depositsmobilazation

By HAMDAN HJ IDRIS,

BSc Econs, MBA ( Islamic banking & Finance)CPTrainer (MIM)Academic Fellow

INCEIF

Islamic deposits usually serve two main functions, namely:

1.Transaction function : Wadiah Dhamanah current and savings account

2.Investment function : Al-Mudarabah Investment account

By virtue of the transactional nature of wadiah dhamanah deposits, depositors are only interested in deriving benefits from the facility offered by the product. The benefits shall include the ease of cash withdrawals on call as well as protection of deposits. The bank serves as a custodian or safe-keeper to the deposits but is allowed use them to generate income from say, murabahah or ijarah financing. But financing activities do not guarantee fixed income to the bank as it (ie bank) may incur losses arising from bad debts.

Wadiah dhamanah deposits however are protected even if the bank earns nothing from financing. In return for the protection, all income earned from financing activities shall solely belong the bank and depositors do not hold any legal claims on bank’s earning. The trade-off between capital protection and ex-post rate of return is one important economic principle of wadiah dhamanah deposits.

That is, depositors stand to receive returns but only as gifts (hibah). In this way, the distributional model of wadiah dhamanah does not provide any guaranteed sum or return to the depositors. If any, returns are given without any equivalent countervalue, say risk-taking. Wadiah dhamanah customers exposure to capital risk is zero. Thus, by virtue of the principle of al-ghorm bil ghonm, they do not deserve to receive any income or profits from the deposits.

hibahs are determined ex-post meaning it is set only when the outcome is actualized. But actualizing outcome, say making RM100 million profits from murabahah financing does not mean that the bank must or obligated (wajib) to distribute the profits. In this way, the supply curve of wadiah dhamanah deposits may be a flat one since the incentive to save does not revolve around the rate of returns but for safe-keeping and convenience purposes.

Investment function  But the same does not apply to the al-

mudarabah investment deposits. This is because al-mudarabah deposits are meant for investments with explicit agreements about profit distribution and the role of capital and knowledge. Here the economic principle of risk-return shall apply well to the contracting parties in the mudarabah transaction between the bank and the depositors.

The Islamic economic principle on risk-return relationship is none other than that adopted from the legal maxim “al-ghorm bil ghonm” which means that “no profit can be gained without taking risk”. Since Islamic investment account as a product is based on the mudarabah contract (i.e. trustee partnership), incentive to place money in mudarabah deposits must revolve around profits. It is business and nothing more

When the performance of mudarabah deposits outperform interest-bearing fixed deposits, more people are expected to place their money in the Islamic banks. But the risk associated with mudarabah deposits is market related. Systematic risks are risks of capital loss due to say, economic recession and natural calamities that often destabilize markets and therefore prices. They are not controllable by the contracting parties. Mudarabah deposits are not sparred from systematic risks. Depositors can see their savings depleting. There is no capital protection in mudarabah deposits. Instead, systematic risks are endogeneous in mudarabah.

In fact, the Islamic principle of risk-return actually pointed to the fact that risk ie ghorm predominantly refers to systematic risks. However, mudarabah investments are also exposed to operational risks as human error and negligence may jeopardize the mudarabah venture. The mudarib (ie the agent-manager) can abuse his responsibility. Thus, moral hazard is a serious factor to account for in decision making when people plan to place their savings in the mudarabah deposits.

Bearing in mind that mudarabah deposits are exposed to both systematic and operational risks, the decision to place savings in mudarabah deposits can be a challenging one.

How Deposit Insurance WorksDeposit insurance is provided to you automatically, so you don't need to sign up for it and you don't have to pay us to enjoy the protection.

Who We Are and What We Do?A Government agency established under the Akta Perbadanan Insurans Deposit Malaysia 2005 to protect you against the loss of your deposits in the unlikely event of a bank failure, and promote financial system stability.

It is established by the Government to enhance the consumer protection framework and promote financial system stability. It is not related to or managed by general or life insurance companies. Generally, it is a Government sponsored scheme, although in certain countries it is sponsored by the banks.

The deposit insurance system in Malaysia was launched in September 2005 and is managed by Perbadanan Insurans Deposit Malaysia (PIDM). PIDM is a Government agency established under the Akta Perbadanan Insurans Deposit Malaysia 2005.

Benefits to depositors• Deposit insurance protection is automatic• PIDM protects depositors holding deposits with banks• There is no charge to depositors for deposit insurance protection• Should a bank fail, PIDM will promptly reimburse depositors on their deposits

Benefits to the financial system• PIDM promotes public confidence in the Malaysian financial system by protecting depositors against the loss of their deposits• PIDM reinforces and complements the existing regulatory and supervisory framework by providing incentives for sound risk management in the financial system• PIDM minimises costs to the financial system by finding least cost solutions to resolve troubled banks• PIDM contributes to the stability of the financial system by dealing with bank failures expeditiously and reimbursing depositors promptly

With the introduction of a deposit insurance system in Malaysia, depositors receive protection for their deposits under the law. Depositors will know how and when reimbursement of their deposits will be made in the event of a bank failure.

Deposit insurance is recognised internationally as an important component of a country’s financial safety net and has been implemented in some 100 countries around the world.

PIDM’s mandate is set out in the Akta Perbadanan Insurans Deposit Malaysia 2005.

Its objectives are to: Administer a deposit insurance system Provide insurance against the loss of part or

all of deposits of a financial institution Provide incentives for sound risk

management in the financial system Promote and contribute to the stability of

the Malaysian financial system

Role and FunctionsPIDM's main functions are to:

Assess and collect premiums or fees from banks Manage the Deposit Insurance Funds Undertake resolution of non-viable banks Reimburse depositors should a bank become

insolvent Comply with Shariah principles in respect of

Islamic deposits and funds Conduct ongoing public awareness and education

initiatives

Corporate values To support the mission and vision, PIDM adopts five core values to shape its working culture.

Excellence and professionalism Integrity and trustworthiness Communication and teamwork Respect and fairness Financial stewardship

Management of Deposit Insurance Fund Since the deposit insurance system provides

coverage for both conventional and Islamic deposits, PIDM maintains and administers two separate funds:

  Conventional Deposit Insurance Fund all premiums and/or other monies received by

PIDM and assets received or vested in PIDM, as well as all expenditures incurred, in respect of conventional deposits; and

Islamic Deposit Insurance Fund all premiums and/or other monies received by PIDM and assets

received or vested in PIDM, as well as all expenditures incurred, in respect of Islamic deposits.

