Rationale behind Weightage-based profit distribution module under Islamic banking
Thursday, 4 November 2010
Md. Gias Uddin Ahammed
Weightage based module has been practiced for profit distribution on deposits under Islamic banking for a long time and the system has already attained trustworthiness of hundreds of thousands of depositors interested in Shari'ah based banking. Again, Bangladesh Bank (BB) has prescribed the system as a standard framework for calculation of 'Rate of Return' in its guidelines for Islamic banking. However, some questions have been raised against this system and a new system has been proposed recently in its place. We think, the objections being raised against and replies to them lie in the system.
In weightage based profit distribution module, Profit Sharing Ratio (PSR) to Mudaraba deposits (say, minimum 65 percent of Investment Income earned through deployment of Mudaraba Fund) and different weightages for different Mudaraba deposits play an important role in determining ultimate rate of return. Since PSR is somewhat easy to understand we would explain here as to what a respective weightage assigned to one specific deposit product means and why and how different weightages have been assigned to different Mudaraba deposits. In fact, weightage can be explained in many ways. For example, if weightages are assigned 1.30 to product 'A', 1.00 to product 'B' and 0.55 to product 'C'; it may be deemed that Tk. 100 of each product 'A', 'B', 'C' will be considered, for profit distribution, as Tk.130, Tk. 100 and Tk.55 for product 'A', 'B', 'C' respectively and if product 'B' gets 10% as final rate of profit, product 'A' and 'C' will get 13 percent and 5.5 percent respectively provided that no additional amount of profit is paid to any product by the bank over the rate comes as per weightage.
Under this system, different weightages have been assigned to different Mudaraba Deposits by considering many factors. Among them, most vital ones are explained below.
Period of Deposits: It is assumed that the longer the period of a Mudaraba Deposit, the higher the risk it bears with regard to fluctuation of the rates of profit and erosion of the value of deposit due to inflation. In fact, time value of money is considered here.
Banking Facilities: Some deposits such as Mudaraba Term Deposit, Mudaraba Savings Bond, different Savings Schemes do not enjoy any banking facility like operating accounts by Cheques/ATM cards, collection of different instruments, online facilities etc. On the other hand, Mudaraba Savings depositors can get the above services through their accounts. Moreover, Mudaraba Special Notice Depositors enjoy greater facilities relating to making deposits in and withdrawal from their accounts with a short time notice. Maintenance of adequate liquidity is required for these types of deposits. In this context, weightages are assigned such a way that the depositors enjoying higher degree of banking services will get lower weightage and vice versa.
Socio-economic impact: Some deposit products are designed to help especially rural and poor people make savings with a small amount of monthly installment and profit paid on these products have a positive impact on the society as well as the economy. So, they are assigned higher weightages.
Money Market Scenario: Islamic banks in Bangladesh have to operate their activities in a Money Market where conventional banks still play the vital role. So, the pattern of Rates of Return on various types of cost/interest bearing deposits of the traditional banks in the market have also an important bearing on allocation of weightage at different rates.
First objection against the system is that it is a double tier distribution process and hard to understand/estimate Rate of Return. No doubt, it is a double tier distribution process and hard for general people to understand/estimate the rate of return. To ease the problem, depositor interested to open Mudaraba deposit account is furnished with provisional profit rate. Provisional profit rate is fixed by the management of the bank bearing in mind previous year's final rate of profit, condition of money market, regulatory decision and recent as well as projected performance of the bank in investment portfolio.
Second objection against the system is that banks can manipulate and declare provisional profit rate as the final rate of profit. Islamic banks are not supposed to and required to do so. Because, provisional profit is paid on condition that any difference between the profit paid and the final profit made will be adjusted. We, however, see nothing wrong with a bank if it is able to arrive at, by paying minimum 65 percent or more than 65 percent of distributable profit as per Mudaraba contract, a final profit rate identical to the rate it paid as provisional profit rate. Depositors, regulatory bodies, Shariah Supervisory Committee are to observe whether the bank is doing so by paying less than 65 percent or more than 100 percent of distributable profit to cope with the provisional rate.
