ISLAMIC BANKS AND DEPOSIT MOBILISATION
ANWAR MEENAI
Islamic banks have now been around for over two decades. Since their inception, they have come a long way in their operations and their modes of investment. One major dilemma that these banks have faced relates to the acceptance of deposits, for varying periods, similar to those mobilised by traditional commercial banks.
In traditional banking business, deposits are normally accepted on the basis of an agreed rate of interest, whether advertised by the bank or negotiated (usually in the case of large deposits). The exceptions to these are deposits held in current accounts or portfolio accounts (the bank being an agent in the case of the latter).
Usually, the depositors are free to deposit and withdraw their money as often as they desire, except in the case of Term Deposit Receipts (TDRs) or Fixed Deposit Receipts (FDRs), and where there are restrictions on more than a certain number of withdrawals during the week or month.
The above being the case, the return is usually calculated on a daily product basis on the amount remaining on deposit. Sometimes the basis of calculation of return is the minimum or the average balance remaining on deposit. Th e important thing is that a fixed rate, agreed in advance, between the bank and the depositors, is used for calculating the return.
Returns are usually offered on a quarterly, six monthly or annuals basis. The fixed rate, agreed in advance, is applied, on whatever basis is decided upon by the bank, for the actual number of days for which a given amount remains on deposit with the bank. This is why the bank can permit frequent deposits and/or withdrawals.
Major Underlying Assumptions/Factors
The system of deposit mobilisation by commercial banks is based on the following assumptions/factors:
Money, available with people or institutions, in the shape of savings, has a cost. Since it is presumed that money has a cost, it is considered natural for the banks to be willing to pay a price to the savers to obtain the right to use their savings for a determined or undetermined period of time.
As a corollary to the above, it is considered natural that entrepreneurs who are desirous of borrowing these savings from the banks, must pay to the bank the cost incurred by it together with a premium. As a result, the bank stands to earn a profit which is the difference between the cost that it pays to the savers and the price that it charges to the entrepreneur.
The bank is responsible for the safety and security of the savers’ funds under all circumstances, i.e., it is the bank who takes a risk on the entrepreneur. It is very seldom the savers are able to recover all or a substantial part of their savings, if the bank fails.
As a corollary to the above, the entrepreneur remains liable for the safety and security of the borrowed funds under all circumstances. This means that the bank does not take any risk on his character and credibility, or his morals, and the value of the security offered by him.
In practice, the borrowers’ liability to the bank under all circumstances does little to mitigate the adversities that are faced by the depositors (e.g., meagre rate of return) or are likely to be faced by them, should the bank fail. This is because the borrowers may default on their commitments to the bank and, in collaboration with the managements of the bank and/or the powers that be, manage to have huge amounts of borrowing written off. In the case of the bank’s or business enterprise’s failure, the securities lying with the bank are seldom sufficient to fetch the entire amount of loans outstanding.
It is considered the savers’ right to withdraw their savings from the bank at any time, except when they have contracted to leave these for a fixed tenure, e.g., FDRs (In this case, too, premature withdrawal is sometimes allowed, though most of the time, only in consideration for a penalty). Since withdrawals by savers cannot be predicted with any great degree of certainty, the banks normally, keep a portion of their sources (which comprise banks’ paid-up-capital, retained earnings, reserves and the deposits mobilised) in a liquid or near liquid form.
To the extent that the entrepreneurs are often looking for borrowings for a fixed time period (except in the case of overdrafts), the bank also takes a risk by way of mismatch, i.e., timing differences in maturities of deposits and loans.
In view of the fact that the rate of interest to be offered on the deposits (the cost) and the rate of interest to be earned on the loan are predetermined and fixed for an agreed tenure, these rates are applied, on an agreed upon basis, to the amount outstanding to the credit or debit of the customer. Even in the case of cheque accounts (where frequent withdrawals may be allowed and overdraft (where outstanding amount may fluctuate every day), the agreed rate is applied, usually on a daily product basis.
The system outlined above cannot function without a fixed rate being in place. The various Islamic banks have tried to introduce the concept of “expected” rate, to avoid being criticised for indulging in Riba. In practice, however, the “expected” rate is the fixed rate, used in the manner outlined above.
The concept of Cost of Money needs to be critically examined (and rejected) before the Islamic banks can formulate a strategy for their operations.
