A need for synchronised rate of return for Mudaraba depositors
Tuesday, 2 November 2010
Afzalul Haq
It is heartening to note that our banks, including the largest Sonali Bank Limited, have started Islamic banking. This state-owned commercial bank has started Islamic banking operations by opening 5 Islamic Windows. Serious and sincere officials therein seem to be extremely conscious of compliance of the ethical and Shariah standard so that the clients of Islamic banking are not deprived in any way. This seriousness has been reflected in the article 'Does Islamic banking requires any framework of rate of return alternative to Weightage system?' by Mr. Md. Gias Uddin Ahammed of Sonali Bank, published recently in the Financial Express. We must thank him for his client-friendly stand and thirst for fair thinking. He preferred Weightage system. He has also urged upon Islami Bank Bangladesh Limited, Central Shariah Board for Islamic Banks of Bangladesh as well as Bangladesh Bank to advise on the issue. His article was in fact a valuable comment on my recommendation for an alternative to Weightage system. He was kind enough to thank me for that article which appeared in this newspaper on May 19, 2010. But his analysis and inference have brought me for the second time to discuss the issue for clarification.
Mr. Ahammed has very rightly presented Weightage based as well as Income Sharing Ratio (ISR) based framework which is the echo of my above referred article. But surprisingly he drew a transparently reverse inference and opined in favour of the Weightage system ranking the same as superior to ISR based framework.
The depositors might be concerned for rate of distributable profit. But we recognise the same as the strength and never as weakness of ISR. We should rather be proud of this spirit as it really echoes Islamic banking. This is the beauty of (Islamic bankers') Mudaraba contract, under which Mudaraba deposit is collected. Because, in spirit, the return of Mudaraba is always uncertain and the profit rate can not be pre-determined. An earning is treated as profit; in Mudaraba it must be actual profit. It is worth to note that although the purpose is profit, in Mudaraba there remains no guarantee of rate of profit. Uncertainty, resulting in the concern for profit, losing profit and even for principal etc. is inherent in Mudaraba. It is indeed a risky venture. For the sake of transparency, those risk factors are not to be concealed. Then comes the question of the priority of Mudaraba deposit over non-Mudaraba deposit under Weightage system vs proportional treatment of the same under ISR system.
The assumption of non-discrimination between Mudaraba & Non-Mudaraba deposit, in the matter of investment, is not the essential criterion for the ISR (as well as Mudaraba principle). Essential criterion of the ISR is bilateral contract of the bank with each client specifying their respective sharing ratio unlike fixed management fees under Weightage system. (Under weightage system profit of one depositor is affected by others' contract with bank). The ISR itself does not disallow this type of priority treatment. Anyone may design a policy basically based on the ISR but having better assumption to produce better result for the Mudaraba depositors.
Similarly, this is also true for Weightage system. We know that the assumption in prevailing Weightage system to net off the Mudaraba deposit by deducting concerned CRR or SLR in determining the rate of profit thereon cuts off the profit of the Mudaraba depositors. The matter may also be treated by a critic as an ill motive to reduce the income of the depositors. Here also we understand that Netting off is not the basic criteria of weightage system. This assumption can easily be avoided. Depositing Tk100, one may not think it justified to take profit on Tk90 only on the plea of bank's requirement of 10.50% SLR (Statutory Liquidity Reserve). Opportunity cost of SLR may be considered implied operating cost of the banking business. Prevailing ISR framework assumes it so, and therefore, does not reduce it from Mudaraba deposit while determining profit therein. This is not the fundamental criterion of ISR. One may adopt ISR and at the same time, as is done under weightage system, he may net off the deposit amount for profit calculation if deemed fit. Obviously keeping the ISR intact, netting off the deposit would reduce the profit of the Mudaraba depositors; but such an auxiliary component can not be the ground for adopting or rejecting the basic framework. Rather any such assumption may be amended with appropriate explanation keeping the basic framework intact. But at the same time we must keep in mind that all the depositor-friendly assumptions may be washed out by bank through offering lower sharing ratio to the Mudaraba depositors and vice versa. If fundamental or core principle of the contract is valid, then auxiliary assumptions matter a little and as such the latter may be adopted, amended or rejected on the basis of circumstances. Hundreds of favourable assumptions are not enough to rectify any fundamental wrong in any contract.
