Risk Management in Islamic Banking

Posted on June 1, 2018 by Amir Alfatakh

IS THERE SUCH A THING AS ISLAMIC RISK MANAGEMENT?

I had this conversation recently until the wee hours of morning, and although I never thought a lot about it, I have come to the conclusion that there cannot be an exact replica of the Risk Management in the conventional sense.

Risk Management is a tool used by all conventional banking institution in the name of good governance, risk mitigation and prudent practice. It looks at financial exposures and its inherent risks to the business, and deeply believe in the risk-rewards pay-off within the generally accepted risk appetite of the organisation. It focuses a lot on control processes, performance monitoring, collateral value, and decision making policies for credit, market and systemic risks.

To a large extend, the risk management framework employed by the conventional banking businesses can be easily adapted by Islamic Banking counterparts. The components are the same, and there is little argument on its applicability under Shariah law. However, the risk management framework for Islamic Banking institutions must be inherently different as well, or maybe extended to include a bigger scope. It cannot just be seen as a replica of the conventional business; the foundation of Islamic Banking is definitely different.

There are a few divergence in the reason an Islamic Banking institutions should (ideally) follow. This is an on-going argument on the fact while Islamic Banking claims to be a different business model, but it is still engineered by the rules of a conventional organisation. But what are these divergent reasons for setting up an Islamic Banking business?

The lending of money to make money is forbidden.

This may seem like a trivial thing for Islamic Banking as many will say there is no difference between profit and interest. But for us practitioners, there is a big difference in its concept. Because of this difference, the way we think about how a product can be structured is paramount. Underlying contracts, assets, ownerships and roles and responsibilities becomes different from a tranditional / conventional bank (whom are essentially a money lender). To validate a transaction, all tenets and requirements in an Islamic contracts must be met or else it becomes an invalid transaction and any gains from it must be given to charity. Any gains obtained without fulfilling the transactional can be deemed as usury (riba’).

There are specific Shariah requirements that takes Islamic Banking beyond banking.

Some terms are pretty alien to traditional banks, such as commodity purchase, operating lease and rentals, sequencing and ownerships. This is where the divergent begins, because Islamic Banks espouses the concept of “trading” and “entrepreneurship” and “partnership” and “service provider”, away from the “lender-borrower” arrangement. Traditional banks struggle to understand issues of ownership of assets, risk and loss sharing, purchases of commodity and rental of assets. These activities are beyond traditional banking, and may become an operational risk issue if it is not fully embraced.

Islamic Banking should be more closer to a venture-capitalist, crowd-funding model than traditional banking.

The fundamental requirements for earning a profit (and to a bigger extent, how much we can earn from a transaction) is the element of risk sharing, which mean both customer and financier takes some form of the risks of the venture. At the same time, such “risky” venture is mitigated by way of ensuring it is not overstretched i.e. the transactions must be either asset-backed (including the presence of collaterals) or asset-based (evidenced by real trading or assets or commodities) to reflect economic activity.

The amount of risk taken under an Islamic contract can be higher (for contracts such as Mudharabah or Musyaraka financing) but it must be reflective of the economic reality and available assets.

The risk assessment of an Islamic contract must then be enhanced to behave similarly to what a venture capitalist can accept. There will be direct risks on equity, investments and returns. There will be corresponding returns as well. But such concepts will be difficult to digest if the bank is set up based on traditional banking fundamentals, which caters for a totally different profile of stakeholders.

As far as possible, the Shariah committee draws a line for transparency, fairness, and justice.

Islamic Banking should be an extended but integral part of economics. Islamic Banking is supposed to be more than a bank. It shoulders a broader responsibility to the people by looking at needs and providing products that serve a purpose. The idea of responsible financing, transparency and customer service should be the by-word of an Islamic Bank. The payment of Zakat (tithe) on profits which goes back into the community recognises the financial role that it needs to play. Corporate Social Responsibilities also play a role.

In this repect, the Shariah committee plays an important role as gatekeepers to the products and services on offer. Because of the unfamiliar territory of Islamic products, Shariah insists that transparency is critical to avoid uncertainty (gharar), the terms to the products are fair and the banks are ethical in its conduct to ensure justice. Fees and charges must reflect actual costs. Efforts are made to help a customer in distress. And conduct of the bank must comply with the requirements of Shariah.

SO, BASED ON THE ABOVE, WHAT ARE THE OF RISKS FACED BY ISLAMIC BANKS?

As a general rule, all risks faced by a conventional Bank must be “transferable” i.e the nature of the financial transaction must, as far as possible, allow for the TRANSFER OF RISKS. Wherever the opportunity arises, the Bank must be able to quickly pass the risk of the asset or valuation to the customer. Such understanding is also apparent in Islamic Banks. Looking at most Islamic Banking contracts, their structure allows for the transfer of risks, which follows the transfers of ownership, responsibilities and obligations from one party to the other. Contracts such as Murabahah, Musawamah and Qard works by transferring the ownership, responsibilities and obligation from the Bank to the Customer.

Alternatively, mostly exclusive to Islamic Banks, are structures that allows for SHARING OF RISKS. The structure is more “participative” in nature, where there are benchmark by which determines the level of risks a party should have. The regular types of contracts that continues to share risks are Mudarabah, Musyarakah and Ijarah.

COMMON RISKS

As mentioned before, the risks faced by a conventional bank and Islamic Bank should be very much the same, except for risks arising to the execution of Islamic contracts or pronouncement of the Shariah. While there will be common elements of risks for both types of Banks, the importance of Shariah ruling and decisions result in Islamic Banking becoming so unique. The following are the Risks commonly faced by Islamic Banks:

GENERAL RISKS – Risks existing in both conventional and Islamic banks.

