Deposits : Term Deposits

Mudharaba is a favourite contract amongst Islamic Bankers. It allows for the notion of investments and profit sharing, while employing investment strategies that mitigates the risk to investments. It is being used for various types of deposit contracts; savings account, current account, term deposits and investment account. In Malaysia, Mudharaba-based products are classified as Investment Accounts (not Deposits) i.e. non-capital protected, returns based on profit and potentially loss-sharing.

Mudharaba v1

What is Mudharaba?

The contract of Mudharaba is a profit sharing joint-venture where the Investor (as Rab Ul Mal) offers to provide funds to the manager/Bank (as Mudharib) to manage the funds (Ras Ul Mal) in Shari’a compliant investments over a specific length of time.

All the funds for investment are collected in a pool of funds which will be used to invest in profitable ventures. Both the Rab Ul Mal and the Mudharib will agree to a Profit Sharing Ratio (PSR) prior to the start of the investment joint-venture. The profit shared between the Rab Ul Mal and the Mudharib shall be after deduction of management fees and any agreed Profit Equalisation Reserve (PER). Should the investment fail to generate an income or suffers a loss, the Rab Ul Mal shall have to bear the loss of the investment, except when the Mudharib is proven negligent or fraudulent.

AAOIFI’s verbatim Definition of Mudharaba

It is a partnership in profit between Capital and Work. It may be conducted between Investment Account Holders as Providers of Funds and the Islamic Bank as a Mudharib. The Islamic Bank announces its willingness to accept the funds of Investment Account Holders, the sharing of profits being as agreed between the two parties, and the losses being borne by the provider of funds except if they were due to misconduct, negligence or violation of the conditions agreed upon by the Islamic Bank. In the latter cases, such losses will be borne by the Islamic Bank. A Mudaraba contract may also be concluded between the Islamic Bank, as a provider of funds, on behalf of itself or on behalf of the Investment Account Holders, and business owners and other craftsmen, including farmers, traders, etc. Mudaraba differs from what is known as speculation which includes an element of gambling in buying and selling transactions.

Types of Investment Accounts

There are two types of Investment Accounts, namely:

  • General / Unrestricted Investment Account (Mudharaba Al Mutlaqah)

The Investor allows freedom for the Bank to undertake in any Shari’a-compliant investment as he seems fit and within the normal course of business. The funds will be deposited into a General Investment Account pool which will be used by the Bank to manage the funds so long as the investment is made in the best interest of the Investor.

With this type of account, the Investment Account Holder authorises the Islamic Bank to invest the account holder’s funds in a manner which the Islamic Bank deems appropriate without laying down any restrictions as to where, how and for what purpose the funds should be invested. Under this arrangement the Islamic Bank can commingle the Investment Account Holder’s funds with its own funds or with other funds that the Islamic Bank has the right to use (e.g. Current Accounts). The Investment Account Holders and the Islamic Bank generally participate in returns on the invested funds. (AAOIFI 2008)

  • Specific / Restricted Investment Account (Mudharaba Al Muqayyadah)

The Bank is given specific instructions by the Investor to invest in a particular Shariah-compliant business venture, where the funds will not be co-mingled in the general investment pool of funds. The funds will be deposited in a Specific Investment Account where the Bank will invest the funds into instruments identified by the Investor as instructed or outlined in an investment agreement.

With this type of account, the Investment Account Holder imposes certain restrictions as to where, how and for what purpose his funds are to be invested. Further, the Islamic Bank may be restricted from commingling its own funds with the restricted Investment Account funds for purposes of investment. In addition, there may be other restrictions which investment account holders may impose. For example, Investment Account Holders may require the Islamic Bank not to invest their funds in instalment sales transactions or without guarantor or collateral or require that the Islamic Bank itself carry out the investment rather than through a third party. (AAOIFI 2008)

The Investment Process

  1. The Bank, as Mudharib, has the responsibility to prudently invest the funds deposited into the investment pool in low / medium risk short-term investments to mitigate the investment risks.
  2. The Investor’s fund shall be invested in Shari’a compliant investment instruments such as the Islamic Money Market, Islamic Interbank Investments or other investments such as Sukuks. Alternatively, the funds can be used for Islamic financing of assets, when available.
  3. Investor specifies the amount and duration of the investment. Both the Investor and the Bank agrees on the PSR at the start of the investment period and may not be changed once the funds are invested.
  4. Upon maturity, the Bank will divest the funds and make the capital available to the Investor.
  5. The Bank will declare the profit (if any) for the investment at quarterly investment cycles. The profit to be distributed between the Bank and the Investor, calculated after deducting costs and expenses related to the investment based on the agreed PSR.

Utilisation of Funds

The funds for the investment pool will invested in selected Shari’a compliant investments with maturities of up to 1 year. The investor agrees to allow the Bank to manage the funds based on the Bank’s expertise and discretion.

Profit / Loss Recognition

Profit is recognised upon realisation of the investments at the end of each investment cycle and shall be paid to the Investor according to the terms of the individual Mudharaba contract.

