A critique of profit distribution module under Islamic banking
Saturday, 29 September 2012
Md Gias Uddin Ahammed
Very recently, this writer came across a booklet named Profit Payout to Mudaraba Depositors (Bangladesh Perspective) written by M Azizul Huq who can be called the mentor of Islamic bankers in Bangladesh. In the booklet, the limitations of weightage-based framework have been noted as follows:
a) This framework charges uniform management fee for the bank against all groups of Mudaraba depositors collectively.
b) It is a two-tier distribution process. Tier one is for appropriation of bank's management fee from the funded income as per pre-agreed ratio (say 30 per cent) of the distributable income, and tier two is for computing the rates of profit for each group of Mudaraba depositors by applying the weightage assigned to each group.
c) A client's rate of profit is affected when (all other things -- total deposit, total investment income, profit sharing ratio (PSR) etc., remaining unchanged), i) the proportion of individual deposit type among the total deposit is changed, ii) weightage of any one or more types of the Mudaraba deposits is increased and iii) a new Mudaraba deposit product with higher weightage is introduced.
Focusing on these issues, a few write-ups were published in this newspaper earlier. Rebutting the views, one article of this writer - 'Rationale behind weightage-based profit distribution module under Islamic banking' was also published in this newspaper.
However, considering the gravity of the subject, we would like to explain it again.
a) Under this framework, it is assumed that different liquidity positions are required against different deposits. As liquidity and profitability are inversely correlated, rate of return on investment and subsequently rate of distributable income on different types of deposit (AWCA, MSA, MSND, MTDR, HAJJ etc.) will be unequal. Different weightages assigned to different deposits play a vital role to distinguish them from one another. As cost of Mudaraba deposits is in principle zero, bank demands the same profit sharing ratio (PSR) as its management fee against all types of deposits. Needless to mention, fees charged against the same amount of various deposits are not the same because of varying weightages. Table I will illustrate the point.
b) Two-tier (rather three-tier) distribution processes have been practised in Bangladesh since long. Bangladesh Bank (BB) in its 'Guidelines for Islamic Banking' has used three Tables for easy calculation. Table-1 is for calculating ratio of participating Mudaraba Fund in the outstanding Investment. We sometimes ignore it assuming 100 per cent (say, Tk 30m) Mudaraba fund in the outstanding investment. Table-2 is to segregate distributable profit. In our present case, it is 70 per cent of Tk 30m i.e., Tk 21m to depositors and 30 percent of Tk 30m i.e., Tk. 9m to the bank. Table-3 is to allocate distributable profit (Tk 21m) to Mudaraba depositors as per weightage and get rate of return. Unfortunately, Table-2 and Table-3 have created confusions even among some experienced bankers. They deem PSR 30 per cent (Tk 9m) as against all types of depositors collectively and hence bilateral contracts become invalid. But alternative (single tier) calculation is possible as we showed above. Since bank's PSR is the same against all types of deposit, bank will get 30 per cent of Tk 30m, i.e. Tk 9m keeping all terms and conditions intact. It means weightage-based framework restricts bank's (Mudarib) profit co-related to its Investment Income which is the main spirit of Mudaraba principle. The more investment income it earns, the more it will get and vice versa. Under this framework, no unscrupulous bank can unjustifiably boost its profit at the expense of the depositors.
c) Generally we establish a functional relationship between two factors/variables keeping other pertinent factors unchanged. Here also three relationships are made between (i) rate of return (rr) and deposit mix, (ii) rr and weightage and (iii) rr and new product where rr is a dependent variable and deposit mix, weightage and new product are independent variables. Total deposit, total investment income and PSR are kept as constant.
(i) Weigtage-based framework assumes that rr is a function of many factors. Among them, most vital are total Mudaraba deposit, total Investment Income, PSR and weightages. Again, total Investment Income is a function of total investable fund which is again a function of deposit mix and deposit mix is a function of weightage schedule. So, the above mentioned relationships will not reflect the real scenario if we change deposit mix and weightage but keep Investment Income unchanged. Let us see the practical scenario.