PIDM will manage and invest the Funds prudently to generate a reasonable return for PIDM while ensuring that the Funds are readily available to cover operating costs and make payments to depositors in the event of a bank failure. The Islamic Deposit Insurance Fund is being managed in accordance with appropriate guidelines in line with Shariah principles.

  For this reason, PIDM currently only invests its funds in safe and

liquid instruments such as Ringgit denominated securities issued or guaranteed by the Government or Bank Negara Malay

Since mudarabah deposits and incomes are not guaranteed, the bank that acts as the mudarib must be able to convince depositors that placing their money as mudarabah deposits is a good investment. It should be able to show depositors their good track records and capacity to perform well in the mudarabah ventures.

Since mudarabah deposits are risky, depositors expect more returns for each investment made. In fact any successful mudarabah deposits should outperform interest income derived from fixed deposits.

Finally, the Islamic principle of deposits in essence defies the law that guarantees the right of creditors to interest payments. This is because the law of depreciation must hold for all creatures and creations of Allah. It is common knowledge that all things in this world will undergo wear and tear. They lose value over time. This is a law in nature

In Islam, Allah is the only Being that cannot depreciate as He is the Creator and therefore all creation of God must depreciate.

The Holy Quran says, “Everything thereon is vanishing, there remaining only the Face of Your Lord, the Possessor of Majesty and Generosity (55:26-27).

In conventional economics, people will supply deposits only when they decided to save instead of spending their income on current goods and services. The decision to save, that is postponing current consumption is much influenced by the amount of money needed to compensate them from postponing current spending. This saving behaviour is explained by the concept of time-value of money (TVM).

Time preference indicates the extent of a family’s preference for current consumption over future consumption. The rationalization of interest as a price of credit began when people believe that present consumption is superior to future consumption. People prefer the present because the future is uncertain. They also think that present wants are more keenly felt than future wants. Also, people think that the present goods possess a technical superiority over future goods. That is, the passage of time allows the use of more roundabout methods of production that are more productive

In this way, the concept of time value of money examined people preferences about spending their income today or in the future. If people prefer current consumption to future consumption, then they are said to adopt a positive-time preference (PTP) outlook. They believe that current consumption brings more satisfaction than future ones

Therefore, people who are asked to postpone current consumption (i.e. creditors) must be compensated for the benefits the pleasure foregone today.. They do so because it is firmly believed that the future is uncertain and risky, thus one may not know how much utility he or she can enjoy out of future spending as opposed to current spending. In a nutsell, the PTP concept says that 1 dollar today is worth more than 1 dollar tomorrow.

However, some people do not believe that future spending is inferior to current spending. Instead they are truly convinced that they can derive more satisfaction or utility if money is spent not now but in the future. By believing so, the decision to save is based on the negative time preference (NTP) model.

For example, when people are not sure whether they can secure permanent or lifetime job, spending all their money today is not a good idea at all. Without a job in the future, money becomes a scarce commodity and thus spending them during difficult time yields higher utility. The NTP concept believes that 1 dollar today is worth less than 1 dollar tomorrow which is opposite to the positive time preference (PTP) model.

Finally, there are also some people who feel indifferent about spending their money today or tomorrow. They believe that money spent today always yield the same level of utility as money spent tomorrow. This is the neutral time preference model. People with neutral time preference do not care less about when to spend.

Conventional economics actually believed that people prefer current consumption to future consumption. This is the dominant view in global financial markets today. This is only because they believe the future as uncertain and people have no idea what the future has to offer them !!!

The belief that current spending generates more satisfaction than future spending (ie PTP) paves the way for the rationalization of interest-rates as the reward for saving. In other words, people who save will forego the satisfaction derived from current consumption. The same level of satisfaction cannot be realized when they spend the same money, say one year from now.

The saving behaviour in conventional economics is therefore dependent on the reward or compensation for waiting ie postponing current consumption. By virtue of positive time preference (PTP), creditors demand interest while debtors pay interest. But the same cannot apply to saving behaviour in Islam. Although Islam has to some extent recognizes the concept of positive time preference, it does not implicate or bring about the payments and receipts of interest as evident in conventional economics.

THE FACT THAT ISLAM FORBIDS INTEREST AS RIBA IT DOES NOT MEAN IT IS AGAINST THE CONCEPT OF POSITIVE-TIME PREFERENCE (PTF). INDEED, ISLAM HAS GIVE DUE RECOGNITION TO PTF AS EVIDENT IN THE SAYINGS OF PROPHET MUHAMMAD (PBUH). THE PROPHET (PBUH) SAID, “ VIRTUOUS ARE THEY WHO PAY BACK THEIR DEBTS WELL”.

IN THE ABOVE HADITH, DEBTORS ARE ENJOINED TO PAY MORE THAN THE PRINCIPLE LOAN (QARD) RECEIVED. ONE MAY ASK WHY THIS IS SO? ONE REASON IS GRATITUDE. THE DEBTOR IS THANKFUL FOR THE LOAN HE GETS AND BENEFITED FROM. HE KNEW THE CREDITOR HAS FORGONE HIS CURRENT CONSUMPTION FOR THE SAKE OF HELPING HIM WITH THE MONEY. HE ALSO RECOGNIZES THAT THE CREDITOR HAS RELINQUISHED THE OPPORTUNITY TO EARN RETURNS FROM LOAN GIVEN AWAY. THESE RETURNS ARE UNKNOWN AS THEY ARE SUBJECT TO BUSINESS RISK.

IN THIS MANNER, ONE DOLLAR TODAY IS SEEN MORE VALUABLE THAN ONE IN THE FUTURE. AS A TOKEN OF APPRECIATION, THE DEBTOR PAYS MORE. UNLIKE RIBA, THE INCREMENTAL AMOUNT IS NOT STATED UPFRONT AND DOES NOT CONSTITUTE A LEGAL CLAIM OF THE LENDING PARTY.

In Islam, therefore recognizing PTP does not imply awarding a contractual increase on the principle loan. Any increase from an Islamic loan (qard) can only be stated at maturity and not upfront as normally practiced in interest-bearing loan contract. The increment which is voluntary is set by the debtor. It is given away out of goodwill. In contrast, the increment from riba loans is contractual and set by the creditor.