Credit Risks – Arises due to counterparty risks (possibility of default by the party taking financing) where the counterparty fails to meet its obligations, in terms of payment, uncertainty of industry, change of direction or diminished collateral value. This lead to settlement risks which means the Asset quality has diminished.
Market Risks / Interest Rate Risks – More macro in terms of effect on the risks. It relies on the performance of the market as well as the quality of the financial instruments (price, performance, valuation, demand, yields and inability to reprice. It leads to exposure to interest rate risks, where the risk of the bank increases with movements in the rates.
Liquidity Risks – Refers to the risk of inability to return cash to investors or stakeholder in stressed scenarios, resulting in forced borrowings from the market (usually at higher price) coupled with the possibility of not able to dispose assets. This may lead to valuation risks.
Operational Risks – Due to inadequate control of internal processes and operational practices, the risks may result in real loss of income and potentially reputation. Human errors may be difficult to unwind especially if there is financial implications. There may also be legal risks as it may be considered a breach in contract by the bank.

ISLAMIC SPECIFIC RISKS – Risks arising from operational and processing function

Transactional risks – Especially under Islamic Banking structures, transactions play an important role as part of the Aqad, where required. For example, the sequencing of a Murabahah transaction. Failure to ensure compliance to the Aqad requirements will lead to potential invalid transaction and loss of income (or flow to charity).
Valuation Risks – Due to the nature of some Islamic Banking contracts, especially equity based structures, there will be challenges in valuation of the portfolio. Reduction in valuation will result in real losses for the investors.
Displaced Commercial Risks – Displaced Commercial Risk (DCR) refer to the risk of mismatch between the fixed/contracted obligation to the depositors vs the uncertain returns on the financing (income) which may result in the income is insufficient to meet the obligations to the depositors. For example, the commitment for Islamic Fixed Deposit is 4% (contractual) but the Financing portfolio into which the Fixed Deposits is deployed into only earns 3% (actual returns). Therefore, the 1% shortage is the DCR where the Bank will have to flow 1% of income from other portfolio to meet the deposit obligation of 4%.

SHARIAH RISKS – Risks arising to non-compliance of Shariah decisions and Shariah instructions.

Shariah Compliance Risks – The operation of an Islamic Bank is hugely dependent on the requirements of the Shariah Committee and approvals obtain on the process and procedure. Inability to comply with Shariah requirements puts the operations of the Islamic bank at risk as the department may be regarded as non-Shariah compliant business.
Fiduciary / Ownership Risks – Some of the structures under Islamic contract requires the bank to operate outside the scope of a financial intermediary. It requires the bank to hold property or trade commodities or own and lease assets, with various contracts using various roles and responsibilities. The risk of multiple roles and function must be clearly defined and implemented.
Regulatory / Reputational Risks – Changes in regulations requires quick adaptation to ensure compliance to regulation and maintaining the banking reputation intact.?

SO HOW DO YOU MANAGE ISLAMIC RISKS AND SHARIAH RISKS

As mentioned, Islamic management of risks should not be any different for the base of conventional bank’s methodology of measuring risks. There must be deep understanding of the products and structure for the bank to be able to assess the risks associated. To manage an Islamic Bank and its risks, the bank must first identify each of the risks and form safeguards to settle the above. Then only an Islamic bank can formulate suitable controls to ensure the Shariah specific processes and Shariah pronouncements are being monitored and implemented with sufficient support (internal or external). Wallahualam.

Connecting the Dots : Islamic Fintech

Posted on December 31, 2017 by Amir Alfatakh

REVOLUTION OR EVOLUTION?

This posting is in the danger of being written too long, but I think it is necessary to close this year with this topic, simply because it looks at the future. The word “Islamic Fintech” has been buzzing for quite some time now and there have been pockets of excitement on what it should mean. Many financial institutions have jumped onto the bandwagon declaring they are also part of this new wave of what a bank could offer.

While all these are still early stages of development, I do notice a lot of effort is built into “digitalisation” and “apps-based application” and “efficiently and convenience” of EXISTING banking processes and relationships. These enhancements are still driven by financial institutions and centred around improving traditional processes for banking services, or short-circuiting the credit processing elements of financing. Although enhancements via technology is an important aspect, these should not be defined as “fintech”. There is an element of fintech in process improvements, but PROCESS IMPROVEMENT itself are not fintech.

DO PEOPLE NEED BANKS?

Traditionally, banks always hold the impression that “People need Banks, one way or another”. It is this understanding that the bank can continue investing into their brick and mortar business model, with customers always coming to them when they need capital, financing funds or products and services. The competition is that who can deliver existing products in the most efficient manner, with technology as the enabler. Money is spent to improve accessibility to the bank’s EXISTING products, services and proposition.

In improving processes, banks just needs to concentrate on all the products and services offered and build the corresponding infrastructure to ensure efficient delivery with technology. It can be “Apps-driven” based on inquiry or transaction-based, with new features attached to existing products. It is just creation of new delivery channels which will deliver existing products to customers faster than before.

But that in my view is NOT what fintech is all about.

IF FINTECH IS NOT PROCESS IMPROVEMENTS THEN WHAT IS IT?

The easiest google/cut/paste definition of Fintech is that “fintech is a new financial industry that applies technology to improve financial activities“ and “FinTech is the new applications, processes, products, or business models in the financial services industry, composed of one or more complementary financial services and provided as an end-to-end process via the Internet”. The key words I believe are:

New Financial Industry
New Application
New Processes
New Products
New Business Model

While “Process Enhancement” can help support the “New Processes” element, but I think it falls short of the idea for fintech i.e to re-think the business model of financial services. The idea of fintech should be this: Understanding what the requirements of the Gen Y customers are and how they work, develop the products and services on platforms that they are most familiar with, and the proposition that the bank can offer on their chosen platform. It is a total re-think of delivering products and propositions to the up-coming Gen Y potential customers.

SHARING OF FINANCIAL WALLET

As much as banks and financial institutions like to believe the financial wallet cannot exist outside the regulated financial system, the evidence is slowly being presented as otherwise. Companies are finding ways to survive, live and thrive outside the banking system with facilities and opportunities in the New Economy, slowly eroding the traditional banks’ share of financial wallet.