An investor needs not know where bank's fund comes from. Investment process does not categorise its sources of fund, unless there is any restricted a/c or Refinance Schemes. Any such exceptional issues can't be generalised and as such kept beyond the purview of our discussion. Return on investment is never decided on the basis of the specific sources of fund which is injected therein. It may rather be based on the overall cost of deposit/ fund of the bank as a whole and other pricing factors. Except for specific ones there would hardly be found any instance where rate of return on investment is lowered because a particular fund to finance the same has been arranged from low cost source say MSA (Mudaraba Saving A/c) and no investment is priced higher as fund therefor is collected from a very costly sources say MHSA (Mudaraba Haj Savings A/c). In general the pricing/ rate of return on investment funded by each Tk.100 of MSA and each Tk.100 of MHSA may be same disregarding their difference in respective cost of fund. This is because of the fact that investment is made from the pool of fund, not from the specific source based fund. Source of fund of investment is practically not demarcated in general, for specific investment.
In banking business, a fund manager can't always confirm to fulfill entire need of fund from non-Mudaraba sources avoiding Mudaraba fund. Any unscrupulous technique to cheat the depositors should, however, not be our issue to talk about. We are talking about the principle, not of the malpractice.
For comparison purpose we would highlight the basic points only. Weightage framework provides uniform / fixed Management fee for the bank against all groups of Mudaraba depositors collectively. Again in the second tier of distribution, each group of depositors gets different sharing ratio in the name of Weightage. This 2nd tier distribution distorts the profit of different groups on different occasions, like change of Weightage of a particular group or change of deposit mix etc. Therefore, ISR based module by way of entering into separate Income Sharing Ratio with different types of depositors was prescribed in the article of 19/05/2010 with reasonable details. Readers are only referred thereto, avoiding repetition for obvious reason.
It is simply immaterial or irrelevant which method produces better profit for the depositors. The important is the validity of the relevant contract, no matter which bank incurs low cost for its better deposit mix i.e. by virtue of efficient fund management. Better fund management complying Shariah is a sign of prudence. A finance officer is not to bother whether a depositor gets higher or not. He must be economic until Shariah bars. It is the bank as a whole, which should pay the due profit to depositors according to the valid contract. We, at this stage must stick to a single point. If the Weightage framework is beyond questions in the eyes of Shariah, then no need of any new module like ISR arises at all. Otherwise a valid contract like ISR should replace the void or suspicious Weightage contract. We must bear in mind that both ISR and Weightage system are bound by Mudaraba contract. We are to be sanguine that the contract itself (which binds the bank and the depositor) fulfils the fundamentals of relevant Shariah principle. Assumption, on the other hand, as already pointed out is nominal for both of them. Fundamentals are like Fard (Mandatory, essential) and auxiliary assumptions are Nafal (optional, extra) and hence subject to change or may also be avoided under circumstances. Fundamental is the factor that matters. So, fundamental of Mudaraba is to check. Mudaraba is a contract between two or more parties to, among other things, share profit according to predetermined ratio.
A Mudaraba contract to be enforceable, each of the concerned parties should be independent, be it individual or institution. In prevailing Weightage system, weightage is ratio among the depositors themselves only. At that time bank remains no more a party to the contract to share residual or ex-bank profit among the depositors. Here the total of distributed profit remains unchanged like that of the bank. Only depositors' share of profit is engineered. Bank is only an agent to calculate the respective shares of the depositors. Absence of contract among the depositors (who are affected for the contract between the bank and any of the depositors) themselves make the Mudaraba contract of Account Opening Form defective. A client (say Mr. X) is not aware when bank makes an agreement with Y. Yet this agreement with Y may substantially affect the dues of X. It can't be a fair deal because bank and Y making a contract between themselves shouldn't snatch the share of profit of X where the latter is not a party and as such has no role to play.
The contract is supposed to be between the Mudarib (bank) and Shahib-al-mal (fund provider). What is the agreement between a client and the bank regarding profit distribution under Weightage system? Say X, Y & Z are individual depositors. They all individually make bilateral agreement with the bank to share profit say at a ratio of 30:70 for bank and the clients respectively. Besides this ratio X, Y & Z are given weightages of say .7, .5 & .4 respectively. What actually happens here is that the profit sharing between the bank and the clients remains static and of course valid as 30:70. On the part of the Mudaraba depositors as a whole 30% is forgone for the bank. Now comes the second-tire distribution (application of weightage on residual profit) of say Taka 70 (assuming investment income of Tk100), as bank is away from the scene having got its 30% share i.e., Taka 30. Who are the parties concerned with the rest Tk70? It is simply X, Y, Z who are at all neither related nor do they have any joint entity, nor do they all three sign any agreements among themselves.
