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Category Archives: Investment Account

INCUBATING ISLAMIC BANKING DREAMS

Posted on July 20, 2019 by Amir Alfatakh
5

CAN ISLAMIC FINANCIAL INSTITUTIONS DO IT ALL? MUST ISLAMIC FINANCIAL INSTITUTIONS DO IT ALL?

Incubating Islamic Banking Dreams

For the longest time, Bank Negara Malaysia (BNM) have been conducting their experiments on Islamic Banking institution to build a viable business model that can be the example to the world. Islamic Banks are naturally seen as the prudent, stable and right platform to design, build and test new structures and conditions. That exploratory mode has resulted in an industry that is not just adaptive and innovative, but also strongly built around Shariah.

EXPECTING THE MULTI-TALENTED BANKS TO DELIVER ALL THE FUTURE ENDEAVOURS.

Yet, it has not always been smooth sailing. Although there is stability in financial institutions, adding new roles and functions to the institution can sometimes result in instability, uncertainty and financial pressure. When a bank has been operating successfully for many years under a certain operating model, a new requirement will certainly result in material changes; some of which may be disruptive.

Due to the changing nature of the financial markets and the entrance of new disruptors to the industry, financial institutions including Islamic ones, are asked to innovate, adopt and adapt to remain competitive in the “new” industry.

Perhaps it is worth to list down the roles that Banks are asked to play over a foreseeable period of time, either evolving into or playing multiple roles at the same time:

  1. TRADITIONAL BANK : Based on the old and tested conventional banking model, we are generally a traditional bank, which is a blue sturdy truck. The Bank’s commitment is to provide sales and services easily useable by each customer and the products on offer are what is very much familiar to consumers in the market. Common, generic, with some sophistication to cater for different individuals, but mostly safe products. The level of risks that is to be willingly undertaken by a traditional bank’s shareholders (capital providers) are generally low risk to medium risk. Products generally offered are Debt-Based or Sale-Based, with little risk appetite for high risk products. Risks are mitigated by pricing of products i.e. the higher the risks associated with a product, the higher the pricing will have to be (Risk Informed Pricing). Most of the Islamic Banks in the market start of this way, and still prefer this model, simply because the bank is SET-UP based on THIS model since inception. All the bank’s infrastructure is set-up to manage the operations of a traditional bank.
  2. EQUITY BANK : Traditional Islamic Banks are the “expected” to move into the “equity investment and financing” model, simply by virtue of the notion that equity or investment intermediation is more “Islamic” than debt-based financial intermediation.   While scholars are encouraged by the efforts to introduce contracts such as Ijarah, Musyarakah Mutanaqisah or Istisna’a for financing, and Mudarabah and Wakalah bi Isthihmar for investments, this does not mean that the banks are moving into “equity” structures. Far from it, as the banks, which remains traditional in nature, retains the same level of risk appetite and infrastructure. Really, what has changed from the traditional model into the intended equity model? The risks appetite from the shareholders remains low to medium, and thus not logical to undertake high risk investment and equity financing products. We are not set up like that! If you assess the contracts under the so-called equity structures, many times there are undertaking clauses (Wa’d) that allows for a debt-based recourse should things go wrong or into default. It is arguable that having some equity-based structure qualifies the bank to transform from a traditional bank to an equity bank.
  3. VALUE-BASED BANK : What is a value-based bank? Ever since the introduction of the strategy paper of Value Based Intermediation (VBI) by BNM to re-align some of the concepts with widely-accepted global standards of ESG’s and SDG’s, the Islamic Banks have been wondering what is the best approach to move into this space. There is a fine line between CSR activities, ESG adoption in practices, and VBI which aims to be an all-encompassing standard for Islamic Banks based on the Maqasid Shariah (objectives of Shariah). Not many Islamic banks have a clear understanding of the requirements, as they are asked to service and support a narrower group of  customers operating in sustainable, green, environmental friendly business, that has a positive social impact to the community, while retaining a good level of profitability. It is a small group of customers in Malaysia that is aware of the benefits of operating a “value-based” business. There is no direct incentive from financial institutions for going green. Again, the set-up of a traditional bank is to maximise returns at the lowest possible acceptable risks. Financing into industries which are green and sustainable and new tech and unconventional and requires new understanding of business model is NOT AN EASY SWITCH in thinking and credit decisioning for any traditional banks. Thus so far, Islamic Banks are only focusing on communal activities instead of financing and investment activities into the community (which is a new segment for many banks). Again, the infrastructure is not necessarily set up to handle VBI.
  4. DIGITAL BANK : This is really a stretch to expect Islamic Banks to also look at structures involving blockchains, smart contracts, eWallets, cryptocurrencies, P2P and crowdfunding platforms. There have been many forums and seminars on these topics of Disruptions in Banking as well as Islamic Banking. There is no model to refer to at the moment. The banks are out of their element when it comes to fintech. There is uncertainty in the types products that can be offered. There are no guidelines or regulations from BNM yet. While the Digital Revolution 4.0 envisioned banks becoming a new value proposition breaking away from traditional products, the set up is again the main deterrent factor where banks are not designed for the virtual world. The Digital Bank will be more attractive to a different set of customers who are different from the Traditional Bank’s customers. It is however, trendy to be “Digital” but whatever digital transformation that we see happening today are mostly “digitalisation of existing banking products and processes” to improve efficiency and turn paperless. Converting a manual process into an automated process is hardly becoming digital. All the products and processes are still very traditional. The proper term is Automation or Digitalisation. That’s it.

WHY MUST IT BE A SINGLE ENTITY TO DO EVERYTHING? 

I feel it is unfair to expect everything from the Bank. For many years Islamic Financial Institutions were asked questions such as “Why don’t Islamic Banks do more Musyarakah products or Mudarabah products?” and “We should share the risks between the customer and bank” and “Why not you help the community to give more charity?” or even “Banks shouldn’t charge profits so high but instead give interest-free loans to customers” statements.