Big Data companies have proven that their database is far more powerful (and valuable) than the database an individual bank would have on its existing customers. Bitcoin and other cryptocurrencies goes through thousands of transactions within blockchain and is only realised into banks network when actual physical cash is needed. eWallet lets value resides in tech platforms for purchasing and sales of goods and services (more like barter or exchange of goods and services), and up to a certain extent provides microfinancing. Prepaid and loaded value arrangement provides free seed funding and capital for businesses, without the cost of borrowing incurred via banks. Peer to Peer (P2P) arrangement links crowdfund Investors to Entrepreneur without complicated documentation with speed and transparency levels never seen before. Sharing of risks and profits (including potential pay-offs) are now more understood as compared to traditional financing arrangements. Mudharabah, Musyarakah, and Ijarah may now have a place in an economy where equity participation is expected and sought after.

“FINANCIAL SOLUTIONS” ARE JUST A SINGLE ELEMENT IN THE UNIVERSE

Technology can now provide a single-point possibility of all our needs; goods, services, food, shopping, bills payment, money transfers, investments, borrowing, deliveries, medical, transport, social interaction, travel, holidays, education, careers development, information and even branding. Financial services can be integrated into all these elements, now driven via apps. But for this new infrastructure, the various “relationships” are needed to be identified and re-looked and re-engineered. With the proper Shariah compliance consideration.

This “single point” proposition is where tech companies play a crucial part. Rethinking the financial model must happen with the involvement of tech companies due to the advantage of everything being on the internet (internet of things). There are still a lot of limitations to what a bank can do, understandably due to financial regulations. The space of where banks are continuously competing (or evolving) is the “FINANCIAL SOLUTIONS” box above, and maybe payment gateways linked to service providers. But tech-companies? The revolution of technologies move so quickly that regulations will continue to struggle to catch up.

In the diagram above, I attempt to identify some of the areas of traditional banking where fintech can come in and provide a like-for-like solution or even fully replace the proposition by traditional banks. Certainly a lot of the consumer touch-points can be easily replicated in a technology platform, and crowdfunding and crowdsourcing can replace traditional financing and working capital requirements as well. Some services are still embedded into a banking structure (such as Current Accounts or Treasury product propositions) but over time, such products may be linked to fintech and the banks may eventually become ancillary service providers rather than main bank, earning just fees for services provided.

The landscape of what a bank offers will ultimately change in the next few years, when consumers no longer go to banks for financing, services, remittance and settlement of business transactions. As the new generation grows up with tech and becomes financially affluent, their expectation of how a banking experience should be will also dictate the model a bank adopts.

CONNECTING THE DOTS

So where do I see the banking industry in the next 5 years? Personally, I think a “price-comparison platform” will emerge, as seen nowadays in the travel/hotel/tourism industry. Information from all the financial service providers are flowed into a single platform, and consumers are able to immediately compare products, services and prices on a single platform and choose their solutions. Instead of customers subscribing to multiple banks offering different products and services (at different pricing), they only need to subscribe to a single platform where all information on the products are available to select. This is where the promise of fintech can thrive; accuracy of information, convenience of access, and speed of transaction.

It is a matter of time the various industries converge. We may think regulatory pressure will halt some of the progress but mostly it have been reactive regulations. And the challenge is that these developments are driven by tech companies which has no loyalties to banking regulations as their scope of business cuts across various industries. It will be a period of “non-regulated” until the market starts to recognise the need to regulate and managing the risks. A regulatory sandbox will be usefull, but if the “New Economy” moves faster than the speed where regulations are being formalised, there will be a lot of speculative and arbitrage opportunities for the market to gain.

This also means the New Economy brings new risks that the consumers are not aware off. While the banks have been fine-tuning its risks that it takes over the past half-century or so, the fintech companies may not see the elements of risks other than technology risks or systemic risks. Almost all the risks faced by banks are also prevalent in fintech companies or non-banks, plus the specific risks by fintech companies. They might be great at integration of technology, but banks are still masters when it comes to understanding financial risks.

WHAT NEEDS TO BE DONE?

As I mentioned, banks understand risks better than a tech company. A tech company understand speed, efficiency and channels better than any banks can have. At the moment, banks are developing “fintech” on their own which is mostly a process improvement project. Tech companies are developing “banking services” on their own as well, where it linked investor’s money and economic entrepreneurs via technology. The question is really, “why not a bank consume or enter into a partnership with tech companies to provide a solution beyond traditional banking?” We have started to see this trend where banks attempt to purchase outright a tech company and use the company as an incubator for new products and services. It should look into having a different operating structure which encourages new ideas, innovation, internet-based solutions, as well as delivering to a larger segment of consumers (including the Unbanked segment).

The end-result might not look like what we recognise as banks we see today. This could be a separate line of business for banks, where the element of technology integrated into the wider economy is more dominant than its traditional banking products and services. You could have Bank A offering the traditional products and services, and Bank A-Tech offering fintech solutions to a new generation. The same bank catering to 2 business lines, employing different delivery channels.

But breaking away from such traditional infrastructure may take time, and the greatest fear is that the market cannot wait. Fintech companies may be able to offer similar proposition in half the time required, and this will not motivate fintech companies to join-venture with a financial institution. In an environment where new opportunities arise at the blink of an eye and regulations have yet to be formalised, the temptation to go on its own will drive innovation by the fintech companies, leaving behind banks. Fintech companies have the capability to look at consumer needs and develop the solutions from the bottom, and flow the linkages to the top. Connect the dots where the solutions provider are linked together in a platform.

Will fintech companies be the next driver in providing financial solution? I know my answer to that question. It is perhaps just a matter of time where future banking is done outside of a bank. Perhaps the model of banking needs to be re-imagined.

Wishing all my readers a Happy New Year in 2018. I appreciate the support I have received so far. But the new world beckons and hopefully we can do enough to ensure the continuation of the banking industry. I hope Islamic Banking can play a bigger role in taking the industry into this exciting online generation.

The Unbanked

Posted on November 30, 2017 by Amir Alfatakh

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:

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?
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?
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:

Creation of relationships without transactions or track records
Reduced Costs of doing business i.e. cheaper transactional costs
Speed and mobility
Less regulatory requirements (which could be a bad thing…)
Ease of Cross Border transactions
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”:

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.
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
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.