Distribution of Tk.70 is affected for any action of any of them or other depositors including future clients. Problem lies here. Distribution of depositors profit of Tk.70 is made according to any such weightage for which among the beneficiaries there remains no contract at all. Nor do all the beneficiaries have any single entity to act on behalf of the whole. X is not aware that Y interferes into his share; Z does not have any agreement with X to play role in lowering or raising his share of profit out of Taka 70. All these distribution do not at all matter the Bank's share of Taka 30. But what is desired or fair? Profit sharing contract must be among the sharers. If we stick to distribute profit on Mudaraba principle we must have a direct sharing ratio between the bank and the client. This vital point is absent in the weightage based agreement. For bringing validity in such a contract there remain two options:
I) All the Mudaraba depositors throughout the country and throughout the year should sign a single contract with the Bank. All (existing and future clients) may, forming an entity, authorize some one to sign on behalf. Or
II) There must be multilateral several contracts within the Mudaraba depositors requiring a permutation computation for arriving at the number of contracts required.
Both the above options are impractical.
So, we stick to distribute profit on Mudaraba principle. We must have a direct sharing ratio between the bank and the client. Income Sharing Ratio (ISR) is one of such ratios. All other assumptions, auxiliary to the system are always subject to customisation, and changeable. Under ISR based framework, every Mudaraba depositor agrees respective predetermined ISR, be it 10:90 or 70: 30 or any other different ratio. Every contract is a bilateral agreement between the Rab-al-Maal (fund provider / depositor) and the Mudarib (Bank). Every bilateral contract is independent. Bank's contract or recontract with any existing or future client does not at all affect any other depositor's share. Assuming other things in order, bilateral contract of every account holder on one side, and bank on the other side is alright.
Separation of fixed management fees (30% for example as cited) was, therefore, stipulated in the first tier of Weightage system. This step inadvertently made the mechanism of depositors' sharing of residual profit within themselves through weightage defective. Central Shariah Board of Islamic Banks of Bangladesh has recommended ISR based profit distribution framework.
Weightage system as it is now should either be placed or repaired to make bilateral independent contract with each client separately. This is not a matter of personal or institutional ego. We would do all this for the satisfaction of Allah and to leave a fair module for our successors.
The writer is the First Vice President and Head of Islamic Banking of Bank Asia Ltd. He can be reached through e-mail afzal@bankasia.com.bd Opinions expressed in the article are of the writer's own and not necessarily of the organisation he
is serving for.
It is heartening to note that our banks, including the largest Sonali Bank Limited, have started Islamic banking. This state-owned commercial bank has started Islamic banking operations by opening 5 Islamic Windows. Serious and sincere officials therein seem to be extremely conscious of compliance of the ethical and Shariah standard so that the clients of Islamic banking are not deprived in any way. This seriousness has been reflected in the article 'Does Islamic banking requires any framework of rate of return alternative to Weightage system?' by Mr. Md. Gias Uddin Ahammed of Sonali Bank, published recently in the Financial Express. We must thank him for his client-friendly stand and thirst for fair thinking. He preferred Weightage system. He has also urged upon Islami Bank Bangladesh Limited, Central Shariah Board for Islamic Banks of Bangladesh as well as Bangladesh Bank to advise on the issue. His article was in fact a valuable comment on my recommendation for an alternative to Weightage system. He was kind enough to thank me for that article which appeared in this newspaper on May 19, 2010. But his analysis and inference have brought me for the second time to discuss the issue for clarification.
Mr. Ahammed has very rightly presented Weightage based as well as Income Sharing Ratio (ISR) based framework which is the echo of my above referred article. But surprisingly he drew a transparently reverse inference and opined in favour of the Weightage system ranking the same as superior to ISR based framework.
The depositors might be concerned for rate of distributable profit. But we recognise the same as the strength and never as weakness of ISR. We should rather be proud of this spirit as it really echoes Islamic banking. This is the beauty of (Islamic bankers') Mudaraba contract, under which Mudaraba deposit is collected. Because, in spirit, the return of Mudaraba is always uncertain and the profit rate can not be pre-determined. An earning is treated as profit; in Mudaraba it must be actual profit. It is worth to note that although the purpose is profit, in Mudaraba there remains no guarantee of rate of profit. Uncertainty, resulting in the concern for profit, losing profit and even for principal etc. is inherent in Mudaraba. It is indeed a risky venture. For the sake of transparency, those risk factors are not to be concealed. Then comes the question of the priority of Mudaraba deposit over non-Mudaraba deposit under Weightage system vs proportional treatment of the same under ISR system.