In Islamic economics, spending behaviour of household is expected to influence their saving behaviour as well. For example, consumers who practice moderation (zuhud), will secure more surplus income ie. savings compared with those who are extravagant (tadrif). The moderation behaviour is approved by Islam and applicable only on the consumption of luxuries (kamaliyat).

Under a zuhud lifestyle, Muslims live a simple life although they can afford luxuries. While Islam does not prohibit Muslims to consume luxury goods, Muslims are free to choose their lifestyles. They can live a simple life or lead a luxurious one as long as they do not fall into debt or amass wealth from illegal sources. They too must spend on basic necessities (daruriyat) and make spend well for their families.

Savings in Islam does not mean keeping money as idle balances. All savings must be injected back into circulation. It must be invested. If money is kept as idle balances, people who need money for working capital or to purchase plant and machinery will not be able to do so. Without money to spend business will cease to exist and the economy will fall into a recession with implications on growth and employment

Savings can be put into many financial products. People can save by buying stocks and bonds or unit trusts. They can also save by buying insurance policy. But usually most people save in bank deposits.

The objective of savings is best described in the Quranic story of Prophet Yusof (may God be pleased with him) where the importance of savings is highlighted in its true color. Surah Yusof (12:3-49) tells the story of a Pharaoh in Egypt who had a strange dream about seven fat cows. He also saw in his dream seven green ears of wheat and seven withered or ears of wheat.

He asked his advisors to interpret the dream, but no one is good enough to do so. Prophet Yusuf who is well known for his honesty and special ability to interpret dreams was brought to see the Pharoah.

In his interpretation about the dream, Prophet Yusuf enlightened the Pharoah about the future problems of Egypt. He also suggested the remedies. He said that Egypt will enjoy seven years of prosperity with abundant harvests. In modern times, this may be taken to mean high economic growth. Prophet Yusof advised the people of Egypt to cultivate their crops diligently and use a reasonable amount for food and sustenance while storing the remaining surplus. This is because when prosperity comes to an end, Egypt will suffer from serious drought for seven long years when no crops would grow. But with the reserves in store, the people of Egypt could survive the seven bad years.

Prophet Yusuf cautioned the Pharoah not to consume all the reserves but to leave the best portions for seeds to cultivate later when rains filled the Nile. In other words, people must set aside money for savings and investment. To postpone current consumption to make way for production of future goods was one of the main messages that Prophet Yusuf wanted the Pharaoh to do for his people.

The incentive to save can also be examined at the micro level of Muslim behaviour. In Islam, savings will always means surplus income to be placed for investment purposes, thus keeping money in circulation. All savings must be invested again in the economy. Otherwise it is tantamount to hoarding (ihtikar)

The basic idea of savings is to avoid hoarding money as the latter is prohibited in Islam. When people hoard money, there is less currency around to use. It will frustrate business transaction and put production to a halt since there is no money available to pay suppliers and workers. Hoarding money will put money out of circulation and therefore reduces sale and purchases.

When people hoard money for fear of losing them, they must know that the idle money is subject to Zakat. For example, Ali places his $20,000surplus in his safe-deposit buried under his house. At the end of the year, he must pay 2.5 per cent zakat ie $500 from the idle balances. Zakat in this manner is a penalty for the hoarding behaviour where he will find his money to fall in value to $19,500. If the money is keep idle for years, it will soon depreciate in nominal value and Ali losses his money to his own ignorance.

For this reason, Muslims must save and invest their surpluses so that the value of the savings increases over time despite the payment of zakat. Zakat on idle balances is penalty on hoarding behaviour and eventually leads to the depreciation of wealth if kept unchecked. In this way, zakat both purifies wealth as well as penalizes those who choose to hoard wealth.

To prevent this unnecessary depreciation, zakat will force people to spend their cash balances either for nafaqah, sadeqah or investment ie. savings in bank deposits, unit trust funds or investments in projects based on the partnership principles. Doing so will allow money to circulate in the economy, which then help reduce shortfall in business spending and capital formation For example, when money is put in circulation via investment, zakat income and individual wealth will both increase

Case (1) Hoarding Idle cash (i.e. wealth/mal) at year end = $20,000 Zakat = 0.025 x $20,000 = $500 Cash balances (wealth) after Zakat =

$19,500   Case(2) Savings Cash invested = $20,000 Profit = 10% = $2,000 Wealth/mal = $22,000 Zakat = 0.025 x $22,000 = $550

Wealth after zakat = $21,450.

From the above illustrations, it is clear that in Islam wealth is not an end by itself. Wealth is a means to attain happiness (sa’ada) and success (falah). To do so, Islam enjoins man to spend it well (infaq) and not to indulge in hoarding. By spending, it can mean many things such as:

Consumption of basic necessities (daruriyat) Consumption of comfortables (hajiyat) Consumption of luxuries (kamaliyat) Savings in bank deposits, mutual funds,

stocks, properties etc. Sadeqah as ‘amal jariah (continous good

deeds) Zakat obligation

To attract people to save in Islamic bank deposits, the banking firms are expected to invest deposits into projects with high yield potentials. If Islamic deposits can outperform investments in unit trusts and other equities products, it should be able motivate more people to save. This will increase capital formation much needed for economic growth and development.

Savings in Islam does not mean keeping money as idle balances. All savings must be injected back into circulation. It must be invested. The role of zakat and the underlying motivations for savings in Islamic economics are also discussed in this topic,

Differences between conventional and Islamic deposits

  There are distinctive differences for deposits

received under conventional banking and Islamic banking system. The main criteria is the avoidance of interest or “usury” by Islamic banks throughout its activities.

  Although usually the deposit operations and

facilities are very similar, the differences lie in several underlying principles, such as follows:-

Deposit contract   The deposits received under conventional banks

are based on borrowing contract, i.e. banks borrow the money (deposit) from depositors for a stipulated period of time, payable upon maturity with the promised interest.

  Meanwhile, under Islamic banks, deposits are

received under either one of these two contracts

a Wadiah contract Wadiah, literally means “safeguarding of

assets”, where banks received the depositors’ money for safekeeping until withdrawal request is made.

Although under this contract the banks are allowed to use the deposits for investment activities, they not obliged to give return to depositors. Yet they are allowed to give it on a voluntary basis or known as “hibah”.