Musharakah Financing

Posted on July 3, 2017 by Amir Alfatakh

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.

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.

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).

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).

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.

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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.

Sometime In The Near Future

Posted on April 28, 2015 by Amir Alfatakh

Imagine this conversation at a local bank near you. Customer walks into the Bank, with RM20,000 to open a new account. He walks up to the Relationship Manager (RM) that’s typing away at his keyboard. He looks very busy.

Customer : Good morning

RM : Good morning sir, please have a seat.

Customer : Thank you. I want to open an account. I want to deposit RM20,000 but I want the flexibility to withdraw my money anytime. It’s for my day to day use.

RM : Do you want to earn a return on your deposit?

Customer : Yes I do. I’m looking for at least 2.00% return on my deposit.

RM : Why don’t you open an Investment Account with us. It’s new and we can potentially pay more more that your expected 2.00%. Of course it depends on the performance of the market. There is always a risk because it is an investment.

Customer : You mean, there is a risk I won’t get any returns?

RM : Sir because it is an investment product based on profit/loss sharing, there could be a risk that the returns can also be lower, or there is a loss, by which your principal amount will be affected.

Customer : You mean I could lose my initial deposit? Isn’t it covered by PIDM?

RM : No PIDM generally does not cover loss of returns. PIDM covers your principal amount if the Bank fails. Besides, they only cover a deposit product, not an Investment product.

Customer: What?? Do you have a product where my initial deposit is guaranteed?

RM: Yes we have a deposit product under protection by PIDM. It is not an investment product.

Customer: Great!!! As long as my principal is guaranteed. What is the returns that you are able to give? Will it be more than 2.0% per annum?

RM: I’m sorry sir. This product we cannot promise any returns up-front. We can only give a return based on our discretion as a gift.

Customer: Will I get this gift every month end?

RM: No I cannot promise you will get anything, and if you do, I cannot promise you can get it every month.

Customer: Can you give me an indicative rate?

RM: No I am sorry I cannot give anything in black and white

Customer: Have you paid some returns before?

RM: Yes we have, based on our discretion

Customer: Can I see the historical returns you have paid before? Just for my reference.

RM: No you can’t. We cannot show you what we have paid before.

Customer: Then how will I know if I can get any returns on my RM20,000?? What returns can I get?

RM: Sorry sir. It’s a secret.

It could happen here. How does one complete a decision without all the information to make that decision? Are we being too secretive? For deposits (or investments for that matter), it seems that the Bank have the ultimate control of the customer’s money and its return.

When the Banks have moved toward transparency and over-disclosure, Islamic Banking could be taking the other way for its deposits product; sole discretion and uncommitted returns, based on actual performance. Good and bad, but it will definitely produce more questions than answers, more confusion than clarity, and hopefully not, more conversion than growth.

We are only talking about opening Current Accounts and Savings Account options here.

The issue is not because I have an issue with complying with the Investment Account / Mudharabah guidelines or the proposed drafts for Wadiah, Qard and Hibah, more importantly I am imagining how a conversation would be like in an Islamic branch. It would not be so bad if it only a dedicated Islamic branch, but a shared branch where both Islamic and conventional operates side by side, the above conversation will be deemed ridiculous and a challenge to even seasoned bankers. In the era of deposit building, it seems Islamic Banks were given the same asks but with one hand (or both hands) tied behind their backs.

Exciting way forward. A serious shift is required in the way we think about Current Account and Savings Account.

Equity-based Financing vs Debt-based Financing

Posted on January 28, 2015 by Amir Alfatakh

Recently I have been asked again on why Islamic Banks still uses a lot of Debt-based Financing products, instead of moving to Equity-based Financing products, which on perception was supposed to be more “Islamic”.

Yes, ideally an equity-based financing do equate to a more “Islamic” structure, if your definition of being more “Islamic” is risk-sharing. Not all structures must be risk-sharing; transfer of risks are definitely acceptable in Islamic Banking circle. The idea is an age old idea; if you undertake a low-risk structure or there is no risks for the bank (where all risks are transferred to customers) then technically the bank should earn low returns for it. If the risks are higher i.e. Bank carries the risks, Banks would be entitled to higher returns. High risk equates to High returns.

TYPES OF RISKS 02

BUT IN REALITY, ARE COMMERCIAL BANKS SET UP LIKE THESE?

If an Islamic Bank operates in the same environment as a conventional Bank, it is difficult to imagine having two models running side by side I.e. the Islamic Banks operating an equity-based business and conventional Banks operating a debt-based business. The risk profile of these banks would be significantly different, and this affect many areas in banking; risk rating, cost of funding, profile as well as capital requirements. The bank with the perceived higher risk rating will ultimately become less competitive.

The real truth is that the shareholders of traditional banking set up expects the following: medium to high returns on their equity at the lowest risk and operating cost as possible. In short, their “investment” must record the best Return on Investment (ROI) as possible. Based on this view, debt-based financing can fill that criteria.

SO WHAT ARE DEBT-BASED FINANCING STRUCTURES?

Many have the perception that equity-based structures and debt-based structures are dependent on the types of contract employed by an Islamic Bank. To a certain extent, this may be true. Certain contracts by nature promotes the sharing of risks (which is equity financing) while others rely on the transfer of risks (which is debt financing). For example, a Musyaraka (partnership) structure is traditionally an equity financing structure, where the Bank and customer enters into a partnership arrangement with both parties giving capital into the venture. Risks on the venture is shared according to equity ratio, and so is the returns where it will also be shared. The risk factor is therefore elevated because there is a possibility of losses being shared between Bank and customer.