My answer is this: Why must Banks? We are set up based on a certain criteria, with restrictions in our capital, governed by the financial ratios similar to conventional banks, able to handle only a certain type of risks, and serves a particular market segment. The idea of banks is very much different from what we envisioned Islamic Banks to be able to do. It is like a wooden box where you keep adding new stuff. It won’t expand. The new stuff WILL NOT FIT.

THIS CONCEPT OF HAVING AN ECOSYSTEM

In my last posting, I mentioned about Islamic Banking ecosystem, where different entities set up for different purposes should live separate but with connected lives. A Bank is set up to handle financing based on low-risk debt at the lowest cost of capital; leave them be. It will be unreasonable to ask them to take higher risks products while their capital is provided by low-risk investors and shareholders. There will be reluctance to engage in higher risks without higher returns.

So each institutional variation should be part of the larger financial ecosystem where each institutions have a specific role to play. Then the capabilities of each institution will be enhanced based on their function. It is true that some of the function can overlap into multiple models, but more of complimentary offering but not primary.

My suggestion: Stop asking one entity to do what they are not set-up to do in the first place.

I like this idea of an ecosystem where one party interacts and lives off other parties, at the same time contributes to other parties. If I may propose the components of the ecosystem:

  • Traditional Bank : Debt-Based products, SImple Products, Low Risk/Low Returns, Fixed Returns or Floating Returns, Financially Stable with observance of regulatory ratios, Service Provider, Asset Management. Highly Regulated. Product Replication and Financial Supermarket.
  • Equity Bank : Equity-Based products, Sharing arrangeent, Medium to High Risks, Potentially above average returns, Requires strong capital and liquidity, Sustainable business strategy needed, Investment Management, Highly Regulated, Product Differentiation compared to conventional bank offers.
  • Value Based Bank : Combination of Debt-based and Equity-based products. Product embedded with value elements (CSR, charity, financial inclusions, community outreach), requires strong flow of income, sustainable strategy required, micro-financing and bespoke financing, Cash Flow Management, Shariah-centric, Ethical Banking values, Product partnerships.
  • Cooperative Bank : Shareholders value, investment driven, community based. High RIsks / High returns, serving unbankable and micro financing and consumer needs. Sustainable income flow. Self sufficient and self generating income. Local impact. Operates outside the capital markets. Highly Regulated but different regulations. Consumer-based products. Profit and loss sharing.
  • Digital Bank : Outside the traditional banking environment. Core system based on blockchain infrastructure. Alternative currencies such as Ethereum and Bitcoin. Services driven, but allows for financing via crowdfunding or P2P and alternative sources. Digital contracts, smart contracts and robo-advisers. Linked into Big Data and digital Apps. Fintech based. Speed, Accuracy, Security, Reliability and continuous building of technology.
  • Challenger Bank: Serving the underbanked, unbanked and minority communities. High returns due to the higher risks, but potentially more lenient credit requirements. Requires high capital, and high liquidity to service the segment. Can be fintech based and offers traditional products. Serving the medium-high risks customers that is rejected by traditional banks. Less collateralised requirements.
  • Waqf Bank : Deploying unutilised assets and converting it into economic assets that generate returns. Potentially profit sharing arrangement as preferred method. Cheap source to generate economic activities. May be hampered by country’s regulations and mismanagement of the Waqf operator, but medium risk of default. Under-developed structure with high cash-release potential.
  • Takaful Institutions : A key component in an Islamic ecosystem. Provide mutual protection for member contributors and having large cash reserves for investment and funding deployment. Long term sustainability business, and strong understanding of risk and its correlation to returns. Potential liquidity provider.
  • Zakat Institutions : An important wealth aggregator and distributor. Set up to cater for very specific segment of the market aimed at improving the economic condition of the segment. Potential source of funding for the economy.
  • Fintech and Crowdfunding : An alternative digital solution aimed at providing greater access to liquidity and funds at the fastest and most efficient manner. Higher risks but will serve a certain segment, similar to venture capitalist structures. Potential Disruptor.

BUILD THE ISLAMIC BANKING ECOSYSTEM

Since no one is telling, let me suggest what do we need to have a working Islamic Banking Ecosystem.

  1. Interbank Market – While liquidity is available in the real world, a mechanism should be designed to flow money from the interbank physical into the blockchain digital.
  2. Financial Institutions Model – There could be various financial institution models but each must have clear objectives and reason for being. Be specific and focus in building capabilities. Overlap can occur but generally each institution must focus in a single purpose.
  3. Fintech – Fintech must be the bridge between the real world and the blockchain digital world. Apps must be able to transfer money seamlessly and link to relevant records. All fintech development should focus on linking the two worlds.
  4. Interconnectivity – All elements in the blockchain and all financial institutions must be linked to facilitate transactions between both staging areas.
  5. Alternative Structures – There are still many underdeveloped structures that lives in a very small space. It is not greatly promoted or known thus letting it gather dust. Some great ideas may have been overlooked or demised but the industry must relook and ask how much does such structures contribute to the overall economy.
  6. Products – Products in both Digital world and Physical world may look and function differently because of the infrastructure they are in,  but both Digital and Physical MUST be able to talk to each other despite the difference.

SUMMARY

Stop asking the Islamic Financial Institutions to load on new structures, concept or products that are not suitable for them. Develop infrastructure in separate operating model with the resources available that can fit into the overall ecosystem. Let those models grow side by side with the rest of the financial institutions in the same space. A financial ecosystem needs to be built where all the important components and institutions are linked and working together for a single purpose : to build a sustainable ecosystem for financial institutions.

