BNM has finally came out with a comprehensive guide on how Islamic Banks in Malaysia can charge late payments on default accounts. This is certainly good news for the Banks, as for the longest time, Islamic Banks have been abused by delinquent customers due to the low penalties for late payments. Historically, BNM has only approved a 1.0% p.a. compensation charge on arrears with the intention to cover actual costs of managing the non-performing account.
Comparatively, non-Islamic Banks have been charging the loan interest rates + the penalty rate of 1.0% for delinquent accounts. If the interest rate for the loan is 4.40%, non-Islamic Bank will therefore charge 5.40% p.a. on the arrears. Until recently, non-Islamic Banks is also charging this based on a compounded basis.
While on the onset we see that the new guidelines will aim to address this imbalance, a close assessment of the guidelines will show the Banks that the imbalance is still not fully addressed. What it alleviates is only the point of removing the abuse by the customers. If a non-Islamic Bank can charge a penalty fee of 5.40% p.a. on the arrears, Islamic Banks can also do so (technically).
The guidelines goes to say that the Islamic Banks can also do so, with certain conditions. A summary as follows:
- Banks are allowed to charge Late Payment Charges (LPC) up to the Average Financing Rate (AFR) of a portfolio. For example, the portfolio of an Islamic Mortgage has an AFR of 6.0% p.a., the Banks can therefore charge an LPC of up to 6.0%. This calculation of 6.0% must be submitted to BNM on a yearly basis for their review and approval.
- The LPC itself is split into 2 components i.e. Compensation (Ta’widh) and Penalty (Gharamah). Banks are allowed to charged either LPC i.e. Ta’widh + Gharamah, or just Compensation i.e. (Ta’widh).
- If the Bank chose only to charge Ta’widh (which is business as usual for most Banks anyway), the maximum rate chargeable is up to 1.0% of the arrears amount (non-compounding). This 1.0% charge may be recorded in the Bank’s books as “Revenue” to off-set the actual expenses incurred in managing the delinquent account. This 1.0% charge must also be review, justified and approved by the Bank’s internal Sharia committee members on a yearly basis.
- If the Bank chose to charge the LPC i.e. both Ta’widh and Gharamah, there is a specific treatment required for Gharamah. While Ta’widh’s treatment remains the same as above, Gharamah can only be taken for the penalising the delinquent customer but without benefiting the Bank. This means the Gharamah portion must be flowed into payments to Charity and must not go into the revenue books of any kind. The Bank must not derive any benefits from Gharamah, directly or indirectly, and this Charity amount must be managed under the oversight of the Sharia committee.
- As mentioned, the maximum that can be charged under LPC is up to the AFR rate. If the AFR is 6.0%, this means the Bank can recognise up to 1.0% of Ta’widh as its revenue, while the remaining 5.0% is to be taken as amounts for charity account.
- There is also a change in the compensation for off-tenure accounts i.e. accounts already expired or matured. For such accounts, BNM allows the usage of the daily Islamic Interbank Money Market (IIMM) rate for the LPC calculation on the Balance Outstanding. In this case, the whole amount can be recognised as Bank’s revenue.
I try to best as possible summary the above in the following diagram:
While this is a good measure to allow the Banks to charge compensation accordingly to minimise risk of default, it does not provide a level playing field for Islamic Banks as the compensation for non-Islamic Banks can be fully recognised as “revenue”. Because of this, Islamic Banks are reluctant to make the changes to their systems, processes and documentation (which will incur development costs and valuable man-hours) to accomodate Gharamah where no revenue can be recognised. To spend money to develop a feature that gives back no returns to the shareholders would not make any economic sense. As such, the leniency afforded by the LPC Guidelines is just on paper.
Nonetheless, the intention of the guidelines is to deter and control delinquency. That may yet be motivation enough for some Banks to make this development.
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May I know if SAC latest released resolution will automatically supersede old version of resolution? Eg 2012 Resolution on Tawidh will supersede 1998 resolution on Tawidh? Also, Islamic Banks in Malaysia must follow.the latest version of resolution when deriving Tawidh calculation?
In general we will refer to the latest documents for compliance. If there is inconsistencies, the latest document prevails for new cases. As for existing cases, the new regulations may or may not be adopted by the bank. Generally, we allow the existing cases to follow the older regulations unless the newer regulations are more fair to the customers.
Mr Amir Alfatakh, thank you very much for your reply and explanation.