So, many Banks prefer the safer haven of Debt-based financing. How, then, do you change a Musyaraka structure into debt-based? Simply by providing a purchase undertaking, a document agreed and signed which states that should the venture go bust, then the customer agrees to undertake the purchase of the Bank’s remaining share in the venture thus making the amount to be immediately due by the customer. This is in a way, an indemnity given by the Customer to provide assurances during contractual breaches. By having a purchase undertaking document, the risks are effectively transferred to the customer in times of default. The Musyaraka therefore still works where profits are shared during the good times, but dissolves in spirit during bad times when purchase undertaking document takes effect.

The talk about having an equity-based financing is usually moot with the use of purchase undertaking document. The element of risks is removed for the Bank, and puts the product on par with its conventional banking product equivalent.

So will we ever see Equity-based financing?

I believe you need real political will for this. You need:

Shareholders who understand the risk nature of equity based contracts, the way venture capitalist understand venture capitalism. Risk and return are greatly considered but more importantly, the possibility of losses.
Bank with a risk appetite outlined for greater risk-taking. The risks to be understood and accepted. Then the venture in entered into with eyes open although it will take time for a Bank to understand the business risks they take under equity-based structures.
Customers willing to stomach the losses or share the spoils of profits. It will take even longer time for customers themselves to be able to accept the structures under equity-based. Customers must be able to understand that they are active partners in a venture, the responsibilities and also the sharing aspect of it; they don’t just share the losses with the Bank, but also the profits or gains with Banks as well and this can be above and beyond what they can traditionally accept.

To achieve this, it will take significant paradigm change for everyone when they have only the financing structures in mind. In actual fact, such structures are already common in the consumer psyche as there are similar structures when they deal in unit trusts, shares or other types of investments, where risks are taken. But to flip it into an “equity financing” concept will remain a challenge to Islamic Banks that are serious to offer something significantly “Islamic”.

The Mudharabah, The Deposits and The Investment Accounts

Posted on January 2, 2015 by Amir Alfatakh

Investment Account 2015

2015 promises to be an interesting year as the IFSA 2013 comes into effect for Malaysian Banks. We will finally see that shift in the industry as the 30 June 2015 deadline approaches where Banks will draw the line in the sand, separating their Current Account / Savings Account portfolio into the following:

Banks that will migrate their Mudharaba deposit account into either a Wadiah deposit account or Qardh account
Banks that will convert their Mudharaba deposit account into Mudharaba Investment Account
Banks that will introduce a totally new structure to the Mudharaba deposit customers, such as Tawarruq deposit or something fantastical.

The push by Bank Negara Malaysia (BNM) is really quite clear; Mudharaba as the flagship product that introduces the customers to the world of risk-taking and therefore, potentially higher returns. And if the Mudharaba is to be classified as an Investment Account, then it should behave as one.

But in all honesty, Mudharaba has always been an “investment or entrepreneurial” contract. Worldwide, the concept of Mudharaba means; take customers funds and enter into an investment and share the profits (if any) and should there be a loss, the customer will take that capital losses. This definition does not change, post-June 2015 when the IFSA for deposit comes into effect.

What has changed is that Mudharaba will now be classified as Investments, instead of investments that behaves like a Deposit. There is no fundamental difference between the “now” Mudharaba and “future” Mudharaba. The clause where the capital investment of the Mudharaba is open to potential losses has always been there. The terms and condition contains this. But due to the classification of Mudharaba as Investments post-June 2015, the treatment on how a Mudharaba Investment is processes, managed and executed now changes.

Under a Mudharaba Deposits, the following happens:

Customer comes in as an Investor, and sees the historical returns on the deposits
Customer enters into a Mudharaba contract, which allows the Bank to manage the funds on a pooled basis on predetermined terms
Bank deposits the funds into a managed General Investment pool. Bank will manage the allocation into the financial assets according to Bank’s investment direction
At a determined period, or maturity, the Bank calculates and accrues the “distributable” profits to the customer
Bank distributed the profit to the customer, based on the individual Profit Sharing Ratio.

But what happens if the Mudharaba must now behave as an Investment? The process looks very similar to how you onboard a customer as an Investor in a more sophisticated product, such as Unit Trusts or Structured Investment products, or even equity shares on the stock exchange. Notice the types of product that the Mudharaba is now being aligned to; higher risks, specific investments, strategy allocation as well as potentially higher returns, depending on the prevailing market conditions,

So if Mudharaba Current Account or Savings Account is to be deemed as Investments, the following must happen:

Customer comes in as an Investor, and must come with their eyes wide open. They will see the historical returns on the investments. Customer will also be informed of where their Investments are being invested into and the risks and potential future rewards of the investment. Both for worse case and best case scenario of the investment. This includes the part where the risks to their capital must be clearly be made known to them.
Customer understands the risk and is evaluated via the Investment Suitability Assessment. A risk grading is assigned and the customer is presented by a list of Investment that their risk grading qualifies for.
Customer, with all the information available to him, makes his own decision to either enter into a Mudharaba Investment contract for the “right” Investment, decline it, or chose to undertake a higher risk profile Investment with the indemnity to the Bank.
Bank takes the customer on as an Investor, and invest the funds into the “specific” Investment Asset (This makes the Bank sound like it is now a Fund Management company!!!). The Bank now manages the funds as a Specific Investment pool. If re-allocation of asset in this pool is required, the Bank is to inform the investor of the change in the portfolio.
At a determined period, or maturity, the Bank calculates and accrues the “distributable” profit to the customer. If the Asset is an external investment, there will be a “market value” to be calculated (Mark-To-Market) and any early redemption may result in loss of capital/equity. In some cases, profit needs to be “realised” to be “distributable”.
Bank distributes the actual realised (or accrued) profit, if any, to the customer based on the individual Profit Sharing Ratio. The investment is either divested based on prevailing market value, or re-invested into a new tenure with new investment terms or parameters.

So you see, the Mudharaba now is defined closely into what a real investment is; capital not guaranteed, returns based on risks, and real valuation. Some will even carry redemption risks i.e. loss of capital if redeemed before maturity.