The assumption of non-discrimination between Mudaraba & Non-Mudaraba deposit, in the matter of investment, is not the essential criterion for the ISR (as well as Mudaraba principle). Essential criterion of the ISR is bilateral contract of the bank with each client specifying their respective sharing ratio unlike fixed management fees under Weightage system. (Under weightage system profit of one depositor is affected by others' contract with bank). The ISR itself does not disallow this type of priority treatment. Anyone may design a policy basically based on the ISR but having better assumption to produce better result for the Mudaraba depositors.
Similarly, this is also true for Weightage system. We know that the assumption in prevailing Weightage system to net off the Mudaraba deposit by deducting concerned CRR or SLR in determining the rate of profit thereon cuts off the profit of the Mudaraba depositors. The matter may also be treated by a critic as an ill motive to reduce the income of the depositors. Here also we understand that Netting off is not the basic criteria of weightage system. This assumption can easily be avoided. Depositing Tk100, one may not think it justified to take profit on Tk90 only on the plea of bank's requirement of 10.50% SLR (Statutory Liquidity Reserve). Opportunity cost of SLR may be considered implied operating cost of the banking business. Prevailing ISR framework assumes it so, and therefore, does not reduce it from Mudaraba deposit while determining profit therein. This is not the fundamental criterion of ISR. One may adopt ISR and at the same time, as is done under weightage system, he may net off the deposit amount for profit calculation if deemed fit. Obviously keeping the ISR intact, netting off the deposit would reduce the profit of the Mudaraba depositors; but such an auxiliary component can not be the ground for adopting or rejecting the basic framework. Rather any such assumption may be amended with appropriate explanation keeping the basic framework intact. But at the same time we must keep in mind that all the depositor-friendly assumptions may be washed out by bank through offering lower sharing ratio to the Mudaraba depositors and vice versa. If fundamental or core principle of the contract is valid, then auxiliary assumptions matter a little and as such the latter may be adopted, amended or rejected on the basis of circumstances. Hundreds of favourable assumptions are not enough to rectify any fundamental wrong in any contract.
An investor needs not know where bank's fund comes from. Investment process does not categorise its sources of fund, unless there is any restricted a/c or Refinance Schemes. Any such exceptional issues can't be generalised and as such kept beyond the purview of our discussion. Return on investment is never decided on the basis of the specific sources of fund which is injected therein. It may rather be based on the overall cost of deposit/ fund of the bank as a whole and other pricing factors. Except for specific ones there would hardly be found any instance where rate of return on investment is lowered because a particular fund to finance the same has been arranged from low cost source say MSA (Mudaraba Saving A/c) and no investment is priced higher as fund therefor is collected from a very costly sources say MHSA (Mudaraba Haj Savings A/c). In general the pricing/ rate of return on investment funded by each Tk.100 of MSA and each Tk.100 of MHSA may be same disregarding their difference in respective cost of fund. This is because of the fact that investment is made from the pool of fund, not from the specific source based fund. Source of fund of investment is practically not demarcated in general, for specific investment.
In banking business, a fund manager can't always confirm to fulfill entire need of fund from non-Mudaraba sources avoiding Mudaraba fund. Any unscrupulous technique to cheat the depositors should, however, not be our issue to talk about. We are talking about the principle, not of the malpractice.
For comparison purpose we would highlight the basic points only. Weightage framework provides uniform / fixed Management fee for the bank against all groups of Mudaraba depositors collectively. Again in the second tier of distribution, each group of depositors gets different sharing ratio in the name of Weightage. This 2nd tier distribution distorts the profit of different groups on different occasions, like change of Weightage of a particular group or change of deposit mix etc. Therefore, ISR based module by way of entering into separate Income Sharing Ratio with different types of depositors was prescribed in the article of 19/05/2010 with reasonable details. Readers are only referred thereto, avoiding repetition for obvious reason.
It is simply immaterial or irrelevant which method produces better profit for the depositors. The important is the validity of the relevant contract, no matter which bank incurs low cost for its better deposit mix i.e. by virtue of efficient fund management. Better fund management complying Shariah is a sign of prudence. A finance officer is not to bother whether a depositor gets higher or not. He must be economic until Shariah bars. It is the bank as a whole, which should pay the due profit to depositors according to the valid contract. We, at this stage must stick to a single point. If the Weightage framework is beyond questions in the eyes of Shariah, then no need of any new module like ISR arises at all. Otherwise a valid contract like ISR should replace the void or suspicious Weightage contract. We must bear in mind that both ISR and Weightage system are bound by Mudaraba contract. We are to be sanguine that the contract itself (which binds the bank and the depositor) fulfils the fundamentals of relevant Shariah principle. Assumption, on the other hand, as already pointed out is nominal for both of them. Fundamentals are like Fard (Mandatory, essential) and auxiliary assumptions are Nafal (optional, extra) and hence subject to change or may also be avoided under circumstances. Fundamental is the factor that matters. So, fundamental of Mudaraba is to check. Mudaraba is a contract between two or more parties to, among other things, share profit according to predetermined ratio.