Third objection against weightage system is that due amount of profit to individual type of depositors is affected by a) A positive change of weightage of any one or more types of the Mudaraba deposits, b) change in the proportion of individual deposit type among the total deposit and c) inclusion of any new Mudaraba deposit product.
a) It cannot be denied, as mathematically proved, that due amount of profit to individual type of deposits is affected by a positive change (if negative change, other types of depositors will be benefited) of weightage of any one or more types of the Mudaraba deposits. Fact is that, banks do not change weightage without having strong ground 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, bank can pay additional profit from its own share to any product over the rate comes as per existing weithtage. For example, Islami Bank Bangladesh Limited (IBBL) has to pay an additional amount of profit to Mudaraba Perpetual Bond (MPB) equivalent to 10 percent of the rate of Proposed Dividend over the rate comes as per assigned weightage. Even if bank changes weightage of one Mudaraba deposit for its own sake and wishes not to affect other Mudaraba depositors, it can do it by simply increasing (sacrificing) ratio to Mudaraba depositors.
b) Change in the proportion of individual deposit type among the total deposit will have impact on due amount of profit to individual types of depositors if it has no effect on investment income. But reality says that, deposit of more weighted product helps the bank to go for long term and more investment than that of less weighted product. For example, from Tk. 100 of MSA, maximum Tk. 80 can be invested (considering SLR 10.50 percent and Demand Liability 9 percent) for a short term period whereas from Tk. 100 of MHSA (10 Years Term) Tk. 89 can be utilized for long term investment. So it is assumed that deposit mix of Tk. 300 (MSA-100, MHSA-200) can earn more Investment Income than that of Tk. 300 (MSA-200, MHSA-100) and it will nullify impact of the change.
c) Generally bank introduces new deposit product when it needs fund for investment or liquidity purpose. Investment keeps Investment Income increasing and Liquidity secures existing investment. So it does not assign weightage to the new product such a way that existing depositors will be affected and leave the bank.
As per as Shari'ah/ethics is concerned, whenever discrepancy is noticed in a system, it must be rectified immediately. However, there is always scope for improvement or correction for the sake of the depositors and Islamic banking as a whole.
The writer is a senior officer of Sonali Bank Limited. Views expressed in the article are of author and not the organisation he works for. He ca be reached at E-mail: gias49@ovi.com
Weightage based module has been practiced for profit distribution on deposits under Islamic banking for a long time and the system has already attained trustworthiness of hundreds of thousands of depositors interested in Shari'ah based banking. Again, Bangladesh Bank (BB) has prescribed the system as a standard framework for calculation of 'Rate of Return' in its guidelines for Islamic banking. However, some questions have been raised against this system and a new system has been proposed recently in its place. We think, the objections being raised against and replies to them lie in the system.
In weightage based profit distribution module, Profit Sharing Ratio (PSR) to Mudaraba deposits (say, minimum 65 percent of Investment Income earned through deployment of Mudaraba Fund) and different weightages for different Mudaraba deposits play an important role in determining ultimate rate of return. Since PSR is somewhat easy to understand we would explain here as to what a respective weightage assigned to one specific deposit product means and why and how different weightages have been assigned to different Mudaraba deposits. In fact, weightage can be explained in many ways. For example, if weightages are assigned 1.30 to product 'A', 1.00 to product 'B' and 0.55 to product 'C'; it may be deemed that Tk. 100 of each product 'A', 'B', 'C' will be considered, for profit distribution, as Tk.130, Tk. 100 and Tk.55 for product 'A', 'B', 'C' respectively and if product 'B' gets 10% as final rate of profit, product 'A' and 'C' will get 13 percent and 5.5 percent respectively provided that no additional amount of profit is paid to any product by the bank over the rate comes as per weightage.
Under this system, different weightages have been assigned to different Mudaraba Deposits by considering many factors. Among them, most vital ones are explained below.
Period of Deposits: It is assumed that the longer the period of a Mudaraba Deposit, the higher the risk it bears with regard to fluctuation of the rates of profit and erosion of the value of deposit due to inflation. In fact, time value of money is considered here.