Mudharabah contract   Mudharabah deposits, are deposits made

purportedly for investments with the bank based on an agreed profit-sharing percentage. The bank acting as investment manager, invests the money into permitted investments and Islamic financing activities, realise profits and share the outcomes with depositors based on the ratio agreed. Therefore, for depositors the actual return on deposits is known only upon maturity (or upon periodical payment of profit, e.g. monthly). The return varies according to the actual outcome of investments, though some of them are relatively predictable.

Return on deposits   Under conventional banking, the return or interest

on deposits is fixed and guaranteed regardless of the actual outcome on investments.

  Under Islamic banking, the return or profit to

depositors is subject to the actual investment outcomes. The profit on investments is shared based on the agreed profit-sharing ratio, say 70:30 for depositors and banks respectively.

  Therefore, under Islamic banking, depositors and

banks are equal partners who would definitely share any windfalls or losses, if any, derived from the investments.

Risk-sharing   Under Islamic banking, the parties to

Mudharabah contracts are entitled to equal risk sharing. Therefore, the risk is higher for depositors under Islamic banking as compared to conventional banking, and yet providing opportunity for higher rewards should the investments yields higher profit.

In summary, the deposits under conventional banking has matured and evolved quite significantly especially in terms of its operations and facilities in pace with the technology and Internet developments.

  Compared to other investment avenues;

e.g. unit trusts, capital market, commodity market; deposits are still attractive due to its liquidity, low-risk and payment facilities.

Deposits are defined as funds placed in a financial institution by economic surplus units such as households, corporations, investors and government. These funds can either be from cash, claims to money, like checks placed in depositors’ accounts, bank loans or money from investments (Van Dahm, 1975). Financial institutions such as commercial banks, merchant banks, finance companies and discount houses are granted licenses by Bank Negara Malaysia, the central bank, to accept deposits from their customers.

These institutions are called deposit-taking institutions. Other financial institutions that do not comply with the definition in the Act are non-deposit taking institutions and hence, are prohibited from taking deposits from the public. Examples of non- deposit taking financial institutions are factoring or leasing companies.

deposits represent customers’ savings or their financial assets (Deposit creation…). By depositing money in a bank, the customers expect the bank to safeguard their savings, to utilize them into productive investments for a satisfactory rate of return or to enable them to facilitate their payment transactions.

At minimum, a customer expects that he gets back a dollar that he puts in a bank and the bank has a contractual obligation to honor the claim on demand or upon withdrawal.

To a bank, either operating conventional banking or Islamic banking, deposits is its main source of funding for which it uses to produce income. Some literature has cited that deposits contribute 75 percent of a bank’s total fund (Rose, 1997).

Banks use customers’ deposits mainly to give out loans/financing to deficit economic units or borrowers. Besides financing, banks also mobilize deposits by purchasing trading securities, investments and maintain some as cash in hand to meet withdrawals on demand. The larger the amount of deposits a bank receives from its customers, the better is its capacity to give out financing and the higher is the profit income.

Because of this positive relationship between deposits, loan and interest income, banks are competing intensively and aggressively among other deposit-taking institutions to obtain higher deposits by offering attractive deposit rates or rates plus other appealing packages depositors. Islamic banks are equally aggressive in attracting additional deposits.

To the economy, bank deposit is the main source of money supply that can be mobilized to generate economic growth and wealth creation. By giving out loans to borrowers and investors, banks create credits (Abdul Gafoor, 1996). Banks’ ability to create credit enable them to supply money to borrowers, suppliers and investors to conduct economic activities, such as opening up plants, funding their working capital requirements, financing their business expansion or increasing their investments.

Such economic activities create job opportunities, increasing productivity and income, which subsequently lead to wealth creation in the economy. For interest-bearing deposits, interest rate is very important. When market interest rates rise, so would deposit rates and this would attract higher deposits to flow into the economic system.

In the philosophy of Islamic finance, money is required to be mobilized in productive investments. There should not be idle money. Whoever holds idle cash or demand deposits exceeding the nisab over a year, must pay zakat.

Deposits are equally important to Islamic banks as a source of funds as in conventional banks. But unlike its counterparts, Islamic banks need to comply to Shariah principles which prohibit any payment of interest or a fixed return on deposits

To attract idle cash or deposits from the public for sustaining their financing activities and wealth creation, Islamic banks are offering deposits whose returns are based on wadiah, mudharabah or qard hasan.

The mudharabah or profit-loss sharing basis of Islamic banking is conceived as more production oriented and growth promoting than its interest-based counterparts. Further, the replacement of interest with profit-loss sharing principle is also said to increase investment opportunities in the economy (Islamic Bank Bangladesh Limited, 2006).

Three main concepts of deposits will be discussed here. These are deposits as a source of funds, as liabilities of banks and the returns from deposit mobilization.

A bank has three sources of funds namely (i) bank’ capital, (ii) bank’s reserves or retained earnings and (iii) deposits. Among the three sources, deposits form the main component of a bank’s source of funds.

The basic concept is that deposits are the foundation upon which banks thrive and grow. They provide the most raw materials for bank financing /loans and other investments (Rose, 2002: 387)

Despite increasing diversification towards fee-based income from projects and financial advisory services, banks are relying greatly on interest-bearing deposits and assets to generate interest income and profits ( Rose, 1997 ). Hence, banks compete aggressively to source more deposits from its customers, which can be government, suppliers, corporations, investors or households.

Deposit is also as an integral source of funds for Islamic banking. However, unlike conventional bank, an Islamic bank cannot use its deposits to make profits. This is because under Syariah principles, one cannot trade on non-commodity items and money is treated as a non-commodity item.

Traditionally, a bank “borrows” or utilizes a large proportion (approximately 80%) of its customers’ deposits to give loans to borrowers. A bank’s deposits, then, are the amounts that it owes to its customers (Money and Banking…). Hence, deposits are the principal liability of banks.

The significance of this conduct is that in the event that the bank is liquidated, the depositors have the first claim on the proceeds of sale of the bank’s assets (Rose, 2002: 119).

A specified amount of the deposits is allocated to meet the statutory reserve requirement ratio (SRR) imposed by a central bank. By definition, SRR is the percentage of deposits that commercial banks must maintain as required reserves (Madura, 2003, BNM Statistical Bulletin, 2006) in a central bank.

This item is recorded as “Statutory deposits with Central Banks” in the asset side of the Balance Sheet of a commercial bank). For many countries, SRR ratio is sometimes used as monetary tool to control money supply in the economic system.

