alternatives, where such contracts will never reach its full operational and theoretical potential.

Hoping that a Bank will take the lead to develop products based on all the various Policy Documents instead of relying on only Tawarruq and its variations. The industry needs expansion and enhancement and by focusing on only Tawarruq, the industry will not be able to explore exciting products and expand its horizon. The Policy Documents, as beautifully written as they are, may tragically one day just becomes an academic relic issued by BNM.

Wallahualam.

Earlier writings on Tawarruq and Commodity Murabahah:

  1. Reliance on Commodity Murabahah
  2. Financing : Commodity Murabahah and Tawarruq

Interesting article in LinkedIn

The Difference Between Islamic Banking Financing and Conventional Banking Loans

I know the title of this post is a mouthful, but I am insisting on the title. Simply because today I came across another round of bashing by individuals on Islamic Banking. Again, the contention is that Islamic Banking is no different from conventional banking; worse still it is claimed that Islamic Banking is more detrimental than conventional banking. How can this be? I watched the video and aghast by the level of ignorance to the nature of Islamic Banking. And gauging from the response by the rest of the audience, it seems that the audience themselves knows no better.

It seems that a lot of individuals are still unconvinced about Islamic Banking. Furthermore, the impression that it is worst-off than conventional banking needs to be addressed. Islamic Banking, while on the surface is still banking, but it is built on a totally different foundation. There are significant difference which is brought about by a single requirement; Shariah-compliance.

THE STRUCTURE 

The basic difference between Islamic Banking and conventional banking is the structure of how the Bank is set up. For a conventional banking, the purpose of set up is to collect deposit and to give loans. This is the shareholders understanding of what it should be. 2 very distinct function ie Collect Deposit and Give Loans, and the arrangement is managed by a Treasury function which tries to balance the returns to shareholders’ funds.

Conventional Banking Structure (Diff)

But what is Islamic Structure then? In essence, how an Islamic Bank is supposed to be set up is based on the theory of “Sources and Application of Funds”. There should be a single flow between the deposits and the financing / investment use of funds; this means there is no distinct function. It is a single function where customer deposits or investment pool is used to fund financing portfolio or deploy into investment instruments, from which returns are derived and recognise. Once the returns are determined, these returns are “shared” between the Bank and the customers (deposit/investment). This “Profit Loss Sharing” structure demands a different way of managing the Bank, although not all Islamic Banks are able to successfully pull this off 100% (especially when the Islamic Banks are still under the parentage of a conventional bank).

Islamic Banking Structure (Diff)

In my personal view, the structure of an Islamic Bank is most suited if it is built around the Mudharabah structure. It fits perfectly on how the Bank is to be managed. It should be the backbone of any Islamic Banks, where the set-up is linked end to end resulting in sharing of actual returns arising from a Shariah-compliant financing/investment activity.

Finally, the processes in an Islamic Bank and conventional Bank are also different, simply due to the structure of which it has been set up. There is a broader requirement for oversight and research required to ensure the Islamic products and services meets Shariah requirements. A lot more layers to comply with, a lot more details needed.

Islamic Banking Diff (Structure)

THE SHARIAH COMMITTEE

Shariah Committee is the most important difference between an Islamic Banking business and conventional Banks. It provides an oversight accountability in ensuring that all the operations of an Islamic Bank is consistent with the rules of Shariah.

Shariah Committee (Diff)

There is a huge layer of governance surrounding an Islamic Banking proposition. Whatever features that it offers, it goes through regulatory oversight by the Shariah Advisory Council of BNM, and stricter scrutiny  by the Shariah Committee whom are not under the jurisdiction of the Bank but reports directly to the Board of Directors. The decisions (or “fatwa”) given by the Shariah Committee will be held solely by the committee themselves, therefore there is a huge responsibility for them. The Shariah Committee must ensure their decisions have taken into account all requirements of justice, customer protection, compliance to Sharia, interpretation to customary civil practices as well as practicality of implementation. In short, decisions must be clear, defensible and without any doubt to its validity.

SUSTAINABLE MAQASID OF SHARIA

In Islamic Banking, matters really are determined by intentions. And the intention is to ensure the Maqasid (Objectives) of Shariah are met.

Maqasid

These Objectives are a key consideration in setting up an Islamic Banking operation. But it does not mean the operation of Islamic Banking and the deployment of its funds are for charitable purposes. It is still a business that needs to be sustained by investing in Sharia-compliant economic activities, therefore it is misleading to assume Islamic Banking is a holistic endeavor that “should not charge interest” or merely to “provide assistance to the ummah”. There are costs for running an Islamic Banking business, and as far as possible it should be at par to the costs of running a conventional banking business. Returns on Shareholder capital is also important to ensure that capital is continued to be invested into Islamic Banking for it to grow. With growth comes the ability to continue supporting the ummah. The key word is sustainable banking. You cannot grow or even survive if you are not competitive.

THE PRODUCT & CONTRACTUAL RELATIONSHIP

Designing and launching an Islamic product is not easy. The amount of work that needs to be done in relation to the fundamental difference between an Islamic Bank and conventional Bank. The fundamental difference is the totally different outlook on what happens after entering a contract. The contract between a customer and a conventional bank is simple; a loan where interest is charged upon over a period of time.

Key Diff - Product (Example)

But look at an Islamic contract. It is much more complex structure, but once determined, it really makes total sense. The contract defines the relationship, the relationship defines the responsibilities and subject matter, the subject matter defines the sequencing and ownership requirements for the use in an economic transaction, the transaction defines the rewards and returns on the completion of the contractual obligation. Cause and effect, risks and compensating return, action and rewards.