Banking Facilities: Some deposits such as Mudaraba Term Deposit, Mudaraba Savings Bond, different Savings Schemes do not enjoy any banking facility like operating accounts by Cheques/ATM cards, collection of different instruments, online facilities etc. On the other hand, Mudaraba Savings depositors can get the above services through their accounts. Moreover, Mudaraba Special Notice Depositors enjoy greater facilities relating to making deposits in and withdrawal from their accounts with a short time notice. Maintenance of adequate liquidity is required for these types of deposits. In this context, weightages are assigned such a way that the depositors enjoying higher degree of banking services will get lower weightage and vice versa.
Socio-economic impact: Some deposit products are designed to help especially rural and poor people make savings with a small amount of monthly installment and profit paid on these products have a positive impact on the society as well as the economy. So, they are assigned higher weightages.
Money Market Scenario: Islamic banks in Bangladesh have to operate their activities in a Money Market where conventional banks still play the vital role. So, the pattern of Rates of Return on various types of cost/interest bearing deposits of the traditional banks in the market have also an important bearing on allocation of weightage at different rates.
First objection against the system is that it is a double tier distribution process and hard to understand/estimate Rate of Return. No doubt, it is a double tier distribution process and hard for general people to understand/estimate the rate of return. To ease the problem, depositor interested to open Mudaraba deposit account is furnished with provisional profit rate. Provisional profit rate is fixed by the management of the bank bearing in mind previous year's final rate of profit, condition of money market, regulatory decision and recent as well as projected performance of the bank in investment portfolio.
Second objection against the system is that banks can manipulate and declare provisional profit rate as the final rate of profit. Islamic banks are not supposed to and required to do so. Because, provisional profit is paid on condition that any difference between the profit paid and the final profit made will be adjusted. We, however, see nothing wrong with a bank if it is able to arrive at, by paying minimum 65 percent or more than 65 percent of distributable profit as per Mudaraba contract, a final profit rate identical to the rate it paid as provisional profit rate. Depositors, regulatory bodies, Shariah Supervisory Committee are to observe whether the bank is doing so by paying less than 65 percent or more than 100 percent of distributable profit to cope with the provisional rate.
Third objection against weightage system is that due amount of profit to individual type of depositors is affected by a) A positive change of weightage of any one or more types of the Mudaraba deposits, b) change in the proportion of individual deposit type among the total deposit and c) inclusion of any new Mudaraba deposit product.
a) It cannot be denied, as mathematically proved, that due amount of profit to individual type of deposits is affected by a positive change (if negative change, other types of depositors will be benefited) of weightage of any one or more types of the Mudaraba deposits. Fact is that, banks do not change weightage without having strong ground 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, bank can pay additional profit from its own share to any product over the rate comes as per existing weithtage. For example, Islami Bank Bangladesh Limited (IBBL) has to pay an additional amount of profit to Mudaraba Perpetual Bond (MPB) equivalent to 10 percent of the rate of Proposed Dividend over the rate comes as per assigned weightage. Even if bank changes weightage of one Mudaraba deposit for its own sake and wishes not to affect other Mudaraba depositors, it can do it by simply increasing (sacrificing) ratio to Mudaraba depositors.
b) Change in the proportion of individual deposit type among the total deposit will have impact on due amount of profit to individual types of depositors if it has no effect on investment income. But reality says that, deposit of more weighted product helps the bank to go for long term and more investment than that of less weighted product. For example, from Tk. 100 of MSA, maximum Tk. 80 can be invested (considering SLR 10.50 percent and Demand Liability 9 percent) for a short term period whereas from Tk. 100 of MHSA (10 Years Term) Tk. 89 can be utilized for long term investment. So it is assumed that deposit mix of Tk. 300 (MSA-100, MHSA-200) can earn more Investment Income than that of Tk. 300 (MSA-200, MHSA-100) and it will nullify impact of the change.
c) Generally bank introduces new deposit product when it needs fund for investment or liquidity purpose. Investment keeps Investment Income increasing and Liquidity secures existing investment. So it does not assign weightage to the new product such a way that existing depositors will be affected and leave the bank.
As per as Shari'ah/ethics is concerned, whenever discrepancy is noticed in a system, it must be rectified immediately. However, there is always scope for improvement or correction for the sake of the depositors and Islamic banking as a whole.
The writer is a senior officer of Sonali Bank Limited. Views expressed in the article are of author and not the organisation he works for. He ca be reached at E-mail: gias49@ovi.com