The ratio varies between countries. For Malaysia, SRR is currently set at 2%,. Besides SRR, a commercial bank may utilize the remaining amount of deposits to purchase interest-bearing short-term money market instruments (which are termed as trading securities) and for investments (stocks, shares and medium to long-term securities).

Similar to conventional banking, deposit of an Islamic bank is a liability. The concept of deposit as “borrowing” in Islamic banking started during the leadership of Ar-Zubair al-Awwan. (Sudin Haron, 2005). Ar-Zubair treated the money entrusted to his father for safe keeping as “borrowing”.

Under this concept, he was able to use the money for economic purposes. The deposit became safer since as a borrower, Ar-Zubair argued that he is responsible to pay back the money to the owner. The change in the concept of deposit from trust (wadiah) to borrowing consequently enabled the people to use the money to operate business based on the principles of qirad or mudarabah as well as to share the profits from the business.

Similar to conventional bank, not 100 percent of the deposit amount is lent out to borrowers. An Islamic bank is still subjected to SRR ratio .The remaining amount is utilized to purchase liquid assets and investment and Islamic trading securities.

The third concept related to deposit is return. -depositors are rewarded with a pre-determined rate of return by the conventional bank. The rate of return depends on the type of deposits, the deposit amount, the length of the maturity periods and the bank’s cost of funds. In conventional banking, market interest rate is very instrumental in determining the deposit rate.

The concept of return for depositors in Islamic banking is different from conventional banking. Based on Syariah principles, riba’ or interest is prohibited and a predetermined fixed rate or a guaranteed return on investment is strictly not acceptable. Al-Quran states that:

  “That which you give as interest to increase the

peoples’ wealth increases not with Allah but that which you give in charity, seeking the goodwill of Allah, multiplies manifold”

(Surah al-Rum, verse 39)

The underlying trust in prohibiting a fixed or guaranteed return on deposit is that there is an existence of an element of uncertainties in any project or investment ventures financed by the bank from mobilization of its customers’ deposits.

The profit and loss sharing (P-L) basis is a basis of return where the bank shares business risks with the borrower in return for shares in the profits of the business venture. It is based on mudharabah dan musyarakah principles. Profit and loss sharing concept is a unique feature of Islamic banking and is increasingly getting popular among investors especially in times of economic uncertainties.

Deposit accounts and Principles Applied in Return Computation

Account TypePrinciples Applied

  Current Account qard hasan or wadiah Saving Account wadiah,mudharabah or

qard hasan   Investment Account pre-determined share of

profits Islamic Negotiable Certificate of Deposit mudharabah or qard

hasan

The fixing in advance of a positive return is strictly prohibited by Syariah (Cert “: 47). The rationale for this prohibition of a pre-determined rate of return is explicitly expressed by Imam Razi as quoted in Muhamad Umar Chapra, (2005: 52): “when asked what was wrong in charging interest when the borrower was going to employ the funds borrowed in his business and thereby earn a profit, his answer is as follows:

“While the earning of profit is uncertain, the payment of interest is pre-determined and certain. The profit may or may not be realized. Hence, there can be no doubt that the payment of something definite in return for something uncertain inflicts a harm”

(Razi, op.cit:87).

Islam only recognizes return on capital (deposits) after all costs have been accounted for, and it may be positive or negative since it depends to a great extent on factors beyond the control of entrepreneur. Hence, Islam prohibits a pre-determined positive rate of return in the form of interest but seeks return in a profit and loss sharing basis (Muhamad Umar Chapra: 57).

Below are two commonly used principles governing deposits of an Islamic bank.

(a) Wadiah Wadiah is quite similar to savings account in

conventional banking where a depositor places or deposits his money in an Islamic bank. In doing so, the customer trust his banker to manage his savings in the most professional manner, that is the bank should keep proper records of its client’s accounts and investing his savings in profitable, halal ventures.

The bank has to secure the agreement of its depositor to utilize the deposit and be responsible for its risks management and possible outcomes. Hence, the bank acts a custodian to the customer’s deposits and undertakes the commitment (or guarantees) to return the customer his savings on demand.

. However, the bank is not bound to pay its depositor with a fixed return but in line with the Syariah concept of profit sharing, the Islamic bank may reward or hibah part of the benefits to the depositor for the use of his money. The reward may be in the form of cash or in kinds. In Malaysia, it is a common practice of an Islamic bank to declare a percentage of the bank’s profit as hibah to Al Wadiah depositor. This practice allows an Islamic bank to contribute efforts in creating and distributing wealth to people or the ummah at large.

Mudharabah

Mudharabah is a principle most commonly used in Islamic finance and banking. The principle suggests that a person that has

capital will give his capital to another person that he trusts to run a business venture. He will not interfere with the

business but rather give the partner the independence to run it

In return, the partner will return back the amount of capital that he borrowed plus a share of the profit at the end of the business period. In essence, both parties have a right to the business profits because one party provides the capital and the other, his expertise.

In the context of deposit, the depositor provides capital to an Islamic bank to run banking operations. For the deposit mobilization, the depositor is entitled to a share of the profits agreed by the depositor and the bank. The share can be a third or a half of the profits depending on prior agreement between the depositor and the bank.

This agreement is set at the beginning of the contract. However, the bank does not guarantee the depositor that the business must be profitable although the bank will conduct the investment on best efforts basis to ensure it is profitable. Nevertheless, in the event of a business failure, the depositor will bear the losses.

The Islamic economic principle on risk-return relationship is none other than that adopted from the legal maxim “al-ghorm bil ghonm” which means that “no profit can be gained without taking risk”. Since Islamic investment account as a product is based on the mudarabah contract (i.e. trustee partnership), incentive to place money in mudarabah deposits must revolve around profits

The reduction of interest rates will now make many investment opportunities more viable. This is because, decision to invest usually deals with comparing cost of borrowings (i) and the project’s expected rate of return (r) also known as the internal rate of return (IRR). For example, when r = 7 per cent while i = 9 per cent, cost of borrowing is higher than the project’s expected return, firm will not borrow and the project will not be undertaken as it will only lead to loss.

But when the central bank increases the money supply by making more excess reserves available to make loans, interest rates will decrease. If it falls from 9 per cent to 5 per cent, then many projects at r = 7 per cent are now viable since r > i.

