Deposits Management

1. Introduction

Banking is a business of intermediation between savers (depositors) and users (investors) of funds, and Islamic banking has no exception. However the nature of relationship between Islamic bank and its customers is entirely different from conventional banking. In previous chapters (2 to 8) I have discussed the nature of relationship between Islamic bank and users of funds along with financial impact and legal rights and liabilities. In this chapter I will present the mechanism of deposits management by Islamic Financial Institutions (IFIs). Like conventional banking IFIs are also offering the facility of current, savings and fixed deposits, however no risk free return is offered rather deposits are accepted either interest free loans (current deposits) or  under Musharaka and Mudaraba modes of financing.

Current deposits are accepted as loans from depositors which can be withdrawn on demand by depositors. Some of the Islamic banks are accepting these deposits as Ammanah.  If Ammanah deposits are lost without negligence of bank, making the loss of depositors good is not responsibility of the bank, hence, Ammanah deposits are not recommended to safeguard the interest of both bank and customers. Under loan current deposit scheme bank has the flexibility to use the funds and customer is protected from loss of amount in case of any miss-happening (burglary, fire, theft etc.) in any branch of bank.

Saving deposits are accepted under profit and loss sharing schemes hence Shari’a rulings of Musharaka and Mudaraba apply as the case may be. Generally banks are accepting deposits under Mudaraba then mix the funds of bank and create a joint pool for investment. Out of this pool after meeting the statutory reserve requirements investment portfolio is created and managed by IFIs. Investment Portfolios of IFIs consist of Murabaha (cost plus profit sale), Salam sale (spot payment with deferred delivery), Istisna’a sale (manufacturing transactions), Ijarah (leasing), Musharaka (partnership in capital), diminishing Musharaka (used in house financing) and Mudaraba (partnership in skill and capital). Share of each mode of financing is determined on the basis of risk and return. Any profit generated on investment portfolio is shared by bank and depositors. As deposits are not fixed hence depositors are free to deposit and withdraw which had created problem in profit distribution. IFIs came up with solution of profit distribution on daily product basis (discussed in following section).

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Third category of deposits is time deposits under profit and loss sharing system. Under the scheme deposits are accepted for a fixed period which provides opportunity to IFI to invest in more profitable long term projects hence depositors of this scheme are getting higher profit in comparison of second scheme discussed above. Longer the period, higher the rate of return is earned. This is happening through weight age system discussed in section of daily product. Higher return to longer period deposits is justified because it provide an opportunity to IFI to invest the funds in long term projects, generally giving higher return, without the fear of returning to depositors on demand. 
IFIs working in Pakistan have shown tremendous growth in deposit collection on the basis of profit and loss during last eight years 01/04-31/11 as depicted in Figure 9.1. Increasing number of deposits on profit sharing basis provides evidence of successful application of sharing modes and trust of masses in IFIs working in Pakistan

Fig 9-1. Deposit collected (PKR Billion) by IFIs during 01/04-09/10.

9.2. Daily product system

In banking business facility of deposits and withdrawals is provided to depositors as per their needs and preferences except under time deposits. It created problem in calculation of share in profit and loss of each depositors because profits on investments are generated and disclosed periodically (monthly, quarterly, semi annually and annually). IFIs responded the issue by creation of daily product formula to share the outcome with all depositors except current account holders. Daily product is calculated by multiplying the amount of a deposit with number of days remained in bank, hence daily product of a deposit amounting to Rs; 1,000 remained in bank for one month is double in comparison with a deposit of same amount remained in bank for 15 days. Keeping other things same share in profit of earlier deposit is double than later. Under daily product system profit and loss of a period is shared among depositors on the basis of tenure of deposits.

Another invention of IFIs is the allotment of weight-age to deposits as per tenure. Generally weight of 1 is awarded to a deposit remained in bank for one year and less than 1 is awarded to deposits remained in bank for a period less than one year. what should be weight-age of a deposit of six months, three months and a month depends upon number of factors including nature of investment projects executed by bank, risk free rate offered by conventional banks, because IFIs are competing with conventional banks in costs and profits to customers in order to maintain their competitiveness and saving the customers to pay additional cost or forego return as a cost of being Muslims and transecting business with IFIs. Reasons of matching the costs and revenues with conventional banking are obvious including lack of bench mark for IFIs and capturing of minor market share.

9.3. Financial Impact

Financial impact of deposits under current account is same for an IFI as it is under conventional banking i.e current account deposits are liabilities of bank and reported under short term liabilities in the balance sheet of bank. However financial impact of deposits under profit and loss sharing system is entirely different from conventional banking savings account irrespective of demand and time deposits (figure 9-2). Under conventional banking saving accounts are liabilities of bank while under Islamic financial system savings deposits form part of equity. Conventional banks are bound to return principal amount of deposits along with interest except in case of insolvency which is not the case under Islamic banking. Under Islamic banking these deposits are under profit and loss sharing system and Islamic banks are required by agreement to share the outcome with depositors which can be negative as well as positive. Guarantee of capital is not provided under Musharaka and Mudaraba hence depositors can even lose their principal as well if a heavy loss is being incurred in bank. However empirical evidence suggests that loss of principal by depositors has never happened in a short history of Islamic banking and of course one should kept in view the efficient team of professionals working in banking business and prudential regulations issued by central bank while thinking about riskiness of deposits under profit and loss sharing. Following balance sheet displays the deposits of Islamic banking under Musharaka and Mudaraba system.