Posted in Bank Negara Malaysia, Banking Model, Commodity Murabaha, Crowdfunding, Crowdsourcing, Debt Based Structures, Equity Based Structures, fintech, Guidelines, IBFIM, Investment Account, Islamic Bankers, Islamic Banking, Islamic Deposits, Islamic financing, Islamic Fintech, Islamic Investments, Islamic Trade Financing, Islamic Treasury, New Economy, Sharia Committee, Value Based Intermediation | Tagged Challenger Bank, Cooperative Bank, Crowdfunding Platform, Digital Bank, Ecosystem Banking, Equity Bank, Takaful Institutions, Traditional Bank, Value Bank, Value Based Intermediation, Waqaf Bank, Zakat Institutions | 5 Replies

The Deposit Battle

Posted on April 12, 2018 by Amir Alfatakh
2

IT IS FAR EASIER TO FINANCE SOMEONE THAN HAVE SOMEONE FINANCE YOU.

It really is easier to build a financing book than a deposit book in Islamic Banking. Companies and individuals constantly seek for financing but when it comes to deposits, it really is a price war. Banks are looking to outdo each other with tempting deposit packages to attract the most cash-rich customers they can get. 

But I do not blame Banks for this fight for deposits. Deposits are a part of the whole infrastructure that is required for Islamic Banking. Sources and Application of Funds make up the basis of Mudarabah and Musyarakah, and also other available contract. While the Application of Funds (Financing and Investments) have always seem to have been growing well in the market, the Sources of Funds on the other hand,  is always seemed to be struggling.

Technically, the cheaper the cost of a Bank obtaining their deposits, the better it is deployed into various types of financing at a lower pricing where the profit margins can be maintained. The dream will always be to figure out a way to get cheap deposits.

APPLICATION OF FUNDS

It is not to say it is very, very difficult to build a significant deposit book, as you can always “throw” the highest rates onto your Tawarruq deposits, and customers will flock. But more importantly, the funds must be “applied” and “used” in the most ideal way. It is not to say that building deposit products using high pricing will necessary be useful for the Bank as it will be an expensive deposit-building exercise. Bear in mind these deposits should be ideally used to finance/invest into the right types of assets. For example, what type of deposits is most suitable for a 30 years Home financing product? Is there a 30-year long deposit that will fund the 30-years Home financing? If not deposits, what type of funds is ideally used for 30 years financing?

So, can a Current Account / Savings Account fund a 30 years financing? Current Account / Savings Account are very fluid type of accounts, with no tenure restriction and usually available on demand (at any time the customer can withdraw the funds). There will be a tenure mismatch of daily redemption allowed (1 day tenure) and the house financing is paid over a period of 30 years. 30 years financing funded by 1 day deposits? This is a huge gap that on the surface, impossible to resolve.

But the answer is really simple. It all depends on the behaviour of the deposit products. You would think the most appropriate deposits to fund a 30 year financing is the shareholders funds, and that is always a limitation. Maybe raise a 30-year Sukuk but you don’t raise Sukuk just like that; it takes a lot of effort to launch a Sukuk. Or try to find a 5-year investment instruments, but that is a challenge as well.

CORE DEPOSITS VS NON-CORE DEPOSITS

As mentioned above, it depends on the behaviour of the products, or more accurately the portfolio. Within the various types of Deposit products, you can further split them into Core Deposits, and Non-Core Deposits (Variable, transactions, short-term). We understand a lot of customers do withdraw their cash, whether on needs basis, transfers and payment. But if you analyse the portfolio further, you can identify a minimum amount that is always in the account. For example, if you analyse a Current Account portfolio of RM1 million every month, you may find a certain minimum balance is present  at a constant, continuous level e.g. RM400,000 is always there i.e. the Current Accounts balance have not gone below RM400,000 and therefore deemed as Core Deposit. And Core Deposits are what you use to fund a 30-year home financing.

SO WHAT IS CORE DEPOSIT?

Core Deposits are amounts of deposits that are at constant levels throughout many cycles. Some Banks have bigger core deposits due to higher proportion of transactional accounts in the Banks, where the balances sit for many days in the account. It may fluctuate but mostly the changes in balances are minimum within the core deposit. Because of the stability in the balances, it is used by Banks to finance longer term commitment and financing.

So, the battle for Deposits is to generally build a strong Core Deposits. This type of deposits are resilient, with long term balances that allow Banks to utilise these balances for long-term financing at the cheapest cost of funds. And depending on the growth strategy of the Bank, the types of deposits that a Bank builds (Sources of funds) must compliment the strategy for the Financing portfolio (Application of funds).

If such balance is achieved, the Islamic bank will have maximised the cost efficiency of its balance sheet.

So how do we win this battle for deposits to continue funding the growth of Islamic Financing? Where do we find the source of funds to meet the needs of the industry? What Islamic contracts are the most suitable to attract deposits? Can structures such as Waqf or linkages to Zakat help provide a source of deposits to support the liquidity in the market? Or can there be a more efficient way to pool the deposit resources and make it available to the market, accessing to a new group of funders that we have never touched before.

There must be a way to build a platform to access new group of funders or develop a structure where investors can fund a financing portfolio directly. I see some of these platforms available in the market but needs to have it developed on a bigger scale into the banking environment.

Banking fintech, anyone?

Posted in Deposits, Investment Account, Islamic Banking, Malaysia | Tagged Balance Sheet Management | 2 Replies

The Unbanked

Posted on November 30, 2017 by Amir Alfatakh
1

Banked Unbanked

YOU EXIST IF YOU HAVE MONEY

Throughout our banking life, we were always reminded on the privilege of having a Bank that supports you for your financial needs or your businesses for expansion and growth. The banking products are designed to provide SOLUTIONS and access to these products and services relied on the following:

  1. Your scope of business : What is your business and industry and more importantly, what’s the potential for your business to grow? Is it a sunset industry or emerging business? What is the long term outlook of the industry?
  2. Your credit standing and payments conduct : How strong are you financially? Is your business reliant of project or is there continuous flow of business? Is there any issue in collections and payments? What is the payment track record? Is the Bank able to obtain evidence of your businesses credit strength via Audited Financial Statements, Bank Accounts, Invoices records and any other documents?
  3. Your collateral : Is your business able to provide any form of collaterals that is acceptable to the Bank? What is the valuation of these collaterals? Is there a secondary market for the collateral and what is the likely protection towards the Bank’s capital?