Case 1: i > r Investment decision : Do not invest 

Case 2: i < r Investment decision:Invest

total deposit created by the banking system from an initial deposit from the formula given below:

TD = D / R …………(1) Where: TD: Total deposits created D: Initial deposit R: Statutory reserve requirement  

Suppose statutory reserve requirement is set at 5 per cent and initial deposit of $100 million. Total deposits created by the banking system amounts to $2 billion.

  $2000 million = $100 million / 0.05  

MD = TD / D ………(2)   Where: MD : Deposit multiplier TD: Total deposits created D: Initial deposit

Given TD = $2000m and D = $100m, Deposit (money) multiplier in the above example is 20. That is:

  $2000m / $100m = 20 ( DM)

The deposits multiplier says that total deposits will increase by the multiple of 20 from a given initial deposit. If initial deposit is $500m, then the banking system can create up to $10,000 million total deposits or $10 b deposits !!!

The process of deposit creation makes a lot of assumptions. The simple model of deposits creation assumes the following:

Transactions conducted through the checking system only. That is, bank loans are given in checkable. Borrowers pay their purchases using checks as well.

Excess reserves are used to make loans only. That is, no investments in securities. Banks also do not keep idle balances i.e. excess reserves = 0

All deposits are demand deposits or checkable deposits,

There are no leakages i.e. customers do not keep idle cash in their pockets for transactional purposes.

In this sense, banking companies posses power to create money as they create deposits. The central bank can do so by printing money, that is coins and currency also known as the monetary base or high-powered money.

The central bank control money creation in the banking system by manipulating monetary policy instruments such as reserve requirement to affect the amount of excess reserves available to the banks.

Reserves means cash not utilized in the bank. Under a fractional banking system, once a bank receives deposits, say $100m, the asset side will record a new total reserves (TE) amounting to $100m. Total reserves can be broken down into two, namely the required reserves (RR) and excess reserves (ER). Thus

TE = RR + ER ………(3)

Required reserves (RR) do not generate interest income. The same applies to excess reserves (ER). Usually the bank as a profit maximizing firm will make sure that the excess reserves are converted into loans/financing so as to earn interest/profit.

The central bank can influence the deposit multiplier and hence money supply by manipulating monetary policy instruments which in turn will affect the amount of excess reserves (ER) available in banks. For example, if the central bank is expansionary. It will reduce the reserve requirement (RR), to say 3 per cent, thus increasing the excess reserves (ER) in banks

The process of deposit creation in Islamic banking will be similar with conventional banking when it runs on a fractional banking system and adopt fiat money as a legal tender. Under a fractional banking system, the bank will put aside a fraction of deposits as reserves (i.e cash balances) and uses the remaining balance (ER) to in its financing activities such as al-bai bithman jil, murabahah, and ijarah thumma al-bay’.

The conventional system uses the contract of debts to mobilize deposits that gives them the right to use the deposits to make loans. The same applies for Islamic banks as they apply the contract of wadiah dhamanah and al-mudarabah to mobilize deposits. Both contracts allow the bank to use deposits to finance its investment activities. In this way, the contracts of Islamic deposits make way for Islamic banks to adopt current fractional banking system.

The process of money creation in Islamic banking system will make assumptions similar to the conventional system. One difference is that Islamic banks do not make loans to customers but contracted their purchases under the contract of deferred sale that eventually amounts to credit financing. The other difference is that Islamic banks only use al-bai-bithaman ajil (BBA) contract in its deferred sale products.

An understanding about the Islamic economic principles of deposits is a significant element in the business of Islamic banking since the demand and supply of Islamic deposits (i.e. the market for Islamic deposits) are expected to observe the rules and regulation ordained by Allah swt.

By doing so, the market for Islamic deposits is expected to be free from any form of unfair and inequitable transactions. It will generate a deposit market where justice prevails from which people will gain benefits (manfaat) and utility from the services rendered.

what motivate people to supply deposits?

Economic principles are guidelines that people use in their economic decision making. In Islam, these principles are derived from the Quran and Sunnah. They are in essence a body of knowledge. Economics primarily deals with the problem of choice arising from scarcity. To make the correct choice man is expected to do so with knowledge.

Making a choice without knowledge can mean choosing by way of conjecture and guesswork. It can lead to misallocation of resources and adversely affect economic growth and development. Rational choice alone is inadequate since reason has its shortcomings.

Making a choice using reason is good but using reason alone as the source of knowledge can lead to bad choices. This is because, man who use reason alone can never be free from temptations and evil desires and in many cases will make them irrational instead.

The same applies in shopping behaviour. With huge discounts on offer, people buy things they don’t need !

To guide mankind into make the correct choice, the Islamic economics says that choice must be made on the basis of knowledge revealed by Allah swt. This knowledge is therefore divine in nature. It teaches man about right and wrong, about reward and punishment and about the relationship between man and Allah as well as among man. This knowledge is given in the Quran and the Hadith. Reason and experience are also useful but both must submit to the supremacy of revelation (wahy).

Islamic economic principles are predominantly based on revelation. But some are based on common sense and reason (‘aql). Choosing what goods to produce requires knowledge from Allah as this will define the permissible (halal) items from the prohibited (haram) items. But how much one should produce and using what technique of production do not require the Quran to give answers. This can be readily handled by reason and factual evidence

In the economic life, there are a number of Islamic principles relevant for Islamic banking applications. These are given as follows:

The contract (‘aqd) on which the deposit products are engineered must be valid (sahih).

The income generated from the investment of deposits must contain some degree of a) risk-taking (ghorm) b) work and effort (kasb) and c) responsibility (daman)

In the economic life, there are a number of Islamic principles relevant for Islamic banking applications. These are given as follows:

The contract (‘aqd) on which the deposit products are engineered must be valid (sahih).

The income generated from the investment of deposits must contain some degree of a) risk-taking (ghorm) b) work and effort (kasb) and c) responsibility (daman)

legal maxims are divine principles that one can use in making a ruling about the behaviour of the believer (mukallaf). These principles are constructed by Muslim jurists and are based on explicit Quranic verses as well as the Hadith. One example is that “profit must be accompanied with responsibility” (al-kharaj bil-daman). Another is about risk-return relation - “no reward without risk” (al-ghorm bil ghonm). Since the market for deposits consists of the banking firm and depositors, it is important that the decision to supply deposits by depositors and the decision to mobilize deposits by banks are made on the basis of the legal maxims.