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Fig 9-2. Margalla Islamic Bank

Balance Sheet, as at December 31, 2009

Assets	Rs. (000)	Liabilities & Equities	Rs. (000)
Current Assets Cash and balances Accounts R/A Inventory (assets for sale) Salam financing Short term investments Total current assets Investments under PLS Property, plant & equipment Total long term assets	3,830 2,000  500 500 150 6,980 1,000 2,000 3,000	Liabilities Payables and balances Current deposits Charity fund Total liabilities Equities PLS deposits balances Shareholders’ equity Paid up capital Statutory reserves R. earnings/ Un appropriated Total Equities	400 3,600 4 4,004 1,800 3,000 400 776 5,976
Total assets	9,980	Total liabilities & Equities	9,980

            Note the difference; all types of deposits under conventional banking are reported under liabilities of bank while under Islamic banking only current deposits form part of liabilities while savings deposits are displayed under the heading of external equities which means bank is not obliged to return the amounts except in case of negligence on behalf of bank. This system is reducing the risk of banking business by sharing with depositors and give confidence to depositors being partners in banking business which creates sense of ownership and soft corner for success of banking enterprise among masses.

9.4. Concept Building

Illustration.1. bank Islami ltd; received the following deposits during first quarter of its operation in Suburbs Islamabad.

Name	deposits in PKR	deposit date	withdrawal date	# of days
Khan	100,000	01/01/09	01/03/09	59
Malik	500,000	15/01/09	14/02/09	30
Warraich	200,000	20/01/09	not yet	70
Chaudhry	400,000	01/02/09	01/03/09	28

If profit of bank for the quarter without charging for operating expenses is Rs; 200,000 and operating expenses are Rs; 140,000 what is share in profit of bank and each depositor assuming share of mudarib is 80%? What is percentage return per annum on amounts deposited?

Solution

Following work sheet shows the profit distribution. Bank is receiving Rs; 160,000 [80% of 200,000] as share of mudarib and spends Rs; 140,000 operating expenses consequently profit earned is Rs; 20,000 for the quarter. Balance amounting to Rs; 40,000 is distributed among the depositors on daily product basis.

Work Sheet

Illustration.2. In continuation of illustration 1. Suppose following weights are assigned to the deposits on the basis of tenure.

Tenure	Weight
3 Months	1.00
2 Months	0.80
1 Month	0.60

Required:

Calculate the profit and percentage return per annum on each deposit.

Solution

Following work sheet depicts the calculations.

Work Sheet

Illustration.3. In continuation of earlier illustrations, suppose it is policy of bank to match return on deposits with conventional bank and following rates are offered by conventional banks on deposits.

Tenure	Percentage returns p.a.
3 Months	45%
2 Months	30%
1 Month	20%

Solution

In case of one and two months return under Islamic bank is higher hence no adjustment is required and Islamic bank cannot deduct the additional amount from customer which is his (customer’s) share in Mudaraba.

In case of three months deposit return is lesser than conventional bank and in order to retain customer Islamic bank can sacrifice his share of profit in favor of customer. Hence IFI has to sacrifice an amount of Rs; 1,000 out of his share of profit to retain the customer. This compensation must not form part of Mudaraba agreement, however at the time of distribution if IFI wants to sacrifice a portion of profit in favor of depositors, it is allowed by Shari’a scholars.

Illustration.4. First Islamic bank started operation with a capital of Rs; 10 millions on January 1^st 2010.

Following transactions completed during the first quarter of operation.

2010

January 02       Received current deposit from Mr. Khan Rs; 2,000,000.

January 04       Entered promise with Saqib for supply of 10 computers.

January 08       Khan withdrawn from his account Rs; 500,000.

January 10       Malik deposited in fixed PLS deposit for a quarter Rs; 1,000,000.

January 12       Margalla Corporation deposited in current account Rs; 2,000,000.

January 14       Murabaha sales contracted concluded with Mr.           Saqib for sale of 10 computers with 15% markup on cost price amounting to Rs; 50,000 each computer payable in 2 equal installments semiannually.

January 15       Entered into lease contract with Hasham for car          purchased amounting to Rs; 500,000. Monthly rent agreed amounting to Rs; 10,000.             

January 20       Entered into Mudaraba contract with Shabir with capital of Rs; 500,000 on profit sharing ratios             50:50.

January 25       Received deposit of Rs; 1,000,000 on profit and        loss sharing from Alam.

January 30       Paid operating expenses amounting to Rs; 100,000.

Required:

Prepare trial balance of the bank as January 31, 2010.

Solution

Following is the work sheet depicting closing balances of accounts.

Work Sheet Rs in ‘000’

Illustration.5. Based on information in illustration 4 calculate the profit of bank for first month of operation and prepare balance sheet as at January 31, 2010.

Solution

Following is profit and loss statement and balance sheet of bank.

  

First Islamic Bank

Income Statement,  for the month of January 2010

First Islamic Bank

Balance Sheet, as at January 31, 2010