These are all the tested ways of traditionally assessing your credit worthiness or financial viability. These are what Banks call you if you qualify: BANKABLE CUSTOMERS.

BUT WHAT IF YOUR BUSINESS DO NOT HAVE ANY OF THE ABOVE?

So now, you don’t have any or some of those, or you never really cared. You are a small business, with young people running it, utilising tech as your business platform. You source your materials and goods directly from suppliers, shipped to your home (or just resides at supplier’s premise), advertise on FaceBook and Instagram, and receive your orders online. You shipped them out to your clients via DHL or any decent courier service, and all your payments and receipts are done via epayment. Business is good and you want to grow.

You seek a financing facility with the Bank.

But the Bank promptly tells you : Your business is no good because you don’t fit the criteria that Banks have for their “target clients”. No track record. No financial statements. No collateral. You are officially UN-BANKABLE or UN-BANKED.

WHERE DO THE UNBANKED GO, THEN?

As much as the Banks like to think that the only way for your business to grow is to comply with the requirements to qualify for a banking facility, you have discovered that it is not necessarily so. Many have managed to grow without going through the banking red tape; in fact they avoid the Banks altogether. Options are starting to emerge to help you build your business, and most of them are not even Banks. Is it a scam or a money-game fly by night operation? Dare you take the risks? But it seems that they are willing to take a risk on your business, and since there is little other options, why not give it a try.

The banking world is ultimately changing. We hear all the new words being used; Fintech, Bitcoin, Ethereum, Blockchain, Crowdsourcing, Crowd funding, Big Data, Antminers, Challenger Banks, Venture Capital, Seed Funding, Angel Investors, Digital Banking, ePayments, eWallet, Mobile Banking, Apps Banking, Tribe, etc. All these new “non-banking channels” appeals to a different type of customers; ones that understand technology and has a lot of trust in its capabilities.

Now the first experience for a new business in obtaining funding may no longer be via a banking experience. It could be a social media platform, a tech company or even the greater public (peer to peer). The digitalised “banks” (which are consequently NOT banks) offers the following benefits:

  1. Creation of relationships without transactions or track records
  2. Reduced Costs of doing business i.e. cheaper transactional costs
  3. Speed and mobility
  4. Less regulatory requirements (which could be a bad thing…)
  5. Ease of Cross Border transactions
  6. Digital interface instead of human connection

WHERE ARE WE HEADED?

I agree with the view that the form of traditional banks must change in 5 years time to offer products and services that’s totally different from what we have now, reaching out to a wider group of Gen-Y and Millennials. But how do we attract such emerging generation whom are now glued to their mobile devices?

This is where the Social Economy will be prominent. Just as the ease of the social media connects the Gen-Y to everything quickly and effortlessly, the new generation will not subscribe to the old tedious banking model. It will be about conveniences, and life which is more online 24/7. And if they are not able to obtain a required facility, they will be more likely to look at their own community for support, or else “Do-It-Yourself” solutions which taps on the fintech, internet or mobile infrastructure. They will become Digital Entrepreneurs, and Banks have yet to create a space for these young tech-savvy entrepreneurs to occupy.

“ISLAMIC BANKING” OUTSIDE ISLAMIC BANKS

While the banking industry continue to develop traditional Islamic Banking products and services, there are many small initiatives that has taken the practices of Islamic Banking (knowingly or unknowingly) and made it into a viable business model. Even now we have real life example such as EthisCrowd.com that’s able to raise funds within 45 days for affordable property development projects to complete within 1 year via Mudharabah arrangement; this basically means there is no longer a need for banking institutions as a source of funding.

And ironically, some of these alternative banking models are so aligned with Islamic Banking principles, and borders more of “socialism” more than anything else. The desire to “share risks” and “support the community” and “fund a worthy cause” moves the financial model away from “money making” and “return on investments” that we often associate “banking” with. This smacks familiarity with what the Islamic Banking industry has been created for in the first place; the realisation of Maqasid Sharia.

Even Musyarakah (partnership) structures are already at work, where risk sharing translates to appropriate risk rewards for investors. This is also a relevant to the idea of Investment Account where the sources of Mudharabah funds are used to finance a project directly and returns are based on actual performance. Equity financing (as per my previous month posting on Dr Daud Bakar’s commentary on Profit Loss Sharing) is already being practiced by non-Banks, thus begging the question whether a Bank can really be as effective (or quick) to support equity-based structures as a non-Bank initiative.

While this is yet to be a mainstream phenomenon but do remember as the Gen-Y and Millennials grow up into the bankable space with credible financial strength, their views of what banking should be may be far different from what we think it is now.

SHAKING UP THE TREE

With all the alternatives happening around the Islamic Banking industry, it really is time for practitioners and industry to consider the model that we have always wanted to build. That is where the discussion must happen to embed the Islamic Banking industry into the “Social Economy” and “Alternative Banking”:

  1. Challenger Banks. The funding structure offered by these non-bank entities may/may not be based on crowdsourcing or crowdfunding. These essentially can be arranged as a Mudharabah (profit sharing), Musyarakah (partnership), Wakalah (Agency) but without the regulatory shackles. The question is on the rights and warranties for the crowd. Extra due diligence may be required but it should not be a tedious process. Otherwise, the crowd will see this as just another “banking” entity which they wanted to avoid in the first place.
  2. Crypto-currency. Much has been debated on the presence of bit-coin and ethereum where these “currency” were raised from algorithms processed by “mining” machines. So it may or may not be real money, but the more prudent definition of crypto-currency is “stored value”, “work-credit” or “medium of exchange”; not currency yet. And Shariah discussion on what these really are in the Islamic transactional context shall continue at least for the next few years
  3. Online Payments & Mobile Money. A key part of the process where the transactions may by-pass regulated banks and go straight from Peer to Peer (P2P). All online payment structures will be validated via blockchain infrastructure, at the fraction of a price and even faster speeds of transaction. Shariah will also be interested in the sequencing and the process flow and issues of ownership of the cash when it is done at the blink of an eye.