When Allah swt prohibits riba, it implies that profits arising from loans are unlawful (haram). This is because profits from loans are both fixed and collateralized. So it only favour the lending party who will receive profits without taking any risk. By doing so, it introduce injustice into the business since borrowers must pay up even though they are not capable of doing so, say due to loss of job or declining earning capacity.

In the conventional deposit market, particularly in the supply of deposit - a bank actually borrow from the depositors at a fixed interest rate. In other words, depositors gave the bank a loan (qard) with a fixed interest payment. This payment is an interest expense and constitutes a cost to the bank. It also riba as deposits are created out of a loan (qard) contract between the bank and the depositors.

In theory, the higher the interest rates – the higher is the supply of deposits. People are motivated to postpone current consumption when the compensation for doing so is attractive. This positive relationship between supply of deposits and interest rates actually reveal the behaviour of the economic man

Islamic deposits usually serve two main functions, namely: 

Transaction function : Wadiah Dhamanah current and savings account

Investment function : Al-Mudarabah Investment account

By virtue of the transactional nature of wadiah dhamanah deposits, depositors are only interested in deriving benefits from the facility offered by the product. The benefits shall include the ease of cash withdrawals on call as well as protection of deposits. The bank serves as a custodian or safe-keeper to the deposits but is allowed use them to generate income from say, murabahah or ijarah financing

That is, depositors stand to receive returns but only as gifts (hibah). In this way, the distributional model of wadiah dhamanah does not provide any guaranteed sum or return to the depositors. If any, returns are given without any equivalent counter value, say risk-taking. Wadiah dhamanah customers exposure to capital risk is zero. Thus, by virtue of the principle of al-ghorm bil ghonm, they do not deserve to receive any income or profits from the deposits.

In economics, hibahs are determined ex-post meaning it is set only when the outcome is actualized. But actualizing outcome, say making RM100 million profits from murabahah financing does not mean that the bank must or obligated (wajib) to distribute the profits. In this way, the supply curve of wadiah dhamanah deposits may be a flat one since the incentive to save does not revolve around the rate of returns but for safe-keeping and convenience purposes.

Since mudarabah deposits and incomes are not guaranteed, the bank that acts as the mudarib must be able to convince depositors that placing their money as mudarabah deposits is a good investment. It should be able to show depositors their good track records and capacity to perform well in the mudarabah ventures. Since mudarabah deposits are risky, depositors expect more returns for each investment made. In fact any successful mudarabah deposits should outperform interest income derived from fixed deposits.

In this way, the concept of time value of money examined people preferences about spending their income today or in the future. If people prefer current consumption to future consumption, then they are said to adopt a positive-time preference (PTP) outlook. They believe that current consumption brings more satisfaction than future ones.

Therefore, people who are asked to postpone current consumption (i.e. creditors) must be compensated for the benefits the pleasure foregone today.. They do so because it is firmly believed that the future is uncertain and risky, thus one may not know how much utility he or she can enjoy out of future spending as opposed to current spending. In a nutsell, the PTP concept says that 1 dollar today is worth more than 1 dollar tomorrow.

However, some people do not believe that future spending is inferior to current spending. Instead they are truly convinced that they can derive more satisfaction or utility if money is spent not now but in the future. By believing so, the decision to save is based on the negative time preference (NTP) model.

The NTP concept believes that 1 dollar today is worth less than 1 dollar tomorrow which is opposite to the positive time preference (PTP) model.

Finally, there are also some people who feel indifferent about spending their money today or tomorrow. They believe that money spent today always yield the same level of utility as money spent tomorrow. This is the neutral time preference model. People with neutral time preference do not care less about when to spend.

Conventional economics actually believed that people prefer current consumption to future consumption. This is the dominant view in global financial markets today. This is only because they believe the future as uncertain and people have no idea what the future has to offer them

Changes in tastes and preferences or the price-level may alter and reduce the level of utility of happiness derived from future consumption. On the contrary, when people buy goods today, they can instantly enjoy the utility derived from spending. In this way, one dollar today is worth more than one dollar tomorrow.

The belief that current spending generates more satisfaction than future spending (ie PTP) paves the way for the rationalization of interest-rates as the reward for saving. In other words, people who save will forego the satisfaction derived from current consumption. The same level of satisfaction cannot be realized when they spend the same money, say one year from now.

The saving behaviour in conventional economics is therefore dependent on the reward or compensation for waiting ie postponing current consumption. By virtue of positive time preference (PTP), creditors demand interest while debtors pay interest. But the same cannot apply to saving behaviour in Islam. Although Islam has to some extent recognizes the concept of positive time preference, it does not implicate or bring about the payments and receipts of interest as evident in conventional economics.

THE FACT THAT ISLAM FORBIDS INTEREST AS RIBA IT DOES NOT MEAN IT IS AGAINST THE CONCEPT OF POSITIVE-TIME PREFERENCE (PTF). INDEED, ISLAM HAS GIVE DUE RECOGNITION TO PTF AS EVIDENT IN THE SAYINGS OF PROPHET MUHAMMAD (PBUH). THE PROPHET (PBUH) SAID, “ VIRTUOUS ARE THEY WHO PAY BACK THEIR DEBTS WELL”.

IN THE ABOVE HADITH, DEBTORS ARE ENJOINED TO PAY MORE THAN THE PRINCIPLE LOAN (QARD) RECEIVED. ONE MAY ASK WHY THIS IS SO? ONE REASON IS GRATITUDE. THE DEBTOR IS THANKFUL FOR THE LOAN HE GETS AND BENEFITED FROM. HE KNEW THE CREDITOR HAS FORGONE HIS CURRENT CONSUMPTION FOR THE SAKE OF HELPING HIM WITH THE MONEY. HE ALSO RECOGNIZES THAT THE CREDITOR HAS RELINQUISHED THE OPPORTUNITY TO EARN RETURNS FROM LOAN GIVEN AWAY. THESE RETURNS ARE UNKNOWN AS THEY ARE SUBJECT TO BUSINESS RISK.

IN THIS MANNER, ONE DOLLAR TODAY IS SEEN MORE VALUABLE THAN ONE IN THE FUTURE. AS A TOKEN OF APPRECIATION, THE DEBTOR PAYS MORE. UNLIKE RIBA, THE INCREMENTAL AMOUNT IS NOT STATED UPFRONT AND DOES NOT CONSTITUTE A LEGAL CLAIM OF THE LENDING PARTY.

