Deposit Paradigm Shift

Posted on November 16, 2016 by Amir Alfatakh

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.

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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).

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.

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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.

The Negative Carry Problem

Posted on November 3, 2016 by Amir Alfatakh

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.

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).

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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.

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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!

The Investment Account

Posted on June 30, 2015 by Amir Alfatakh

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?

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.
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
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).
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.
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.
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.
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).
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.

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Category Archives: Investment Account

Deposit Paradigm Shift

The Negative Carry Problem

The Investment Account