There is no logical reason to assume that money available in the form of savings has a cost per se. The decision to save is always taken by human beings, either in their individual capacity or collectively. Cash is an asset that is of no use in its original form. It must be converted into assets in another form and combined with human skills to add value.
This is possibly only when an entrepreneur is willing to put cash to a productive use. This entrepreneur could be the saver himself or it could be another person or group of them. If left in its original state, cash will not increase a bit over any period of time.
Once this has been understood, it is not difficult to appreciate why Riba is forbidden. A Riba-based transaction is extremely likely to cause a loss to either of the two parties involved. Indeed, it will only be a coincidence if the two parties (the borrower and the lender) were to end up with the profits/return that they would have earned if the profits were equally distributed.
To switch over to Islamic banking, in its true form, it will be necessary that the bankers as well as the investors, realise that there is nothing as the cost of money and that they cannot contract for the use of funds at a predetermined cost or rate.
When this position is explained, people are quick to point out that abolition of this concept will adversely affect savings and encourage current consumption, so that capital formation will suffer. But, it ought to be understood that abolition of Riba is often erroneously equated with nil return on investment.
Obviously, this is not the case. Islam does not prohibit the seeking of a positive rate of return on one’s investment. Until such time that it can be proved that all businesses in which an Islamic bank will invest by way of Mudaraba or Musharaka will either fail or make losses continuously, there is no reason to presume that savers/investors will cease to earn any return on their investments.
Note must be taken however, of the fact that in a Muslim society, there will be no concept of the bank taking risk solely on the character, credibility or honesty of any of its partners in business. It will be taken for granted that those who are entrusted with the task of managing businesses will be doing so with utmost diligence and that the results of every business enterprise will be honestly reported and audited. In the context of Islamic banking, this is a basic requirement. To hope for the instant success of Islamic banks, given the existing standards of moral values and principles, is at best a fantasy.
A question may then be asked that if that is so, why establish Islamic banks? The answer is that while the instant success of the Islamic banks, organised on lines radically different from the conventional banks, is unlikely, the prospects for their success in the long run are bright.
The establishment of Islamic banks, on altogether different lines, would entail big sacrifices by the few who initially venture into it. It will be appreciated that as individuals affect institutions, the reverse is also true, in that institutions also affect individuals. To begin with, the number of individuals willing to make efforts for the success of Islamic banks may be small. It is hoped that gradually, many people who are sitting on the fence will join this small group. The number of such people is likely to increase manifold when they realise the benefits of Islamic banking’s distinguishing feature – justice in its relationship with the depositors as well as the entrepreneurs.
The concept that money (whether in the form of cash or capital assets) is a factor of production independent of the entrepreneur and must get a return for its use, just as land receives rent and labour receives wages, has to be changed.
The Concepts of Liquidity/Security of Deposits
As mentioned earlier under “Major underlying assumptions/factors”, the traditional bank operating in a capitalistic system is responsible for the safety and security of depositors’ funds at all costs and under all circumstances. As such, when it comes to the asset side, these banks not only predominantly invest their resources in fixed income securities/instruments (loans at a fixed rate of interest, commercial papers, bills, government debt), but also obtain all kinds of securities when lending on a commercial basis.
Some banks do build up equity portfolios, but such investment is usually a very small part of the total balance sheet of the bank. Since the bulk of the funds are tied in fixed income securities, it is possible for the traditional banks to accrue income on all their investments except the funds tied in equity.
It has also been mentioned earlier that these banks allow frequent deposits/withdrawals, so that the depositor does not feel that his investment is illiquid. Even when a depositor has invested in FDR/TDR or fixed tenure schemes, he is allowed to withdraw funds prematurely, albeit after incurring some kind of penalty.
Another way of providing liquidity to depositors for fixed tenure is to allow them to borrow against their deposits, with the deposit standing as security. Various instruments of corporate or government debt are traded on the stock exchange.
To be able to provide liquidity, the banks normally keep a portion of their resources in liquid or near-liquid forms (e.g., gilt-edged securities). They also make arrangements with other banks to borrow should they run out of liquidity. The Central Bank acts as the lender of last resort. A portion of the liquid resources of every bank remains on deposit with the central bank. Yet another portion must remain invested in government securities, which can be easily bought and sold or borrowed against.
It will thus be seen that liquidity, which is an important cornerstone of banking as it is run in a capitalistic system, is dependent upon borrowing for various tenures, for which it is essential that a fixed rate be agreed upon in advance.