I admit all of these are still new terminologies and understanding to me, but it represents such a huge opportunity to rebuild the industry on the right footing, learning from past mistakes, taking the best practices from non-Bank models and moving away from simply debt-financing. It is an exciting world that is still evolving, and will be driven by the new generation so comfortable with technology, community and convenience. The banking model must change to meet this reality, the question is how to also get the Shariah elements into the various key processes.

There is no better time to incubate this. Especially in the Islamic Banking space of equity-based structures. Welcome to the new world, and it is a big world out there.

Posted in Crowdfunding, Investment Account, Islamic Banking, Islamic Banking Concepts, Islamic Deposits, Islamic financing, Islamic Fintech, Maqasid Shariah, Mudharabah, Musyaraka, Wakala | Tagged alternative banking, bitcoin, block chain, Crowdfunding, crypto currency, digitalisation, ethiscrowd, fintech, social economy, technology | 1 Reply

Musharakah Financing

Posted on July 3, 2017 by Amir Alfatakh
Reply

Investment

Recently I got a query from a reader in Macedonia on the Musharaka Financing model. A few questions which I feel are worth exploring to see if anyone have the viable answer. I have put up my responses in Islamic Banking 101.

In my humble opinion, Musharaka Financing has its own place in the Islamic Banking world, but not necessarily suitable for the likes of traditional Islamic Banks. Banks, as financial intermediary, is essentially set up to do “banking business” and the scope of banking revolves around debt financing, where the risk faced by the Bank is predominantly Credit Risks. The Shareholders, and to the large extent the Customers, dictates the type of risks that they are will to undertake when choosing a Bank. The main intention of banking with a financial institution is to protect the value of their deposits, without taking excessive risks, and with the expectations of reasonable returns derived from low risks investments.

RISKS UNDER MUSHARAKA CONTRACTS

Because of the above, the most suitable structures where Credit Risks is assessed are contracts such as Tawarruq (Commodity Murabahah), Murabahah, Istisna’a, Ijarah Thumma Al Bai (AITAB), Musawamah, Musharakah Mutanaqisah and Qard. The nature of these contracts are creation of an obligation between one party and the other, and because the above are based on sale or lease on an underlying asset, the risks are purely Credit Risks, and Interest Rate Risks.

However, Musharaka and Mudharaba financing risks should be based on consideration of Valuation Risks, Equity Risks and to some extend, Market Risks (I also include Ijarah and Murabaha Purchase Order into this category).

Click on this link to read an earlier post on the Differences between Debt-Based Financing and Equity-Based Financing

In essence, a Musyaraka refers to “equity partnership”, arriving from the word “Shirkah” or in Malaysia we commonly know it by the word “Syarikat”. It means, a group of investors pool their money (as capital), and jointly enters into a business venture as partners, be it finance or expertise for the business for the purpose of making a profit. A leader or manager may be appointed to run the business. All the partners agree on a profit-sharing ratio for profit they intend to share, and this is negotiated up-front based on what they contribute (money, skills or otherwise determined). However, this also means that the partners agree that any losses will be shared amongst the partners but limited to their capital contributions.

USE OF MUSHARAKA IN ISLAMIC BANKS

As I mentioned, not many Banks are set-up to handle “equity-based” financing, as the risks are above and beyond the threshold a normal Bank is willing to take. The risky nature of the endeavour, and potential diminished Equity, does not bode well with many Banks.

While it is difficult to offer these products directly from Banks, there are already initiatives by Bank Negara Malaysia to develop the product via a stand-alone platform, where Bank’s involvements are kept at a minimum and the platform acts as a direct link between the Customer (as Investors with Equity Funds) and Businesses (as Entrepreneurs seeking Equity) as partners.

IAP RA

This platform is the Investment Account Platform (IAP) which was launched in 2015 and Shariah-Compliant. So far, the ventures listed in the IAP uses either the Musharaka Restricted Investment or Mudharaba Restricted InvesTment Accounts (RA).

MUSHARAKA AS AN EQUITY-BASED STRUCTURE

Equity Financing2

Further, the application of “equity-based” structures are limited in the banking world, as it must be able to manage “Investment Accounts” for the purpose of equity financing. Many Banks do offer this via Restricted Investment Accounts (RA) set-up, commonly known as Profit Sharing Investment Account (PSIA). This is a direct “equity financing” arrangement where the Investors (usually the parent financial institution, and the Islamic Bank itself) will provide a sum-equity to match-fund a particular project or financing requirement of the customer (entrepreneur). The Islamic Bank, in this case, also acts as a manager where it earns a “manager fee”. The risks and rewards of the Musharaka, is enjoyed together by the Investors under the PSIA arrangement. However, this structure is not offered to Retail customers, as the structure is designed to retain the “investment” throughout the financing tenure (no early redemption of the investment).

READ MORE ABOUT MUSHARAKA FINANCING

In short, there are already structures based on Mudharaba or Musharaka Financing that we can look at in the Malaysian market, although at this moment, many parties involved are threading with caution. It remains to be seen how successful these will be, but slowly the market would be able to understand the requirements for such products. Besides, these products and structures have been operating as Venture Capitalists (VC), Partnerships and Crowd Funding. It is a matter of operationalising it in the banking space, either in the existing Islamic Banks (which is highly regulated) or consider a totally new financial institution that is able to take higher “equity” risks, which promotes innovation and re-think the way we look at financing.