Say, a fund manager has a total deposit mix of Tk 300 million (MSND -Tk. 100m, MSA- Tk 100m and MTDR- Tk. 100m). His experience tells that keeping adequate liquidity, maximum 60, 70 and 80 per cent of MSND, MSA and MTDR fund respectively can be invested in short term securities (say, in Money Market or placement with other bank) @ 13.33 per cent, in middle-term securities (say, Bai-Muazzal) @14.29 per cent and in longer-term securities (say, share and debenture) @ 15 per cent respectively. So his annual Investment Income will be Tk. 30m.
Now, if you change the deposit mix, your Investment Income will certainly be changed. Table II shows that deposit mix of Tk. 300 million (MSND- 50m, MSA-100m and MTDR-150m) can earn more Investment Income (Tk 32m) than that of Tk 300m (MSND-150m, MSA-100m, MTDR-50m) - (Tk. 28m). If a fund manager does not agree with our views and say that he can earn the same Investment Income (greater one) with both the deposit mix, we will just salute him as the grand master of liquidity management.
(ii) A bank does not change weightage without strong grounds behind it. It has statutory as well as Shariah obligation to disclose the weightage and any subsequent change in weightage of Mudaraba deposits before the starting of any accounting year/Mudaraba contract. Besides, changes in weightage schedule will influence depositors to shift their deposit and the shift will certainly change the deposit mix. Effect will be as described above.
(iii) Generally, bank introduces new deposit products when it needs fund for investment or liquidity purpose. Investment causes Investment Income to increase and liquidity secures existing investment. So, it does not assign weightage to the new product in such a way that existing depositors will be affected and leave the bank. It will assign higher weightage to a new product if it has the opportunity to invest at a higher rate of profit or if it is going to incur huge loss due to liquidity crisis. Depositors should not forget that bank is the Mudarib here and any genuine loss will ultimately affect the Investment Income and their rate of profit accordingly.
The writer is Senior Officer, Sonali Bank Limited. Views expressed in the article are of the writer. gias49@ovi.com
Very recently, this writer came across a booklet named Profit Payout to Mudaraba Depositors (Bangladesh Perspective) written by M Azizul Huq who can be called the mentor of Islamic bankers in Bangladesh. In the booklet, the limitations of weightage-based framework have been noted as follows:
a) This framework charges uniform management fee for the bank against all groups of Mudaraba depositors collectively.
b) It is a two-tier distribution process. Tier one is for appropriation of bank's management fee from the funded income as per pre-agreed ratio (say 30 per cent) of the distributable income, and tier two is for computing the rates of profit for each group of Mudaraba depositors by applying the weightage assigned to each group.
c) A client's rate of profit is affected when (all other things -- total deposit, total investment income, profit sharing ratio (PSR) etc., remaining unchanged), i) the proportion of individual deposit type among the total deposit is changed, ii) weightage of any one or more types of the Mudaraba deposits is increased and iii) a new Mudaraba deposit product with higher weightage is introduced.
Focusing on these issues, a few write-ups were published in this newspaper earlier. Rebutting the views, one article of this writer - 'Rationale behind weightage-based profit distribution module under Islamic banking' was also published in this newspaper.
However, considering the gravity of the subject, we would like to explain it again.
a) Under this framework, it is assumed that different liquidity positions are required against different deposits. As liquidity and profitability are inversely correlated, rate of return on investment and subsequently rate of distributable income on different types of deposit (AWCA, MSA, MSND, MTDR, HAJJ etc.) will be unequal. Different weightages assigned to different deposits play a vital role to distinguish them from one another. As cost of Mudaraba deposits is in principle zero, bank demands the same profit sharing ratio (PSR) as its management fee against all types of deposits. Needless to mention, fees charged against the same amount of various deposits are not the same because of varying weightages. Table I will illustrate the point.