As a start, the Mudharaba Investment Account, migrated from a Mudharaba Current Account or Savings Account, will now carry their own risk profile, depending on the portfolio of the Investment Assets. It can now be categorised into:

Low Risk Investment Account – suitable for short term arrangement, with low returns instruments
Medium Risk Investment Account – suitable for a diversified portfolio
High Risk Investment Account – suitable for a targeted investment expecting high returns, and volatility

Therefore, even for a basic Current Account or Savings Account, once it is converted into an Investment Account, carries some degree of risks post-June 2015. For one, the PIDM cover will no longer include Investment-type of accounts, and while there are questions of its applicability in its current state, the comfort of such cover is now lost to the daily consumers. Having said that, ideally the Banks should reinforce the idea that with higher risk there should be higher returns. Living in the old thinking that Investment Accounts are the same as Deposits Account (Savings or Current Account) will only result in a disconnect to what BNM is trying to do.

The idea of Investment Account is not only limited to Mudharaba-type of contracts. Any contracts that carries an element of risks to the customer’s capital will be classified as Investments. The on-boarding treatment of customers into these contracts will be the same; The risks of the investment must be made known to the customer, customers must be assessed to identify the risk profile, customers must make their own decision on the risks that they are willing to take, and enter as a real investor taking real market risks. Such contracts will include Wakala Fi Isthihmar (Investment Agent) or Musyaraka (Partnership).

As a summary, what will happen in 2015 once your Mudharaba-type of account (Savings or Current Account) be converted into an Investment Account?

Yes some change will happen, and Banks will be looking to seek customers consent whether to allow the conversion into an Investment-type of account, with the additional disclosures and risk warning statements, or to convert the account into a deposit type of account. As I see it from the Bank’s perspective, the management of the funds in the account remains largely the same, with greater level of transparency needed in terms of where the customers funds are invested into (the Investment Assets), the management of returns and valuation of the assets on maturity or early redemption. Sounds complicated, but really it is not. It is business as usual for the Banks, with some additional reporting, management and compliance requirement to adhere to.

Personally, when the Mudharaba account migrates, I do not foresee a significant increase in risks to the customer capital (as it will still be managed similarly as before) and no significant increase (or decrease) in returns on their “investments”. If the Bank keeps the Investment Assets as “low risk”, there should not be any concerns to the average customers.

There will be other options available to the average investor, but the purpose of this post is to highlight to the existing “investors” that there is no panic button to be pressed. There will be a period of awareness building (reinforcement, more likely) on what “future” Mudharaba is all about, in the stricter understanding of its investment nature. But all this while, the Mudharaba structure is already being managed as an “Investment” via the General Investment pool.

The investment risks have always been there, but because the pool has been managed properly and successfully by Banks, it has become Urf’ (customary) to the customer to believe that capital is protected (when actually it should not). It really is not, as Mudharaba is always an Investment arrangement, and is reflected even in existing documentation and product terms & conditions. Now it may look like it is going to be a different animal in June 2015, however if you take a step back, it is actually an increase in disclosures to the customer on the product features; nothing more. Internal banking processes will be adjusted and enhanced to meet the additional disclosure requirements.

Investment Accounts may seems like a huge change, but it is actually a refinement of the contract requirements. It provides greater transparency to customers, and enhance their involvement in the product by understanding the risks undertaken. The definition of Investment Account has already been captured in organisations such as AAOIFI, where Investment Account and its treatment are defined. BNM is now taking steps in the same direction.

Investment Accounts may change the way you bank at the moment, but it really is a similar proposition to the Mudharaba Deposit account with eventually greater transparency and disclosure. We look forward to welcoming Investment Accounts into our midst of products available.

Goods and Services Tax on Islamic Products

Posted on April 7, 2014 by Amir Alfatakh

Goods Services Tax (GST) will be one of the hot topics for the years to come in Malaysia, when the GST finally comes into place in 2015 to replace the Services Tax. Many arguments have been made on both side of the political divide but the reality is that GST will be implemented and have a huge impact on how services and goods are being priced.

A quick look at the GST finds that Sharia compliant banking, while having all its contracts requiring underlying transactions, asset ownership and movement of actual goods, the impact that the GST may have on Islamic contract will remain similar to what impacts a conventional banking product. There is not expected to have a “worse-off” effect on Sharia compliant banking.

It is heartening to see that Customs has made an effort to understand the various Islamic banking contracts and how it works, and identify potential transactional points where a GST may be imposed. I find the attached document (GST Industry Guide – Islamic Banking (As at 1 November 2013)) extremely useful summary of the intended GST implementation on Sharia banking contracts.

10 particular contracts have been identified and the GST points are outlined accordingly.

Banking with Non-Islamic Banking Institutions

Posted on January 9, 2014 by Amir Alfatakh

I remember many years ago being in an interesting conversation with my Bank’s Sharia Advisor on the topic of accepting funds from an organisation which deals with non-sharia compliant activities. What was the view on taking funds you know were generated from doubtful sources. Whether it is reputationally acceptable to take in deposits from customers involved in gambling, usury and prohibited activities.

Some institutions were reluctant to take in these institutions as customers, even though they were huge, cash-rich corporations. The worry is on the perception that we Islamic bankers are supporting them via our activities, that they benefit from their patronage of our bank. Some even said that taking their “dirty” money and putting it into our pool of “clean” funds will result in co-mingling of the funds. The fact that we provide services to non-Sharia compliant institutions, bothered some quarters.

My advisor said it simply. Why not we take their funds? If you don’t take it, where would it then go? It will go back into the conventional system, generate more money, providing more funds to allow the conventional banks to loan the money to more customers. This will grow the conventional pool of funds, increase the loans portfolio in interest-lending and further strengthen a conventional banks profit. Islamic banks will then have to grow organically, fighting for the piece of pie that’s available against huge conventional banking giants.

Take the money. Invest in Islamic industry. Grow our books. Invest in Sharia-compliant manner. And provide good returns to the conventional depositors and investors. Change their mind by proving that Islamic banking is universal. That the model is viable. Innovative, competitive and fair. Provide the alternative for a feasible banking structure. Give da’wah and awareness on Islamic banking and its underlying principles. Prove we can co-exist side by side.

