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.

Looking Back at 2016

Posted on January 5, 2017 by Amir Alfatakh

240436_10150203306784333_4365034_o 2016 was another interesting year for Islamic Banking. Economically, the industry followed the growth trend of the market; while still recording about 12.10% growth in the first 6 months of 2016, it is showing a slowdown in line with the overall economy. Nonetheless, there are still significant demand in Islamic Banking, and some financial institutions are also in the midst of moving from a conventional offering into Islamic Banking. Bank Pembangunan, for example, is undergoing transformation exercise into Islamic Banking. And another foreign bank just started to offer Islamic Banking products via a window in July. Small steps towards increasing the market presence for Islamic Banking.

While I cannot possibly recap all the happenings in the industry in this post, I would just like to look back into a few key items that I felt contributed to the industry’s development. The ones I picked up are:

Issuance of new Policy Documents (PD) in 2016. Another busy year for regulations, where BNM issued a total of 6 (six) new Policy Documents for Islamic Contracts ie Wakalah, Kafalah, Qard, Hibah, Wadiah and Ijarah. The biggest impact was perhaps the Qard PD where banks are expected to migrate existing portfolio of Wadiah into Qard by 2018. Also issued in Dec 2016 were the 2 cards-related Policy Document for products ie Debit Card-i and Credit Card-i. To go to the Regulations page, click HERE
Investment Account and Investment Account Platform. Investment Account remains one of the focus products by BNM pushing for risk-sharing structures mainly the Mudharabah (profit sharing entrepreneurship) and Wakalah Bi Isthihmar (Agency for Investment). Maybank Islamic, in particular, has gone out to actively promote Islamic Investment Account, and introduced Term Investment Account, which did very well in 2016 with declared returns of around 4.0% p.a. This outlines the potential to grow this product further. Furthermore, The Investment Account Platform (IAP) which is based on Musyarakah (Partnership) structure also saw the first few listing of ventures made available to the public. A good start in 2016 and expected to see more listing in 2017.
Employee Provident Fund-i and Bursa Malaysia-i. These are 2 significant additions to the industry to provide more focus on Shariah compliant investment activities. EPF-i got a lot of positive news when it was announced, and the fund commenced operations beginning 1 January 2017 when participants funds who registered are now managed under the rules of Shariah. Bursa Malaysia-i was also launched with much fanfare where it is dubbed as the “world’s first end-to-end integrated Islamic securities exchange platform” where you are able to list, trade, clear and settle Shariah compliant instruments which complies with Shariah rules.

These developments hopefully will push the industry further, and personally I would like to see more being done in the Islamic Fintech sector. While I note there have been a significant number of “seminars and forums” discussing Islamic Fintech, unfortunately very little is being done in terms of Shariah discussions to support the real development needed. Hopefully those Banks that have started these initiatives to develop Islamic Fintech can introduce some of the innovations soon. I feel there is much work that is yet to be done.

For readers of this website, I also want to express my appreciation for you comments, feedback and support for 2016 and hope we can continue to build progressively our understanding and knowledge of Islamic Banking in 2017. Thank you and happy reading.

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.

iap-2

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

The role of the Bank moving forward

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

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

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

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.

product-concept-investment-account-v4

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

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

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

Solutions from Investment Accounts

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

The solution is already here. Use it!

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.

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.

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