I still have doubts as below, I hope you can assist me.
1) BBA Islamic financing contract was signed in 2005, 8 years tenure and tawidh rate was 1 % in contract , client default in 2008, facility recalled by Bank in 2008, client made full settlement in mid 2012.
(a) may I know shall bank follow tawidh rate and computation as per Late Payment Charges guideline 1/1/2012 because client made full settlement in mid 2012? Or bank can follow 1998 SAC guidelines for tawidh rate?
(b) what was.the relationship between client & bank after facility recalled in 2008? Will the financier v client relation maintain until mid 2012?
(c) will the tarikh matang maintain until.end of 8 years ie 2013 Or right after 2008 after the facility recalled?
(d) in this situation, shall new version law supersedes older version?
Mr Amit Alfatakh, can I have your email? I am not sure if my reply and further questions went through because seen an error message just now. Thank you.
Hi, I am working for Govt.of Malaysia. Govt also give loan to several State govt, GLC and Statutory Bodies for specific social purposes. How does the Govt decide on late payment charges under Islamic terms?. Usually our term on profit rate is below the AFR and the Govt is not profit oriented. If the govt following the BNM instruction on 1% tawidh, the borrower will abuse the loan by investing on money markets and delaying the payment. Any suggestions. Thank you
Apologies for the late reply.
The intention of allowing the late payment charges by BNM must serve a couple of things ie #1 is to stop the customer from abusing the arrangement and #2 ensure that the bank do not suffer unnecessary losses (but not to earn additional profit).
Therefore you need to consider a balanced approach of deciding on a rate suitable to the customer so they will not abuse the system (if too low) and not be a big burden for them to make payment (if too high). I am not sure what you mean by “profit rate below AFR”, but the idea of AFR is that it is the “right” rate for your institution. The concept of AFR (Average Financing Rate) is not the same with BFR (Base Financing Rate). AFR looks at your own cost of funds + average margin that you charge, and therefore determined by your internal funding structure, whereas BFR is a market rate that is determined by BNM for the industry to use as a base rate. So, your AFR is really your own profit rate, which will consist of your cost of funds and your spread.
It is then ok to charge AFR for your purpose.
But I think there could be a mix up in your assumption.
The BNM guidelines states you can charge customers a rate on their installment based on the following options:
1) 1.0% ta’widh rate x Overdue Arrears ie Instalment. This 1.0% is to compensate for the bank’s actual costs of recovery efforts.
2) IIMM rate x Outstanding Balance for expired financing i.e. outside the tenure agreed from the Aqad. So if the Aqad is for 60 months, and after 60 months there is still Outstanding Balance, the Bank is not allowed to earn “additional profit outside the Aqad”. The bank can only collect a sum to offset borrowing costs (cost of funds), and the closest indication of cost of funds is the IIMM rate published by BNM (overnight borrowing rate). This is to compensate the cost of funds only, but not to earn additional margin or profit from the Outstanding Balance.
So, in events of default, the late payment chargeable is to compensated actual recovery costs (1.0%) and/or borrowing costs (IIMM Rate).This is to compensate the bank.
But how do we discourage delay in payments and abuse of the loan agreement?
BNM allows you to charge ANY rate to discourage the customer from abusing the deals. It could be 10% x amount in arrears or it could be 5% x amount in arrears. For Banks, to give a guide on what rate to decide, and be fair to consumers, the requirement states the maximum rate a bank charge to discourage abuse must be based on Average Financing Rate (AFR). Banks are asked to show BNM on the method of coming up with the AFR, and obtain BNM approval on the methodology and not be oppressive to consumers. Each Bank must submit their own calculation, and can differ from Bank to Bank.
But, if you decide to charge AFR to discourage abuse, the amount collected must be split into to categories ie:
1) Ta’widh (compensation) where this 1.0% or IIMM Rate is kept to compensate actual loss or cost of borrowing (without any profit spread), and
2) Gharamah (penalty) which is the difference between the AFR and the Ta’widh rate of 1.0% or IIMM Rate. This amount cannot be recognised as your income as it is an amount outside the agreed Aqad, so it must be given to charity. So if the AFR is 6.0% p.a. and the IIMM Rate is 3.12%, the 2.18% (i.e. 6.0% less 3.12% = 2.18%) must be given to charity as you cannot recognise it as an additional profit or spread.
Therefore in your case, the calculation should be consistent.