Can Islamic Banks Match These?
Let us now look at the critical question as to whether or not, the Islamic banks can compete in these areas? That Islamic banks are doing so presently, is a different matter altogether. Our focus will be on whether this can be, or even should be, done within the precincts of the Sharia.
That the Islamic Sharia does not permit a fixed, guaranteed return to any investor is well known. The Sharia clearly requires that all capital invested in any legitimate business should be invested as “risk-bearing capital”. The two principal modes of investment allowed by the Sharia are:
1. Mudaraba: where one or more people participate with their capital and another set of one or more people participate with their expertise. Profits are shared in agreed proportions. Financial losses are borne by the financiers alone, loss of the time and effort being the loss to those who did not participate financially. The management remains in the hands of those who participate with their efforts.
2. Musharaka: where all participants invest their funds. Profit or losses are shared in agreed proportions. The management may be vested in the hands of all the investors or a few of them.
It is quite obvious that businesses, whether Mudaraba or Musharaka, which employ better capital resources are more apt to make high profits. As pointed out earlier, however, capital alone, whether in the shape of unproductive assets (e.g., cash, bullion, bank balances) or in the form of productive assets (e.g., machinery, plant and equipment) cannot produce anything on its own unless combined with human skills. The Islamic Sharia, therefore, views capital as a part of the enterprise. The entrepreneur who employs better capital resources is to earn higher profits.
No one can, however, predict with any certainty if the business will make a loss or a profit, and if the latter, then how much. As such, the Sharia considers it unjust that the entrepreneur should bear the entire brunt of the uncertainties by committing himself to make a fixed return on the financier’s capital.
This prohibition strikes at the very root of the cost-of-money concept. To begin with, all money in a business is invested in the shape of equity. Since it is not known whether the business will make a profit or incur a loss, this money may be considered “zero cost” money. As business opportunities in the society continue to present themselves, and since the quantum of profits in different businesses may be different, there will gradually emerge a phenomenon which is called “the opportunity cost” of money (and which exists under the present system as well).
This would mean that businesses with high-profit potential may attract more entrepreneurs and investors until such time that an equilibrium is reached. This process will continue. Factors such as obsolescence and technological developments will continue to affect businesses as they do in the present-day capitalistic system.
As a corollary to the above, it should be automatically evident that Islamic banks will not be in a position to provide liquidity to the investors, as traditional banks do, for the following reasons:
1. No business is normally in a position to spare any substantial portion of its resources in the shape of cash without any notice or even at short notice.
2. It is but natural that any business normally looks for resources that are committed for a definite period of time; at least for such period that it takes to complete its cash conversion cycle.
3. In view of the fact that there will be no predetermined rate of return to work with, every investor must wait to earn his part of the return until such time that the books are closed, accounting profits determined and individual shares worked out.
4. It would be very difficult, if not impossible, to work out returns on investments for broken periods, whether these were withdrawn before the completion of the cash cycle or whether they crossed a cash cycle and continued in another.
5. Investors who withdraw their investments prior to the completion of the business cycle (most likely as a result of the sale of the investment to a third party), must wait until such time that the books can be closed, accounts finalised and profits determined.
Since businesses will not be able to realise their resources in the shape of cash, on demand or at short notice, the banks will not always find it possible to come up with enough liquidity to pay investors only. In the new set-up, the banks will be acting as the agents of the investors as well as investing on their own account.
Since there will be no return to earn by way of interest, it will not be worthwhile for the banks to retain any resources in cash, except for whatever is deposited in current accounts, on which the traditional banks too do not pay any returns. Indeed, on such deposits, the Islamic banks must levy an administrative charge to cover their costs and earn a profit for their services.
Islamic banks may play the role of stock exchanges in that they can assist the existing investors, as whose agents they are acting, to liquidate their investment by diverting to them the resources provided by new investors wishing to appoint the bank as their agent.
In such cases, however, the bank will not be able to pay immediately any return to the outgoing investor, since it will not yet know the return on its own investment. Besides which, the problem of apportioning the final return between two or more investors will also crop up.
The foregoing discussion can probably best be understood in the light of the following example:
Suppose there is only one Islamic bank in a system and that it is dealing with ten companies, all of whom close their books on 30 June each year. The bank closes its books on 31 December each year. Let us further assume that each of the ten companies have a one-year cash cycle, i.e., July to June. If an investor who invested on 1st July wishes to withdraw his investment on 30 November, the questions are:
(i) What rate of return should be offered to him and
(ii) Where would the liquidity come from?