For an extended read on Musharaka Financing, please click on this link for Islamic Banking 101 on the topic.

Note: Musharaka Financing is different from the often-seen financing Musharaka Mutanaqisah for mortgages.

Posted in Bank Negara Malaysia, Banking Model, Investment Account, Islamic Banking, Islamic Banking Contracts, Islamic Deposits, Islamic financing, Islamic Investments, Mudharabah, Musyaraka, Questions and Answers, Tawarruq | Tagged Credit Risks, Debt Based Financing, Equity Based Financing, Equity Risks, Investment Account, Investment Account Platform, Islamic financing, Mudharaba Financing, Musharaka Financing, Musharaka Mutanaqisa Financing, Profit Sharing, PSIA, Restricted Investment Account, Risks, Valuation Risks | Leave a reply

Deposit Paradigm Shift

Posted on November 16, 2016 by Amir Alfatakh
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ia-banner-mudharabah

The battlefield in banking has always been deposits. The importance of deposits cannot be underestimated; it provides a cheap source of funds for the Bank to support financing activities. Especially in Islamic Banking, the concept has always been “Linkage between Sources and Application of Funds”. How well the financing portfolio is built depends hugely on the ability to raise the deposits needed for the funding.

However, with the IFSA 2013 introduced to redefine the deposit vs investment landscape, raising sufficient deposits have now become a huge challenge for Islamic Banks. Traditionally, a Bank’s sources of funds are built around Current Account / Savings Account (based on Wadiah) and Fixed Deposits (based on Mudharabah), and any shortfall is supported by Interbank Borrowings / Capital. A healthy ratio between CASA : FD : IBB/Capital would be 40% : 30% : 30% and this is common prior to IFSA 2013.

Now that Deposits are defined under Qard (with greater limitation in providing any returns) and FD defined under Tawarruq, the ratio for raising deposit has become FD-heavy i.e. the CASA ratio falls to about 20% and FD (under Tawarruq) increased from 30% to 50% or 60% of the portfolio. This means the overall cost of deposits for an Islamic Bank has suddenly increased coming from the higher proportion of “expensive” FDs!

Alternative for Source of Funds

In the earlier days of IFSA 2013, there were a lot of comments that perhaps the new law has not taken into consideration the “reality” of Islamic deposits and was passed without too much deliberation. But I do beg to differ because if you really look at it, BNM has a clear agenda to shift the traditional way of funding through Islamic Deposits into a more robust method of equity funding. For many years, traditionalists and academicians have commented that Islamic Banks are simply mirroring conventional banking products. To a certain extent it was true, but now you see BNM laying down the foundation to take equity contracts such as Mudharabah (profit sharing entrepreneurship), Musyarakah (equity partnership) and Wakalah Fi Isthihmar (Agency for the purpose of Investment) to the next level.

paradigm-shift-in-deposits-2016

Funding via Mudharabah.

The next step in deposit building is envisioned to be under Mudharabah i.e. Investment Accounts. I am a big supporter of Investment Account as I see there are huge value, potential and opportunities for the industry to grow via this contract. Mudharabah removes the burden of raising deposits from the Bank itself. It simply offers the opportunity to fund an Asset (financing portfolio or investment assets) to the Rab Ul Mal (owner of the capital) to directly invest and enjoy the returns from that investment. The Bank no longer takes deposits from customers (on a “loan” basis where the Bank has an obligation to return the principal amount) but instead becomes the “fund manager” i.e. Mudharib to manage the portfolio on behalf of the customer.

Under Mudharabah, the customer now owns the Asset (flow-through approach) and takes all the risks on the Asset. The Bank, on the other hand, takes a cut via the profit sharing ratio as a “Mudharib fee” for managing the portfolio. This arrangement also removes all the burden associated from both the obligations on raising the deposits (Statutory Reserves, PIDM premiums) and cost of maintaining financing (capital costs of funds, liquidity premium, opportunity costs from Liquidity Coverage Ratios and Asset Deposit Ratios). These “savings” adds up to the overall income to the Bank.

Funding via Mudharabah is captured under the Investment Account guidelines, where the Assets are to be carved out from the Bank’s Balance Sheet into another reporting line where technically, the customer is the indirect owner of the Assets.

Funding via Musyarakah.

The intention to build confidence and acceptance of the Mudharabah structure for Investment Account hopefully will take the “deposit building concept” into the next stage i.e. Musyarakah structure where the role of “deposits” is transformed into “equity”. What it really means is that, instead of the customer placing money with the Bank to invest in “general investment or banking activities”, the customer now placed “equity” directly into the financing portfolio. The Bank no longer have any involvement in the financing portfolio, but merely facilitates the investment activities of the customer (as investor).

IAP-3.jpg

This is similar to the concept of crowdfunding where the investors come together and place equity in a business as direct investors. The investors now have direct share in the business, takes risks on the performance of the business, and enjoys the returns afforded by the performance of the business. It really is direct economic involvement of the investor into a specific business, where the risks and rewards are made known to the customer prior to them making a decision to invest or otherwise.

So what does the Bank earns? The Bank earns a management fee for facilitating the funding, which includes initial assessment, risk ratings, records keeping, statements and overall management of the account.

iap-2

Malaysia already introduced this “Musyarakah” platform to the public in the guise of “Investment Account Platform – IAP” where investors, retail or institutions, can go to the platform to see available financing requirements from businesses, to evaluate and assess to make a decision to invest into the business for the long term. Check out the write up under IAP above and their website https://www.iaplatform.com/

The role of the Bank moving forward

In all honesty, Islamic Banking no longer needs to raise “Deposit” to support financing activities where the profit is earned. That is the old way of thinking where Banks are ask to “fund before lending”. In the future, the Bank should build a financing portfolio which is funded mostly by customers, thus removing the contractual burden and the financial costs associated with deposit building. The role of the Bank is merely as a Mudharib (manager) of the funds where the Bank earns a “fee” from the returns of the financing portfolio. This role will further evolve under Musyarakah where the Bank don’t even own the Asset in the Balance Sheet, but earns fees from the act of facilitating the investment by the customer via the Investment Account Platform (IAP). This is “venture capitalist” territory but with specific rules to the game. Eventually, the Bank do not need to raise deposits to meet financial ratios, because the customer themselves goes to fund the Assets directly.