A Mudaraba contract to be enforceable, each of the concerned parties should be independent, be it individual or institution. In prevailing Weightage system, weightage is ratio among the depositors themselves only. At that time bank remains no more a party to the contract to share residual or ex-bank profit among the depositors. Here the total of distributed profit remains unchanged like that of the bank. Only depositors' share of profit is engineered. Bank is only an agent to calculate the respective shares of the depositors. Absence of contract among the depositors (who are affected for the contract between the bank and any of the depositors) themselves make the Mudaraba contract of Account Opening Form defective. A client (say Mr. X) is not aware when bank makes an agreement with Y. Yet this agreement with Y may substantially affect the dues of X. It can't be a fair deal because bank and Y making a contract between themselves shouldn't snatch the share of profit of X where the latter is not a party and as such has no role to play.
The contract is supposed to be between the Mudarib (bank) and Shahib-al-mal (fund provider). What is the agreement between a client and the bank regarding profit distribution under Weightage system? Say X, Y & Z are individual depositors. They all individually make bilateral agreement with the bank to share profit say at a ratio of 30:70 for bank and the clients respectively. Besides this ratio X, Y & Z are given weightages of say .7, .5 & .4 respectively. What actually happens here is that the profit sharing between the bank and the clients remains static and of course valid as 30:70. On the part of the Mudaraba depositors as a whole 30% is forgone for the bank. Now comes the second-tire distribution (application of weightage on residual profit) of say Taka 70 (assuming investment income of Tk100), as bank is away from the scene having got its 30% share i.e., Taka 30. Who are the parties concerned with the rest Tk70? It is simply X, Y, Z who are at all neither related nor do they have any joint entity, nor do they all three sign any agreements among themselves.
Distribution of Tk.70 is affected for any action of any of them or other depositors including future clients. Problem lies here. Distribution of depositors profit of Tk.70 is made according to any such weightage for which among the beneficiaries there remains no contract at all. Nor do all the beneficiaries have any single entity to act on behalf of the whole. X is not aware that Y interferes into his share; Z does not have any agreement with X to play role in lowering or raising his share of profit out of Taka 70. All these distribution do not at all matter the Bank's share of Taka 30. But what is desired or fair? Profit sharing contract must be among the sharers. If we stick to distribute profit on Mudaraba principle we must have a direct sharing ratio between the bank and the client. This vital point is absent in the weightage based agreement. For bringing validity in such a contract there remain two options:
I) All the Mudaraba depositors throughout the country and throughout the year should sign a single contract with the Bank. All (existing and future clients) may, forming an entity, authorize some one to sign on behalf. Or
II) There must be multilateral several contracts within the Mudaraba depositors requiring a permutation computation for arriving at the number of contracts required.
Both the above options are impractical.
So, we stick to distribute profit on Mudaraba principle. We must have a direct sharing ratio between the bank and the client. Income Sharing Ratio (ISR) is one of such ratios. All other assumptions, auxiliary to the system are always subject to customisation, and changeable. Under ISR based framework, every Mudaraba depositor agrees respective predetermined ISR, be it 10:90 or 70: 30 or any other different ratio. Every contract is a bilateral agreement between the Rab-al-Maal (fund provider / depositor) and the Mudarib (Bank). Every bilateral contract is independent. Bank's contract or recontract with any existing or future client does not at all affect any other depositor's share. Assuming other things in order, bilateral contract of every account holder on one side, and bank on the other side is alright.
Separation of fixed management fees (30% for example as cited) was, therefore, stipulated in the first tier of Weightage system. This step inadvertently made the mechanism of depositors' sharing of residual profit within themselves through weightage defective. Central Shariah Board of Islamic Banks of Bangladesh has recommended ISR based profit distribution framework.
Weightage system as it is now should either be placed or repaired to make bilateral independent contract with each client separately. This is not a matter of personal or institutional ego. We would do all this for the satisfaction of Allah and to leave a fair module for our successors.
The writer is the First Vice President and Head of Islamic Banking of Bank Asia Ltd. He can be reached through e-mail afzal@bankasia.com.bd Opinions expressed in the article are of the writer's own and not necessarily of the organisation he
is serving for.