The second problem may be resolved if the bank is in a position to acquire the investment on its own account or if, around the same period, another investor with a matching amount comes to the bank and acquires the investment from the outgoing investor. The latter option is less probable.
Even more complicated will be the case of the investor who wants to make an investment on 20 February and then wishes to liquidate it on the next 20 February. Such an investment would not only fall into broken periods in two business cycles but also cross the bank’s year-end.
This having been understood, it will not be difficult to see that in the new set-up liquidity will either come through the stock exchange (in which we will include private placements) or through one’s own resources, i.e., the investors will have to hold on to part of their resources in liquid form. There can be no discussion of liquidity requirement without conceding the fact that part of the resources cannot be productively channelled.
To overcome this problem, some Islamic banks have come up with the concept of “expected rate of return”. This rate essentially acts as the interest rate in the capitalistic system. That there can be no basis for an “expected rate of return” is obvious from the fact that funds mobilised through various investors, for varying periods, are invested in different businesses for varying periods. Until such time that the profitability of different businesses can become known or be ascertained in advance, how can the depositor be advised about an “expected rate of return”?
In Pakistan, all expected rate of return remains fixed for all practical purposes. There is good reason for this. If “expected rate of return” were to vary, then one of the three following situations would always arise:
1. The actual rate of return will be equal to the “expected” rate of return.
2. The actual rate of return will be more than the “expected” rate of return.
3. The actual rate of return will be less than the “expected” rate of return.
In the first case, no additional payment is to be made to the depositor and in the second, the bank owes something to the depositor. In the third case, the depositor will owe something to the bank. Now, if returns are paid to the depositors at the time of withdrawal of deposits, then what does the bank do to recover from the depositor the extra amount paid? This will create administrative problems for the bank.
The foregoing discussion clearly shows that even if the Islamic banks were to retain a part of their resources in liquid or near-liquid form, they would not find it possible to offer liquidity to their investors/depositors in the manner that traditional banks do, in the absence of a “fixed rate”, by whatever name called.
Choices available to Islamic Banks
It is clear from the foregoing discussion that Islamic banks cannot compete with traditional banks in the field of deposit mobilisation. This is because (i) they cannot offer returns on these deposits in the manner in which the traditional banks do, operating within the confines of the Sharia, and (ii) the investment avenues available to Islamic banks are such that the returns on them will not become known until such time as the books of accounts are closed.
The question then naturally arises as to how Islamic banks can finance trade and industry.
Answering this question may require a very detailed discussion, but for the sake of brevity we will discuss the essential points only.
In the Islamic system, all businesses will need to be financed entirely by way of equity. This will include not only the fixed costs of setting up the business but also its foreseeable permanent working capital needs.
Temporary working capital needs may be financed in three possible ways:
a) When the requirement of the business is commodity-based, e.g., purchase of raw materials, consumables, spare parts etc., then the bank could finance these on a cost-plus basis and at the same time offer the facility for deferred payment. Care must, however, be taken to ensure that the bank first takes possession of the goods meant for sale to the customer. The price agreed on a cost-plus basis must remain fixed regardless of the time period taken by the customer to settle. If a 45-day period is agreed and for some reason, the customer wishes to repay on the 15th day, he will pay the price agreed, as he will even if the settlement is delayed by 15 days, beyond the 45-day period.
b) Advance Sale (Bai Salam) by the customer. This mode will again be commodity-based. It will be particularly advantageous to the bank in situations where the finished product of one customer could serve as the raw material (or consumable or spare) for another customer. An advance sale must meet four conditions:
i) The entire price must be paid in advance;
ii) The quantity and quality of merchandise bought/sold must be determined with specifications;
iii) The date of delivery must be agreed and specified;
iv)The place of delivery must be agreed and specified.
c) Redeemable equity (as opposed to redeemable capital), which means that the investment will be represented by shares of a particular class such that these particular shares will be redeemable at a definite future date and will be entitled to receive a dividend out of the profits of the company. Such investment could be ideally used for financing temporary working capital needs such as payments of utility bills or wages or the various duties and taxes, i.e., items which are not susceptible to the cost-plus financing available for commodity-based needs.