And while some may still criticise BNM when they faced difficulties raising cheap deposit via Qard and Tawarruq contracts, they should also realise that the role of the Bank must one day evolve from “Banker to Manager to Facilitator” where products such as Investment Accounts (based on Mudharabah and Musyarakah) are already available for them to take advantage of. Banking is no longer just “banking”. It is envisioned to be more “participative” in nature than what it is now.

Haven’t we all been talking about this model for many many years now? It is truly a time to finally build Islamic Banking as we had always said it.

Posted in Bank Negara Malaysia, Investment Account, Islamic Banking, Mudharabah, Musyaraka, Qardh, Tawarruq, Wakala Fi Istihmar | Tagged Application of Funds, Crowdfunding, Fund Manager, IFSA 2013, Investment Account, Islamic Banking, Role of Banks, Source of Funds | 8 Replies

The Negative Carry Problem

Posted on November 3, 2016 by Amir Alfatakh
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The Headache of “Negative Carry”

One of the problem that is always faced by most banks (including Islamic banks) is the mismatch between the commitment to pay a “fixed” return to depositors (created during deposit building exercises) and the “volatile and underperforming” returns from the usage of these funds (earned from the Assets). Typically, Banks put in a lot of effort in the building of deposits to satisfy and meet several regulatory and/or internal requirements, such as Asset to Deposit Ratio (ADR) and liquidity requirements under the Liquidity Coverage Ratio (LCR) where Banks have to maintain a certain level of High Quality Liquid Assets (HQLA) for every commitment on the deposits. The Bank also incurs opportunity costs when they are required to maintain a certain level of Statutory Reserves Requirements (SRR) deposit with Bank Negara Malaysia (BNM), and internally there could also be other incurred costs such as Liquidity Premiums (LP) and even deposit insurance payments to PIDM for the deposits portfolio.

These cost adds up to the overall cost of maintaining deposits.

Now, the issue arises when the fixed commitment created from the deposit raising exercise is too high against the actual returns from the use of the deposits. For example, the Bank runs a Tawarruq FD campaign of 4.0% p.a. returns for a 12-month placements to raise RM100 million worth of deposits to support the ADR requirements. However, the returns that the Bank earns via the treasury function may not be sufficient to support the fixed commitment of 4.0% p.a. maybe during periods of low returns (due to market performance or high provision of bad debts) or lack/delayed disbursement of new financing. Should the returns on Asset be lower than 4.0% p.a. the Bank is technically “subsidising” the shortfall, either partially or fully, from their own pool of funds to meet the fixed obligation.

This scenario is commonly termed as part of “Negative Carry”. It means due to the high “fixed” deposit commitment which has failed to generate enough returns (due to any/many factors), the Bank pays the shortfall from their own pockets.

product-concept-investment-account-v1

When the Actual Returns of 4.0% is lower than the Customer Deposit “Fixed” Commitment of 4.30% p.a. = Bank to subsidise shortfall (net SHF returns = 3.38% p.a.)

This is prevalent in both Islamic and Conventional banks nowadays. It can also be an expensive problem for the Banks, especially when Banks are forced to offer high fixed Tawarruq returns to big Corporate entities for chunky deposits.

Solving the Negative Carry

Ironically, Islamic Banks actually have a solution to “Negative Carry”. It is called “Investment Account” where instead of paying the customer a fixed return against the “forecasted” returns on Assets, the customer is paid based on “actual performance”. The Islamic contracts that can be used for removing the Negative Carry are Mudharabah, Musyarakah and Wakalah Fi Isthihmar; the 3 contracts identified by BNM as falling under the IFSA 2013 definition of “Investments”.

Consider this. The Bank has an Asset portfolio of RM1.0 billion with an average returns ranging between 3.5% p.a.(worst case) and 4.5% p.a.(best case). The actual performance is influenced by the market conditions and the provisions of bad debts, so it is hard to predict the “actual” returns for the next 12 months. Instead of finding a pool of deposits to support this RM1.0 billion worth of Assets at a “fixed return” of 4.0% p.a. under the contract of Tawarruq, the Bank offers the customer to “directly invest” into the Asset Portfolio. Basically, the Bank carves out a portion of its Assets in the Balance Sheet and “Sells” the Asset to the customer (Investor).

Product Concept - Investment Account V2.jpg

When the Actual Returns of 4.0% is lower than the Customer Deposit “Fixed” Commitment of 4.30% p.a. = Bank AND Investment Account holders “share” the subsidisation of the “Fixed” Commitments

In such scenario, the customer (as investor) takes over the risks of the returns on the Asset as they are paid profits based on “actual performance”. If the Asset earns 4.5% p.a., the customer earns a profit-share based on 4.50% p.a. i.e. earning potentially higher returns. More importantly, if the Assets earns 3.50% p.a., then the customer takes the profit based on 3.50% p.a. and this means the Bank do not have to “fully subsidise” any shortfall if compared to a fixed Tawarruq commitment of 4.0% p.a. The risk is effectively transferred to the customer (as investors).

On hindsight, it looks as if the Bank enjoyed gains when returns are low (no need to subsidise the shortfall) but on the other hand, stand to lose a portion of the returns on the Asset if the Assets performs at 4.50% p.a. As the customer takes the risk on the Asset, under Investment Account they will also take the rewards associated to such risks. So Banks would not earn as much as it could if they had funded the portfolio themselves.

product-concept-investment-account-v4

But is it true that the Bank lets go their earnings?