Probably one of the wisest things I have heard. Although not many will have the same sentiment to this. So it is ok to agree to disagree.
Investment by Conventional Banks
But what if it is the other way around? Can an Islamic Bank invest or place their deposits with a conventional banking counterpart, who deals in non-compliant activities? The answer is obviously a NO. Depositors funds, taken under a Sharia-compliant contract, should be used for sharia approved activities only. Morally, it is wrong to paint a picture that the Bank is Sharia-compliant but is actually a deposit collection arm of the Non-Sharia-compliant bank. It’s misleading and damaging to the Islamic bank to have this reputation.

Yet, is there a solution to this argument? What if we still deposit funds into a conventional bank, yet with a strict condition put on the use of these fund for Sharia compliant investments only? Will that be enough to allay the concerns? If it does, what is the relationship that will be between us and a conventional bank? Can we appoint a conventional bank as our “Wakeel” to execute Sharia compliant transactions?

Personally, I do have reservations on this. Conventional banks do not have any compulsion on the execution of a transaction whether Islamic or otherwise. They do not bother about its use or matters such as sequencing or ownership. Their law is civil law, and is dependent on the legal documentation. This, then, is merely passing of money to a conventional entity, when our depositors have trusted us to invest in Sharia compliant activities. Can we be assured that the monies passed over be used according to our requirements? How do we get this assurance?

What is your Bank doing? Can this be a possible model?

Readings : December Papers x 3

Posted on December 23, 2013 by Amir Alfatakh

And to close off the year, BNM gave us a further 3 reading gifts for us to enjoy our holidays:

The Murabahah Standards looks interesting, and so is the Mudarabah Concept Paper. Do have a read and tell us what you think.

Looking forward to the coming holidays.

Exposure Draft : Wadiah

Posted on December 20, 2013 by Amir Alfatakh

One of the panic buttons we are pressing now is the new Wadiah Exposure Draft (ED). As a rule, Wadiah is a “safe-keeping with guarantee” arrangement, where a Bank agrees to take on-board customers deposits as a loan (Qardh). And in the rules of loan under Islamic Banking, a loan must be returned on the same amount when required; any amount above and beyond the loan amount, if put as a condition at the start or during of the deposit placement, may be construed as “Riba”. If the Bank utilises the deposits for any business activities, the Bank is given the discretion to award “Hibah” or gift payments allocated based on the balance outstanding.

With the introduction of the IFSA and the requirements that Malaysian Banks comply with the Investment Account Framework if Mudarabah continued to be offered to Customers, the common wisdom is to migrate lock-stock-and-barrel into a Wadiah account. In my earlier writings, I already mentioned that to comply with the Investment Account Framework, a massive shift in thinking, processes, and management is required. Therefore to convert into a Wadiah structure may not be the ideal solution, but it will provide an “easier” route towards retaining Customers’ deposit.

However, in this chess game between the Islamic Banks and Bank Negara Malaysia (BNM), the new ED is introduced on Wadiah has effectively further tied the hands of the industry players. BNM had anticipated the industry intentions to move the Mudarabah structure into Wadiah, and promptly outlined further restrictions on Wadiah itself. The industry is now caught between a cold and hard place; stay with Mudarabah and comply with Investment Account Framework, or migrate into Wadiah and comply with the new Wadiah Guidelines.

As we know, Wadiah also puts significant limitation on the marketing of returns and benefits to customers for their deposits. BNM took this a step further; to emphasize that returns on a Wadiah account should always be discretionary, as Wadiah is now seen as a loan. The impact comes in several clauses in the Exposure Draft:

Wadiah Yad Dhammanh is considered similar in nature to Qard. Therefore the rules of Qardh should also apply to Wadiah.
A majority of customers should not be getting a return on the deposit under Qardh. Generally this is saying that out of 100 customers, only 49% of customer will be given a “gift” on their deposits
The payment of the discretionary “gift” should not be construed as regular or common business practice (Urf’ Tijari) else it will imply that the “gift” is a constant return to the customer. Historical performance can be shown to customers.
Any benefits, monetary or otherwise, deriving directly from the placement in the Wadiah account may be construed as “Riba” as well.
Any benefits includes scenarios where should the Wadiah account be opened as part of a financing facility, and benefits enjoyed in the financing facility from amounts available in the Wadiah account (for example a rebate structure to off-set an obligation), shall be construed as riba’ as well.

My main question is; now that Mudharabah is turned into a pure investment account, and Wadiah carrying so many restrictions, what other solutions are there? It cannot be that BNM only expects us to comply but do not help with a viable solution on these restrictions. Yes we are looking at the Commodity Murabahah structures, but operationally this will be a challenge for the Banks to control the cost of commodity trade.

And how do we define majority, then? The system must now be enhanced to determine who gets the discretionary “gifts” based on which formula. Even if they qualify for the discretionary “gifts”, to award them on a regular basis will also lead to it be construed as “Urf Tijari”, where consistent payment of Hibah will imply a similar future returns. How do we define this “non-majority” of Customers whom qualifies for Hibah but do not get regular awards of Hibah? What system logic can we build and will what we build be acceptable to Sharia? More importantly, would the customer even accept such “discretionary” practice?

Now that BNM has issued a new Concept Paper on Shariah Requirements, Optional Practices and Operational Requirements of Mudarabah today, we get a somewhat watered-down requirements to Mudarabah products. I have read it and saw that under this new Framework, the Mudarabah structure remains viable as it is, with enhancements needed for documentation and disclosures. Manageable and workable. The next steps must be; if we were to stick with Mudarabah, which Framework will take precedent. Mudarabah is an Investment structure. So, would we follow the Mudarabah Framework, or to comply with the Investment Account Framework? Both Frameworks makes reference to each other; yet one is stricter than the other.

I am putting all my hopes on the new Framework. That will give me some leeway of having both Wadiah structure and a viable Mudarabah structure (not based on the Investment Account Framework). This is definitely the light at the end of the tunnel. But as usual, indications are to take the “stricter” guidelines into account, rather than keeping hope for an easier implementation.