In the event of loss to the Investor’s investment, the Bank may return a portion of the Profit Equalisation Reserve (PER) in order to stabilise the Investor’s overall returns or reduce the following month’s PER ratio.

PER-01

 

There is a general methodology to treating the losses for Investments, with the following steps to be met:

  1. The loss should first be deducted from any undistributable profits on the investment. This implies to PER.
  2. Any loss amount in excess of the above to be deducted from provisions for  investment losses. This implies the use of any allocated reserves.
  3. Any remaining amount after the above, is to be deducted from the respective equity shares held by the Islamic Bank and the Investment Account Holders, according to each party’s equity contribution. This implies compensation via Shareholders Funds.

For losses resulting from the Bank’s misconduct or negligence, the following method of compensation must be followed:

  1. The compensation to be deducted from the Bank’s Share of Profits. This means the Mudharib Fees may end up being zero.
  2. Any shortfall will be met by Shareholders Funds (equity).

Payment of Profit

The profit from the investment will be paid at the end of the investment cycle. The profit from the investment can be distributed based on the following scenario:

  1. Profit paid on the expiry of the investment contract. Profit and principal will be paid to investor if the expiry of the investment equals to the investment cycle.
  2. Profit paid after the expiry of the investment contract. On expiry of investment contract, the principal will be returned to the investor while the profit will only be paid once declared at the end of the investment cycle.
  3. Profit paid before the expiry of the investment contract. Usually applicable when there is interim payment of profit. For example, the investment contract is for a tenor of 1 year, and profit is declared and paid each quarter. The investor can choose to withdraw the profit each quarter and the principal plus final profit will be paid at the end of the investment cycle.

The Bank can choose to pay additional profits to a particular Investor segment but the additional amount must be deducted from the Bank’s own share of profit i.e. the Mudharib pool of profit. It must not diminish the pool of profits attributable to the Investors.

Partial Withdrawals by Investors

In cases where there is partial withdrawal of the principal, the Bank can provide a reduced rate of return on the amount withdrawn while the remaining portion will be entitled to the full rate of return upon maturity. The calculation of the partial withdrawal profit will be based on the formula for premature withdrawal as above. The total profit will only be payable at the end of the investment tenure. There will not be any profit payment made on partial withdrawal date.

 

 

 

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16 thoughts on “Deposits : Term Deposits

  1. Salaam Mr. Amir,

    I have questions pertaining to the profit calculation among depositor’s of Mudarabah Investment account

    1. When we use Monthly Average Daily balance for determining Depositor’s Rate of Return for each deposit category (Using Weighted method), does this imply that Profit accrual for each depositor will always happen at the month end and not on any between days of the month?

    2. If I want to accrue the depositor’s profit daily, does that mean I will have to use Daily product balance method. If yes, then how do I arrive at Depositor’s Rate of return?

    3. What is the formula we use to calculate each of the Depositor’s profit after we arrive on the Depositor’s rate of return?

    Thanking you!!

    Regards,
    Prashant Vishwakarma

    • Apologies Prashant, I must have missed this entry of yours.

      1. The usual method is daily accrual posted monthly, which gives the same effect as a Monthly Daily Average calculation. We accrued daily based on actual amount. End of the month, the accrued profit is posted.
      2. As we usually use daily accruals, the rate we used are most probably the previous month’s declared rate. So we accrue based on this. However at the end of the month, we will calculate the profit amount based on actual performance and declare the rate of return for the depositors. If the declared rate is higher than the rate used to accrue and paid at the end of the month, we make additional profit payment to customer. If the declared rate is lower, we should claw back (reverse) the amount already paid. Generally the rate declared is pretty close to the rate used for the accruals.
      3. As mentioned above, we calculate and declare the Depositor’s rate of return based on actual performance of the investment. We will then employ the declared rate to the profit sharing ratio of each customer. Under the new Investment Account guidelines, we are not allowed to manipulate or improve the returns to customer artificially; we have to flow actual returns. So if we have overpaid, we will clawback. If underpaid, we will make additional payments.

      Hope that helps.
      Amir

      • Dear Mr. Amir,

        Thanks a lot for the response. 🙂

        I understood it, but it will be very helpful if you can give an example to support your answers(which can help me understand perfectly), which you usually do..

        I am sorry to trouble you on this!

        Thanks,
        Prashant

  2. Salam Amir,

    i used to read your information blog with great enthusiasam.it is one of a kind in islamic banking domain.i really appreciate your efforts.it is such a great help for people like me who is in to product development for islamic banking.i am from india and ours is a startup company.it would be a great help for me if you could provide me your email id so that i can contact you through mail apart from the blog.

    Thanking you,

    Smitha

  3. Dear Amir,

    i was looking for article on Ijarah.couldn’t find anything in your blog site. I have some basic questions in ijara.Can you please help me with that.Read some where that in an operating lease, the lessor normally holds a stock of assets with high degree of marketability to provide to other entities.if that is the case then,the customer will be buying stocks equivalent to a property rental value?.sorry if it is a stupid question.

    i didnt understand this fully when i connect this with vehicle financing or leasing an apartment for rental.
    Saw something similar in Musharaka contract as well.how can we connect equity shares and Assets such as a Vehicle or Building?