If we recall earlier that to maintain a deposit portfolio, there are certain costs associated to it. Firstly, the “negative carry” costs itself have been removed (often referred as cost of capital), and so will the SRR costs as this deposit is now funded by customers. Liquidity premium costs can also be removed, and if the Bank structures their deposit products tenures right, they are also able to gain benefits from the LCR (and reduce the need to maintain a large amount of HQLA where opportunity costs is a factor). From Bank to Bank, there could also be other costs of maintaining the Balance Sheet (including costs for the Asset portfolio itself), which becomes additional savings to the Bank. And lastly, there will also be savings on the deposit insurance at PIDM as the Investment Account is not covered by them.

Therefore, although it is seen as “surrendering Bank’s income” to the customer (who has effectively taken over the Assets as they are the ones funding it) in scenarios where Assets are performing well, in reality the Bank still benefits as a lot of the costs of maintaining the deposits have been recouped as “savings”. The net result of an “Investment Account” portfolio could very well be better than maintaining a pure “Deposit Account” portfolio. Effectively, the Bank has sold off a portion of their Assets to the customers (as investors) thus shrinking the Bank’s Balance Sheet (impact : improved capital efficiency) and the customer now takes over the risks of the returns on the Assets sold to them. The Bank’s Market Risk on the Asset is now moved to customers, and the Profit Rate Risk is now borne by the customer.

Solutions from Investment Accounts

Investment Accounts provides a real solution to the long-standing issue of Negative Carry if it is structured well. It releases the pressure on Banks to raise deposits to support financing. In Investment Account, the customer comes in to jointly “fund” the financing portfolio. Instead of the Bank carrying all the “Market Risks” and “Profit Rate Risks”; these risk are shared with the customers as partners. This is the true element of Profit and Loss Sharing often propagated in Islamic Banking idealists and championed by BNM.

The solution is already here. Use it!

Posted in Bank Negara Malaysia, Commodity Murabaha, Investment Account, Islamic Banking, Mudharabah, Musyaraka, Tawarruq, Wakala Fi Istihmar | Tagged Fixed Deposit, Interest RAte Risk, Investment Account, Market Risk, Negative Carry, Rate of Return | Leave a reply

The Investment Account

Posted on June 30, 2015 by Amir Alfatakh
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Investment Account Notice

Link to Standard Chartered Saadiq Announcement on Investment Account

It has been a busy 2 months for me and my team in launching the Investment Account to replace the out-going Mudharabah Current Account and Savings Account. No longer are these accounts classified as “Deposits”; as at 1 July 2015, they are officially re-born as “Investment Accounts”.

What does being re-born as Investment Account means?

  1. The customers relationship with the Bank is re-iterated as “Fund Provider and Entrepreneur”. The relationship of Mudharabah has always been the same either before or after 30 June 2015. But now we re-emphasize this fact again.
  2. We also re-emphasize that “Investments” should behalf as its namesake. Investment carries risks, and we outline the risks in our Product Disclosure Sheets, on the possible risks and returns to customer investments. There is a potential for the customer to earn more if the investment performs above expectation. But the opposite may also happen during a crisis, putting customers cash at risk. To that extent, the Investment Account would take on the feature of a pure investment, with its risk and return trade-off
  3. By reclassification of the Current Account / Savings Account into the “Investment” definition, PIDM no longer can cover the products (since PIDM stands for Perbadanan Insurans Deposit Malaysia).
  4. Customers now will need to be risk-rated for going into Investment Account. Customers will be asked questions to determine the risk-tolerance level and whether the product will be suitable for them. The current reincarnation of the Mudharabah product carries very little risks, so it is most likely almost all customers will qualify for the Investment Account.
  5. Customers will have more information about the use and deployment of their funds as Banks are required to be transparent to the customers. Customers will know where their money is being invested into, the potential risks and returns and hopefully with the availability of all disclosures and information on the investment, will be equiped to make a decision to go into investments.
  6. Banks will be more involved in managing the customers’ funds as Banks need to manage the assets that is allocated to the investment pool from which the actual returns will be paid to the customer. In the near future, we foresee that the function in the Bank involves active management of the investment pool, much like what a fund manager would have to do on a daily basis.
  7. For customers who was unsure of the Investment Account and its impact to them, they would not have opted into the Investment Account; instead they are converted into a less riskier “guaranteed principle” contract of Wadiah. Wadiah is a “Safe custody” contract which guarantees the return of principal on demand, but offers nothing else. Any returns paid will be as a gift (“Hibah”) and such Hibah is purely discretionary (not obligatory).
  8. My advice : For customers whom have been converted into Wadiah arising from the Mudharabah migration exercise, do visit your Banks and ask to explore Investment Account, as essentially the accounts remains tightly managed by the Bank to generate the desired returns.

We are all excited to take this contract forward and see its response. We note the feedback from customers on Investment Account and it will be a challenge for us as the market slowly wakes up to this new understanding. It could take years of educating the public on Investment Accounts, and it will be a while until we ourselves reach peak efficiency in understanding its dynamics.

I am sure my other colleagues from the various Banks are also basking in the struggles and achievements of launching the Investment Account. It was a team effort to have the product on-board and we can only get better from now on. The market will warm up to the idea sooner rather than later as all the Banks try to meet what is expected of the under the IFSA.

In the meanwhile, I attach an entertaining clip from my good friends from Maybank Islamic, whom also launched their version of the Investment Account. Hopefully the Colourful Maybank Investment Account clip (You Tube) will serve as a good introduction to all.

Posted in IFSA, Investment Account, Mudharabah | Tagged AmIslamic Bank; Islamic Current Account, Bank Islam, Investment Account, Islamic Savings Account, KFH, Maybank Islamic, Mudharabah, Standard Chartered Saadiq | Leave a reply

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