Back To Wadiah

Posted on September 9, 2013 by Amir Alfatakh

True to form, BNM have called for an urgent discussion with the industry players on the implementation of the IFSA. The message is very simple; industry players are given time to comply to the IFSA i.e. no later than 30 June 2015. During this time, we are asked to either:

Retain Mudharabah and Wakala structures to comply with the Investment Account guidelines; or
Move the Mudharabah and Wakala structures into an alternative structure.

Obviously no one has the answer to both options. Especially for Current Account and Savings Account now offered under Mudharabah. To retain a simple product such as Savings Account under Mudharabah, the Bank needs to comply with tedious risk profiling of customers and numerous disclaimers on investments. Customers will be confused by this arrangement, and we foresee many will stay away. Marketing wise, it is a nightmare. Operationally as well, if we were to comply with the investment disclosures. Gone will be the simple structures that customers are used to.

Bringing the Current Account and Savings Account into Commodity Murabahah structures is the most viable solution in Shariah’s perspective. However, operationally tedious, money required for system development, revised documentation and more importantly, building customer awareness and acceptance will be the main challenges for the industry to move to this alternative.

Committees were promptly set-up to discuss solutions, and as expected, there can be no commercial viability into moving to Commodity Murabahah, at least not in such a short period of time. For Time Deposits it is possible, but how to address the daily deposits and withdrawals of funds in a Current or Savings Account under Commodity Murabahah?

The easy solution; take a step backwards.

Wadiah is suddenly the solution. Most Banks has decided to migrate back into Wadiah structures, even with limited value proposition. Hang on, this is not the solution. Perhaps only workable for a short term stop-gap measure, but definitely not feasible for moving forward, especially when there is a conventional banking alternative.

Wadiah is definitely not the solution for deposit building. But then, what else is there? Until someone comes up with a brilliant solution, we will have to make the best of what Wadiah has to offer.

The Islamic Financial Services Act

Posted on April 17, 2013 by Amir Alfatakh

The Islamic Financial Services Act (IFSA) 2013 was introduced to streamline the Islamic Banking definitions and practices. With the introduction of this Act, we obtained clarity on many matters, but not all of it is in our favour. From the Act, we see a significant re-defining of the Deposit product. Needless to say, the Islamic Banking industry is at arms on this new definition.

IFSA DEF

But to classify it as a new definition is also not entirely accurate. We have been taking in Mudaraba-based deposits as our main method of accumulating deposits in the Bank. Mudaraba by nature is profit-sharing investment arrangement for the purpose of obtaining a return. Any profits arising from this investment will be shared amongst the entrepreneur and the capital provider based on agreed ratio; whereas for any losses, it will be borne by the capital provider, unless the entrepreneur is proven negligent. In all intent and purposes, this is an investment, rather than deposits.

However, while there is a risk to the investment, this is mitigated by way of investing in low risk intruments, profit equalisation or even gift (hibah) to ensure a customer’s capital is not lost. Technically an investment, but with indirectly guaranteed capital due to the above mechanisms. Furthermore, this is augmented with the deposit insurance offered by the Malaysian Deposit Insurance Corporation (PIDM) which insures the customer’s deposit with the Bank, should a Bank goes belly-up.

With such assurances, Banks have taken these Mudaraba placements as “Deposits”, categorised internally as part of the Core Deposits calculations i.e. low risk deposits. Why this is important is because if you have higher Core Deposits in your books, you can therefore fund a higher proportion of your financing portfolio, without adding more Shareholder’s capital. Technically, under the Loans to Deposit Ratio (L/D Ratio), the Bank can hold a bigger financing portfolio the higher the Core Deposit amount.

This is the desirable outcome. To collect higher “Core Deposits” via Savings Account, Current Account and General Investment Account (Term Deposits).

With the new IFSA, the Core Deposit definition is redefined.

If the return of the customers deposit (capital) can be guaranteed, this capital is classified as Deposits.
If the return of the customers deposit (capital) cannot be guaranteed, this capital is classified as Investments.

With this, the industry is turned on its head.

Obviously, a Mudaraba, or Wakala fi Istihmar (Agency for the purpose of Investment) will be classified as “non-Core Deposits”. The nature of Mudaraba is investment, and no matter what mechanism one puts into the product to “protect capital”, one cannot GUARANTEE capital due to the potential of loss. This risk sharing is one of the key tenets of a Mudaraba arrangement. By keeping to this tenet, Mudaraba should be classified in its rightful place i.e. Investment.

As mentioned, removing the deposits as reclassifying it into Investment has significant impact on the L/D Ratios.

But also, what’s worrying is that to keep Mudarabah (or Wakala), now defined as Investments, there is a separate Investment Account Guidelines which the Banks will have to comply with. Now that’s another story.

As an industry, we are faced with an option of either:

Building our Core Deposits via an alternative product which Guarantees the capital. We have the readily available Wadiah structure, which is similar to a Qard deposit structure where no benefits can be offered or promised to the customer for their deposits; or
Comply with the Investment Account Guidelines to keep with Mudaraba or Wakala Investment, but will not be able to include those amount into the Core Deposit calculations; or
Develop new deposit structures that will meet both the Deposit definitions and meet customer demands for returns on their deposits and savings. Unfortunately, the available structures in the market requires extensive capital and technological enhancement, while operationally not viable. The industry as a whole has so far not come up with any viable proposition. Research has been done but the disadvantages of such structures outweigh the benefits.

This re-classification, may on the onset, looks a simple thing. But the impact is huge. The risk of capital flight is significant, possibly flight into conventional banking if the consumers are not able to accept the risks of investments or the returns uncertainty of deposits. It will be interesting to see what the industry comes up with.

I remember following BNM briefing on the re-classification back in 2011, the boss has asked me to come up with a Term Deposit under the contract of Wadiah. He knows it is not feasible, but still he asked for it. It only reflects how desperate the time will become when the full significance of the Act is enforced on us.

Now that it is enforced, I wondered if the rope around my neck is long enough.

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