If your normal financing rate is 4.5% p.a. this could be your AFR benchmark. So…
1) If the account is normal: Your financing pricing (profit calculation) will be 4.5% pa x Principal Outstanding. Your installment will be RM1,000 (for example)
2) If the account is 30 days due or default: Your financing pricing profit will remain as 4.5% pa x Principal Outstanding. Your instalment of RM1,000 will now have a late payment charge of 0.83 sen (RM1,000 x 1% p.a. /12 months = RM0.83) which you keep as compensation; or if you want to use your financing rate of 4.50% as AFR, then you will charge the customer a rate of 4.50% x instalment i.e. RM3.75 (RM1,000 x 4.50% p.a. / 12 months = RM3.75). However, you can only keep RM0.83 as your compensation and the balance of RM2.92 (RM3.75 less RM0.83 = RM2.92) you will give to charity.
Therefore if you want stop the abuse, decide on an AFR to charge and charge it to your customers instalment, and any amount above the allowed 1.0% p.a. Ta’widh, pass it to charity. So, you stop the abuse with the high rate of default, and if they still default, collect the amount and pass the penalty amount (gharamah) to charity.
I am not sure if Govt intends to follow BNM guidelines to Bank, but I think it is a fair regulation to follow or be guided with. You can be consistent with the market and the guidelines.
Hope that helps. Apologies for the long-winded writing.
Hi Amir, thank you for your very informative blog. I have a question that is quite the opposite – how is advance (early) repayment accounted for in a Islamic home loan? As an example, assuming my current loan status is as below:
Outstanding Balance: $2,118,008
Outstanding Cost of Finance: $573,201
If I were to make an advance/early repayment of $10,000 how would this affect the balances above? Should the “Outstanding Cost of Finance” simply be reduced by a corresponding $10,000 (as would be the case in a conventional home loan)?
Thanks in advance, and keep up the good work!
Apologies for replying late
Generally, if you pay RM10,000 the amount would reduce both the Outstanding Balance and Outstanding Cost of Finance (Principal) by the same amount. The profit will be calculated based on the reduced principal for the following month. This is consistent with the conventional counterpart, if the bank is an Islamic subsidiary or windows.
But I have to caution you that there are some banks that practice otherwise, ie the RM10,000 DO NOT reduce the principal but stays as “Advance Payment”. Usually, if the conventional bank practice this calculation, the subsidiary will follow the same method. If the conventional parent REDUCE the principal, the islamic subsidiary will also follow suit. This is to ensure consistency.
Thanks for the question. Hope the answer helps
Hi Amir, thank you for taking the time to respond. Appreciate it.
In my case, what happened was the Outstanding Balance did reduce by RM10,000 but the Outstanding Cost of Finance remained unchanged!
I do have another conventional loan with the same bank where any early payment does reduce the principal, so this is a little strange. Perhaps time to pay the bank a visit 😉
Thanks again for your help…
I understand that gharamah is a type of penalty imposed where it will be channeled to charity. But my question is, when can gharamah be imposed to begin with? under what instances that it can be imposed upon customers?
Kindly enlighten me with this matter. Thank you
For many years, users of Islamic Banking products have been abusing the very institutions that offer them Islamic Banking products. In the early days, Islamic Banks do not charge late payments, but what happened is that consumers has taken advantage of this by NOT paying their installments on time. This is harmful to the bank as the bank obtains the funds from its mudarabah depositors. When the financing customers do not pay their financial obligations, the people who suffers are really the mudarabah depositors (Rab Ul Mal).
To stop the abuse by customers, BNM approved the charging of 1.0% Ta’widh on installment in arrears as representation of cost of recovery. But compared to conventional loans, 1.0% charge is still very low. Thus BNM allows the Islamic Banks to charge a high penalty rate to ensure the customers meet their obligations on time, every time. But only with the condition that the penalty (Gharamah) is collected and paid to charity.
So therefore, the thinking is that Islamic Banks can charge a maximum penalty to discipline the customer and stop abuse, but Islamic Banks are NOT allowed to do so if the reason to charge is to obtain the highest profit.
Hope that explains. Thanks
please what is the difference between the “compensation” and “penalty” charge.
Compensation usually refers to compensating actual cost that has been incurred, and recovered as a matter of fairness.Usually banks are allowed compensation to offset their operating cost and shall not be making a “profit”. The rate approved by BNM is up to 1.0% p.a. and shall only offset its expenses.