    Waiting eagerly for your Reply,

    Thanks and Regards,
    Smitha

    • Hi Smitha

      For Ijara, the underlying asset is the property or asset to be leased itself. Transaction is using the said asset. It does not require holding of other asset, unlike a Tawarruq home financing (where you trade commodities although you have a tangible asset ie house)

      So, under operating lease, the asset traded is the property itself where the customer pays for the right to benefit (usufruct) from the use of property. The bank keeps ownership of the property but lease out the “right to use” property for a certain rental amount. No other assets came into play for Ijara.

      Hope this helps
      Thanks

  4. Dear Amir,

    Could you please provide some insight in to Ijara with Musharaka and ijara with Mudarabha.

    Regards,
    Smitha Menon

    • Hi Smitha, not sure in which context you are referring to. Deposits or financing? In an ijara arrangement, the usufruct is rented out while Musharaka and Mudharaba, there is equity inclusion into the arrangement. Can you give me some examples in which context you’re referring to?

      Thanks

      • Dear Amir,

        I highly appreciate your quick response.you can consider me as an intern.iam a starter in islamic banking.so pardon me for my layman questions.iam collecting information for islamic product development from web.so getting confused at times.i read some where that ,One of the most-preferred forms amongst all ijara contracts in the realm of housing finance, is the ijara-Musharaka or the ijara-Mudaraba pairing, both the parties contribute to the equity of the partnership in a certain pre-determined ratio.In this case i would like to know the process flow.The customer will be a shareholder and he takes an ijara financing from the bank and we can consider his share as a downpayment ,which he can withdraw anytime.This is my understanding on Ijara with Musharaka or Mudaraba pair.Please correct me on my understanding.

        Thanks and Regards,
        Smitha Menon

      • Hi Smitha,

        Ok thanks for clarifying. Now I understand you’re referring to financing. Yes, one of the preferred structures by scholars for house financing is based on hybrid of Musyaraka+Ijara and Mudharaba+Ijara. While it is simplistic to envision such strcutures theoretically, putting it into practice is not as simplistic. The Mudharaba+Ijara structure has not been developed in earnest, but there is a basic form for Musyaraka+Ijara in Malaysia which is the Musyarakah Mutanaqisa (diminishing partnership) in Malaysia.The way it is being structured is to achieve a financing result.

        In a Musharaka Mutanaqisah arrangement, there are multiple contracts working at the same time. As a start, the process starts with the contracts.
        1. A Musharaka contract is entered where the customer and bank agree that each party will contribute principal equity. The Musharakah also states that the customer can/must purchase the equity in the property from the bank over a period of time. And if the customer do not continue to purchase the equity, it is deemed that the customer wants to exit the partnership. To exit the partnership, it means the customer want to/will fully purchase all the equity. There is no profit consideration for this portion (just purchase of equity at par value).
        2. An Ijara contract where the Bank earns a return. Theoretically, if a bank and customer enters into a Musharakah arrangement with customer for the purpose of investment, whatever rental amount collected from a third party will be shared between the Bank and customer based on equity ratio. For example, if the Bank : Customer equity ratio is 80:20, it means for every monthly rental collected of RM2,000 from the property, RM1,600 goes to the Bank and RM400 goes to Customer. But in this case, the customer is the lessee (renting the property), so the Customer needs to only pay the rental of RM1,600 to the Bank (RM400 technically belongs to Customer ie Customer paying to himself). Also, as person renting and enjoying the beneficial ownership (usufruct), the Bank and Customer agrees that the Customer is to pay for the utility bills and any assessment payments.
        3) Wakalah ie Agency. To maintain the property in good condition, the Bank and customer agree that the customer will become the agent of the Musharakah to do what is necessary to maintain the house. This means repair and maintenance.
        4) Therefore, the agreed fixed monthly installments will consist of 2 elements, ie the Rental, and the Purchase of Equity. The Bank can also agree to protect the partnership further by putting a ceiling rate on the Rental portion, for example 10% maximum. It means the Customer will never pay Rental of more than 10% even when the market rate moves above 10% p.a.
        5) As the Equity is purchased over time, the partnership is accelerated where the Rental portion becomes smaller and Equity Purchase becomes bigger.
        6) There are other contracts that can be built into Musharakah+Ijara (i.e. Musharakah Mutanaqisa) arrangement such as Istina’ (contruction) or Ijara Mausufah Fi Zimmah (Forward lease), Wa’d (promise) and Rahn (Collateral).Depending on the customer’s and Bank’s mutual agreement.

        Theoretically, the Customer can withdraw his share of equity anytime, but that means finding another party to purchase his equity. That means the dissolution of the partnership arrangement for the bank as the party is now different, with a dissimilar credit standing as the original customer.

        Hope that somehow helps. Thanks
        Amir

  5. Dear Amir,

    Could you please provide the vedio link on your seminar on Deposits.i had saved it for future reference and alas..it’s missing now from youtube.

    Regards,
    Smitha Menon

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