This option may mean that legislation in certain countries (e.g., in Pakistan) would have to change to introduce the concept of treasury stock, whereby a joint stock company may be allowed to buy its own shares.
The modalities in respect of shares issued for a limited period of time will need to be worked out, especially with respect to their issuance at short notice, after the completion of a minimum of formalities, the manner of offering returns (dividends) on these and the voting or other rights that these may enjoy.
Equity financing will naturally mean the imposing of a great discipline on both the providers as well as the users of the funds. The providers will have to take into consideration the fact that they should make their own arrangements for providing liquidity. The users should be careful that they properly forecast their financial needs and realistically assess their requirements.
It may be pointed out that in the Islamic banking system, the availability of loans would be reduced but would not necessarily become nil. This is because, savers who have resources which they do not wish to commit by way of equity investment may still be willing to part with their savings for a definite (short) period of time, with or without security.
In such situations, they will need an assurance about the safety of their principal and its repayment on demand or at an agreed future date. Of course, these loans would not earn anything. Such loans could be denominated in terms of commodities mutually acceptable to the lender and borrower, rather than in terms of monetary units.
This would reasonably hedge the lender against inflation. It may also be pointed out that an economy functioning on Islamic principles and pursuing the right economic and fiscal policies should be able to experience a great degree of price stability in both the short- as well as long-run. Denominating loans in commodities is an issue that requires serious consideration on the part of scholars as well as economists.
The foregoing may appear too academic or theoretical. However, for Islamic banking to function smoothly, certain concepts and notions about money, savings and investments must change. Besides, there are certain structural and administrative changes that the governments in Muslim states must make.
The first hurdle is the concept of safety/security of investment. The common man apart, even some religious scholars make mention of the need for the establishment of institutions where the investors can invest their funds, with the confidence that these are safe, and at the same time earn a ‘legitimate’ return.
The fact that businesses may fail, and even the principal can be partially or wholly lost, is so repugnant that few people are willing to think of it, or discuss it. The same set of people would readily agree that the future is uncertain. Yet when it comes to investing their savings, they desire that it should be the entrepreneur who should bear the entire brunt of the uncertainties, while the investors always earn a positive return on their investment. In the context of Islamic banking this would not do.
The future is equally uncertain for everyone. If a business makes a profit, it must be equitably apportioned between every investor. If it incurs a loss, then this must also be equitably apportioned, unless it can be proved that there was wilful negligence or misappropriation on the part of those who were managing the business affairs.
Secondly, it must be understood that inflation is neither a natural phenomenon nor an uncontrollable one. Readers who take interest in the matter may refer to an article published in the London Economist in February 1992 (The End of Inflation, 22 February, 1992).
A major cause of inflation is deficit financing by the government. Deficit financing is injustice, because it results in eroding the value of the currency. This will, therefore, need to be stopped. The governments must exercise great care and restraint in their expenditure, especially non-development expenditure. The Ministry of Finance, as well as all divisions, departments and subsidiary organisations, must be subject to thorough audits and fully accountable to the legislature.
Thirdly, the tax structure in most countries will have to change. At present, the rate of corporate tax and tax on business incomes is too high. This is only perpetuating the creation of black money and fostering the growth of a parallel economy.
Also, in the present set-up, interest expense, however it may be known, is a taxdeductible expense and provides a tax shield to the borrower. When businesses are entirely financed through equity, pre-tax income will substantially increase. This means an increase in the tax liability of such businesses. There will, therefore, be the need to rationalise the tax structure.
Fourthly, when companies of all sizes, big and small, find it necessary to have their shares listed on the stock exchange, there will probably be the need for more than one stock exchange, each of which may specialise either in particular industrial sectors or in shares of companies whose share capital falls within a certain bracket. This matter, again, requires deliberations on the part of businessmen, brokers, banks and the government.
It is obvious that deposits mobilised by banks in the present set-up have all the characteristics of debt: fixed tenure (or repayable on demand), fixed return and assurance or guarantee about the safety of the principal amount. Islamic banks cannot mobilise deposits in this way. Apart from the fact that this methodology is against the basic tenets of the Sharia, the asset side of the Islamic banks would also not support deposit mobilisation in this fashion.
Up till now, Islamic banks have offered various proposals. In the opinion of this writer, the time has come to seriously discuss these matters and try to evolve a system which is practical but, most importantly, within the confines of the Sharia.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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