As for penalty, it is to stop customers from abusing their obligation to pay on time, but any amount collected as penalty shall be channeled to charity and cannot become part of the bank’s income or compensation.
Hope that clarifies
Can the customer then deduct the Late Payment Charge in computing the statutory business income for tax purposes? Previous years’ income tax filing, the company has been deducting the Financing’s profit but since the financing has matured middle of last year, the bank has been charging Late Payment Charge
Not sure I can advise you on that, but I think the treatment for such deduction should logically follow the same treatment for conventional late payment interest. Does the conventional Late Payment Interest get deducted for the calculation of the statutory business income? If yes, same treatment. This is my understanding based on logical practices, but I cannot confirm it.
Selam alejkum Amir. Please I have a question that seems basic maybe. The amount we calculate the penalty should be the principal in arrears only or installment in arrears as per conventional banks. Which is the purest form? Thank you
The guidelines split into 2 ie:
1) If the installment is still running ie within the Aqad tenure, the 1% is charged on the Installment amount
2) if the installment period is over ie outside the Aqad tenure, the amount outstanding (residual principal and overdue profits) is charged either 1% or IIMM Rates until full settlement.
Hope that helps
I have a question that may not be related to the above topic. I would like to ask about the current rate/percentage that Islamic Banks add to the late payment penalty clauses in Wakala Agreements. Thank you.
Currently the allowed compensation rate is 1.0% pa on the amount in arrears. In the Malaysian context I believe this is the case. But I am not sure about the Wakalah Agreement or how is it designed in a financing scenario. Perhaps a little bit more detail on how a Wakalah Agreement will operate, especially on the trigger for penalty?
Mr. Amir thank you for highlighting Islamic financing and making a lot of sense in this type of banking. I read somewhere that in Islamic finance there are two types of defaulters one who willingly don’t pay though he has the ability and the other who is unable to pay due to financial constraints. Do we treat the two differently?
Hi Roy, unfortunately its hard to differentiate the intentions of man. That’s one of the reasons that LPC is introduced, ie to stop the abuse. But if there are genuine cases where someone is unable to pay, they should come to the bank to discuss maybe a more favourable restructuring of the financing schedule.
Can the Islamic Bank use the Tadwidh income to offer another financing to their customers?
In general, the purpose of Ta’widh is to compensate actual costs. In theory, there should not be any excess for us to do anything else.
Internally, the cost of default should be more than 1% therefore we recovering up to 1%. Under the LPC guidelines, if your cost of default is less than 1%, you can only charge that amount lesser than 1%.
Hope that helps.
Salam En Amir,
Does the BNM LPC covers for foreign currency denominated facilities as well?
Says for e.g. usd financing.
Apologies for the late reply.
For your query, for foreign currency, it is not explicitly mentioned the currency but many banks have taken the same approach for late payment charges ie 1% on the arrears amount in foreign currency, with Shariah Committee endorsement.
As Salam Tuan Amir,
Seek your kind help on the inquiry for Ta’widh. In the event of customer request for redemption statement / early financing settlement notice, is it permissible if we project ta’widh amount that need be paid by customer up to the expiry date of the said notice/statement? Or we only can charge Ta’widh to customer up to date we issuing the redemption statement / early financing settlement notice? Usually we provide one (1) month validity period for said redemption/early financing statement.
Thank you in advance for your assistance on this inquiry.
Salam Redhawi, currently Ta’widh is implemented for a specific purpose which means compensation, which is dependant on an event happening. Strictly speaking you should not include Ta’widh into a early financing settlement notice, but nonetheless for convenience of customers, you can consider putting in the projected Tawidh into the statement, PROVIDED that there is also a clause that the amount will be refunded if the tawidh do not materialise due to further delays. I also advise that you obtain Shariah Committee guidance on the above as each committee will have differing opinion.
I am picking thoughts from the last post. Do we have any ruling on early settlement? What is the shariah stands on this.
There is no specific ruling on early settlement but the general consensus is that debt must be paid or settled, and therefore efforts to settle debts must always be encouraged. A lot of Shariah views mentions that debt settlement or early settlement must not be punished by imposing a fee or penalty, as this discourages the customer to settle their debt. Any charges relating to the settlement of debts must be justified or proven only if there is ACTUAL losses suffered by the bank resulting from the early settlement. If any charges on early settlement represent “additional income” for the bank, it is therefore not allowed. Therefore in Malaysia, all charges to be charged to customers must obtain Central Bank’s approval with sufficient justification.