What usually confounds practitioners (whom are not well versed in Islamic Banking contracts) are the level of detail. Some may consider the issues discussed in an Islamic Banking forum as “petty” but others expressed amazement in the level on consideration undertaken during discussions. For example, an Islamic Banking forum would discuss the nature of loan (Qard) and responsibilities of Qard, conditions of Qard, transferability of Qard, conclusion of a Qard Aqad (offer and acceptance), dissolution of Qard and implications of Qard when attached to other Islamic contract. This level of discussion is missing from the conventional banking space where in their view is that a loan is an amount given to customer where it is to be repaid back with interest.

OVERALL SUMMARY OF DIFFERENCES

There really are differences between Islamic Banking and conventional banking, and there are some of us trying very hard to make a difference in the compulsion towards Riba’. As a summary, below are some quick differences I have compiled from my earlier days in the industry on the differences between the models.

Difference 1

Difference 2

Difference 3

Difference 4

DNA OF ISLAMIC BANKS

For me, the main difference between Islamic Banking and conventional banking is that the concept of justice to customer is not regulatory driven; it is conceptually driven by the idea of Islamic Banking itself. A lot of conventional banking practices are developed to maximize returns while minimizing risk, and risk-transference is a key consideration for conventional banks. Regulators have to be vigilant to ensure conventional banking toe the line to protect customer’s interests.

Islamic Banking, in its DNA is intended more than just being profitable. It is meant to be providing service to support the activities of the ummah (Muamalat) defined within Shariah-compliant transactions. There are specific rules that must be followed; breach of these rules means the penalties are non-negotiable i.e. whatever returns gained from these breaches must be given to charity. Care and consideration is a must. Justice and fairplay is always important in a decision by Shariah Committee. Release of customers burden is a priority.

AVOIDING FITNAH

Many customers still lack knowledge of what Islamic Banking is all about. They collate biased and misleading information from truncated and unverified sources on the internet, facebook postings that intends to be malicious rather than presenting the true picture, and comments by individuals who make generalized comments on their experience which may well be isolated cases due to misinformation, misunderstanding or just plain ignorance to the fact. And yet these comments are sensationalized, made viral and deemed to be the absolute truth without further exploration or verification.

Cut and paste seems to be the easy way forward. Yet people forget the discipline that is practiced by the companions of the Prophet; you must verify the information by determining it all the way to the source of the information, up to naming the individuals who made the first comments, and deciding whether the individuals are trustworthy and of good standing. This discipline is lost in this world of over-abundance of unverified information in the social media where direct accountability is undetermined, and it has become increasingly difficult to separate truth from fact.

I had always advised friends and critics alike to be careful of what they “recommend” when dealing with Islamic Banking due to the huge responsibility of such recommendations. If they are ready to criticise Islamic Banking as “same as conventional” or “open to back-door riba” without full understanding of what it really is, they should be ready to take responsibility for that. If their basis of stating as such is based on “viral whastsapp message” or “comments by third party islamic practitioners” or “explaination by insiders in the industry” or “commentary by blogs”, I do appreciate if we as practitioners can be provided with these “sources” for us to verify its accuracy. Many times I find the comments are based on partial information, taken out of context, outdated writings or information as well as just being malicious without proper basis or discussion. Some are not even Shariah related or relevant to Islamic Banking practices, just operational and processes defects.

Do think of the implications: Should a person make such comments that “Don’t take Islamic Banking products because it is not really Islamic and there is a lot of trickery to it”, and the person listening to that comment thinks “Owh then there is no difference between Islamic product and conventional riba banks’ product” and proceeded to take Riba-based loan products, the implication is that the person who made the comment had directly influenced another person, in my view, in making a wrong and sinful decision. Will that person be responsible for this act of “pushing another Muslim into taking Riba products”? It is a heavy burden to take, not just immediate but in the hereafter. So be careful when a person makes that comment.

And to imagine what will happen when the person who took the Riba product commented to another person (and another) that someone commented that “there is no difference between Islamic Banking and Riba Banking…” . It will become a tree with a massive root, grown by the single seed of the original comment by the first person.

MashaAllah

Hopefully those doubtful questions on Islamic Banking should be directed to Islamic scholars, Islamic banking practitioners or relevant academicians with stature, knowledge and qualifications before the ummah believes and spread untruth that will, in the end, become a disservice to the religion of Islam by spreading “fitnah”.

ISLAMIC BANKING IS EVOLVING

Evolution

Granted, Islamic Banking is a 30 year old structure, with many building blocks are still in progress. But it has not stopped evolving to existing times as and when new regulations and Shariah decisions comes into discussion. It is not perfect yet, but practitioners are aware of the difficulties of meeting all the requirements without enhancements and considerations to practicality. There is a misguided assumption that academia are aware of all the shortfall of Islamic Banking practices and the industry had turned a blind eye to these. Nothing can be further than the truth. Islamic bankers, Shariah Committees and BNM are well aware of all of the issues raised buy academia as well as other practitioners, with the benefit of global awareness as well. In truth, practitioners know more of the issues they faced on a day to day basis, as compared to academia where some of the issues had already been resolved by the industry but not as made known to academia.

Criticisms are always welcome, but ideally it should be constructive on how to improve. It is a heavy responsibility to ensure the differences between Islamic Banking (based on Shariah) and conventional banking (based on lending) are managed diligently. It is an on-going evolution that I am confident one day will reach its apex. Ideas are welcome and proposed solutions considered in earnest. And as I have always said to my product team; If you’re not part of the solution, then you are part of the problem. So, let’s be the solution that we had always wanted.

Wallahualam

My earlier postings on similar conversation:

  1. Consequence for Choosing Islamic Banking
  2. Shariah Banking in Malaysia
  3. Conversations on Islamic Banking in Malaysia
  4. Choosing the Right Options

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