b) Two-tier (rather three-tier) distribution processes have been practised in Bangladesh since long. Bangladesh Bank (BB) in its 'Guidelines for Islamic Banking' has used three Tables for easy calculation. Table-1 is for calculating ratio of participating Mudaraba Fund in the outstanding Investment. We sometimes ignore it assuming 100 per cent (say, Tk 30m) Mudaraba fund in the outstanding investment. Table-2 is to segregate distributable profit. In our present case, it is 70 per cent of Tk 30m i.e., Tk 21m to depositors and 30 percent of Tk 30m i.e., Tk. 9m to the bank. Table-3 is to allocate distributable profit (Tk 21m) to Mudaraba depositors as per weightage and get rate of return. Unfortunately, Table-2 and Table-3 have created confusions even among some experienced bankers. They deem PSR 30 per cent (Tk 9m) as against all types of depositors collectively and hence bilateral contracts become invalid. But alternative (single tier) calculation is possible as we showed above. Since bank's PSR is the same against all types of deposit, bank will get 30 per cent of Tk 30m, i.e. Tk 9m keeping all terms and conditions intact. It means weightage-based framework restricts bank's (Mudarib) profit co-related to its Investment Income which is the main spirit of Mudaraba principle. The more investment income it earns, the more it will get and vice versa. Under this framework, no unscrupulous bank can unjustifiably boost its profit at the expense of the depositors.
c) Generally we establish a functional relationship between two factors/variables keeping other pertinent factors unchanged. Here also three relationships are made between (i) rate of return (rr) and deposit mix, (ii) rr and weightage and (iii) rr and new product where rr is a dependent variable and deposit mix, weightage and new product are independent variables. Total deposit, total investment income and PSR are kept as constant.
(i) Weigtage-based framework assumes that rr is a function of many factors. Among them, most vital are total Mudaraba deposit, total Investment Income, PSR and weightages. Again, total Investment Income is a function of total investable fund which is again a function of deposit mix and deposit mix is a function of weightage schedule. So, the above mentioned relationships will not reflect the real scenario if we change deposit mix and weightage but keep Investment Income unchanged. Let us see the practical scenario.
Say, a fund manager has a total deposit mix of Tk 300 million (MSND -Tk. 100m, MSA- Tk 100m and MTDR- Tk. 100m). His experience tells that keeping adequate liquidity, maximum 60, 70 and 80 per cent of MSND, MSA and MTDR fund respectively can be invested in short term securities (say, in Money Market or placement with other bank) @ 13.33 per cent, in middle-term securities (say, Bai-Muazzal) @14.29 per cent and in longer-term securities (say, share and debenture) @ 15 per cent respectively. So his annual Investment Income will be Tk. 30m.
Now, if you change the deposit mix, your Investment Income will certainly be changed. Table II shows that deposit mix of Tk. 300 million (MSND- 50m, MSA-100m and MTDR-150m) can earn more Investment Income (Tk 32m) than that of Tk 300m (MSND-150m, MSA-100m, MTDR-50m) - (Tk. 28m). If a fund manager does not agree with our views and say that he can earn the same Investment Income (greater one) with both the deposit mix, we will just salute him as the grand master of liquidity management.
(ii) A bank does not change weightage without strong grounds behind it. It has statutory as well as Shariah obligation to disclose the weightage and any subsequent change in weightage of Mudaraba deposits before the starting of any accounting year/Mudaraba contract. Besides, changes in weightage schedule will influence depositors to shift their deposit and the shift will certainly change the deposit mix. Effect will be as described above.
(iii) Generally, bank introduces new deposit products when it needs fund for investment or liquidity purpose. Investment causes Investment Income to increase and liquidity secures existing investment. So, it does not assign weightage to the new product in such a way that existing depositors will be affected and leave the bank. It will assign higher weightage to a new product if it has the opportunity to invest at a higher rate of profit or if it is going to incur huge loss due to liquidity crisis. Depositors should not forget that bank is the Mudarib here and any genuine loss will ultimately affect the Investment Income and their rate of profit accordingly.
The writer is Senior Officer, Sonali Bank Limited. Views expressed in the article are of the writer. gias49@ovi.com