IN ISLAM, THEREFORE RECOGNIZING PTP DOES NOT IMPLY AWARDING A CONTRACTUAL INCREASE ON THE PRINCIPLE LOAN. ANY INCREASE FROM AN ISLAMIC LOAN (QARD) CAN ONLY BE STATED AT MATURITY AND NOT UPFRONT AS NORMALLY PRACTICED IN INTEREST-BEARING LOAN CONTRACT. THE INCREMENT WHICH IS VOLUNTARY IS SET BY THE DEBTOR. IT IS GIVEN AWAY OUT OF GOODWILL. IN CONTRAST, THE INCREMENT FROM RIBA LOANS IS CONTRACTUAL AND SET BY THE CREDITOR.

In Islamic economics, spending behaviour of household is expected to influence their saving behaviour as well. For example, consumers who practice moderation (zuhud), will secure more surplus income ie. savings compared with those who are extravagant (tadrif). The moderation behaviour is approved by Islam and applicable only on the consumption of luxuries (kamaliyat).

Under a zuhud lifestyle, Muslims live a simple life although they can afford luxuries. While Islam does not prohibit Muslims to consume luxury goods, Muslims are free to choose their lifestyles. They can live a simple life or lead a luxurious one as long as they do not fall into debt or amass wealth from illegal sources. They too must spend on basic necessities (daruriyat) and make spend well for their families.

Savings in Islam does not mean keeping money as idle balances. All savings must be injected back into circulation. It must be invested. If money is kept as idle balances, people who need money for working capital or to purchase plant and machinery will not be able to do so. Without money to spend business will cease to exist and the economy will fall into a recession with implications on growth and employment.

The objective of savings is best described in the Quranic story of Prophet Yusof (may Allah be pleased with him) where the importance of savings is highlighted in its true color. Surah Yusof (12:3-49) tells the story of a Pharaoh in Egypt who had a strange dream about seven fat cows. He also saw in his dream seven green ears of wheat and seven withered or dying ears of wheat.

He asked his advisors to interpret the dream, but no one is good enough to do so. Prophet Yusuf who is well known for his honesty and special ability to interpret dreams was brought to see the Pharoah.

In his interpretation about the dream, Prophet Yusuf enlightened the Pharoah about the future problems of Egypt. He also suggested the remedies. He said that Egypt will enjoy seven years of prosperity with abundant harvests. In modern times, this may be taken to mean high economic growth. Prophet Yusof advised the people of Egypt to cultivate their crops diligently and use a reasonable amount for food and sustenance while storing the remaining surplus.

This is because when prosperity comes to an end, Egypt will suffer from serious drought for seven long years when no crops would grow. But with the reserves in store, the people of Egypt could survive the seven bad years.

Prophet Yusuf cautioned the Pharoah not to consume all the reserves but to leave the best portions for seeds to cultivate later when rains filled the Nile. In other words, people must set aside money for savings and investment. To postpone current consumption to make way for production of future goods was one of the main messages that Prophet Yusuf wanted the Pharaoh to do for his people.

The incentive to save can also be examined at the micro level of Muslim behaviour. In Islam, savings will always means surplus income to be placed for investment purposes, thus keeping money in circulation. All savings must be invested again in the economy. Otherwise it is tantamount to hoarding (ihtikar)

The basic idea of savings is to avoid hoarding money as the latter is prohibited in Islam. When people hoard money, there is less currency around to use. It will frustrate business transaction and put production to a halt since there is no money available to pay suppliers and workers. Hoarding money will put money out of circulation and therefore reduces sale and purchases.

For this reason, Muslims must save and invest their surpluses so that the value of the savings increases over time despite the payment of zakat. Zakat on idle balances is penalty on hoarding behaviour and eventually leads to the depreciation of wealth if kept unchecked. In this way, zakat both purifies wealth

For example, when money is put in circulation via investment, zakat income and individual wealth will both increase. This is illustrated in the following examples:  

  Case (1) Hoarding Idle cash (i.e. wealth/mal) at year end = $20,000 Zakat = 0.025 x $20,000 = $500 Cash balances (wealth) after Zakat = $19,500

Case(2) Savings Cash invested = $20,000 Profit = 10% = $2,000 Wealth/mal = $22,000 Zakat = 0.025 x $22,000 = $550 Wealth after zakat = $21,450.

From the above illustrations, it is clear that in Islam wealth is not an end by itself. Wealth is a means to attain happiness (sa’ada) and success (falah). To do so, Islam enjoins man to spend it well (infaq) and not to indulge in hoarding. By spending, it can mean many things such as:

Consumption of basic necessities (daruriyat) Consumption of comfortables (hajiyat) Consumption of luxuries (kamaliyat) Savings in bank deposits, mutual funds,

stocks, properties etc. Sadeqah as ‘amal jariah (continous good

deeds) Zakat obligation  

To attract people to save in Islamic bank deposits, the banking firms are expected to invest deposits into projects with high yield potentials. If Islamic deposits can outperform investments in unit trusts and other equities products, it should be able motivate more people to save. This will increase capital formation much needed for economic growth and development.

Deposit mobilisation is one of the crucial functions of a conventional financial institutions or banks to satisfy one of the requirements of a “banking business”, i.e. sourcing of funds or borrowing money from customers.

  Continuous and adequate deposit mobilisation

would ensure the bank shall be able to sustain its business of lending and investing, thus incurring profit for future growth.

Nevertheless, different types of deposits have different and distinct characteristics and features which in consequence impose different risks and costs to the banks. Therefore, in many cases, deposit mobilisation strategy relies heavily to the banks’ asset and liability management policy.

In a relationship between bank and depositors, the rights and duties for both parties vary according to the nature of deposit mobilisation. The ability of the bank to fulfill their duties is an important measure of the bank’s acceptance by the public, or by far as a comparison yardstick with other banks.

Banks mobilise deposits as their primary source of funds. Having optimal deposits level, banks shall be able to lend the funds to generate interest on lending. In addition to lending, the deposits fund can be placed in certain investments avenues which suits the banks’ or the deposits’ objectives.

Deposit mobilisation is a continuous function for a bank to ensure the sum total of deposits at any time adequate to maintain the current level of lending and investments especially to compensate the withdrawals made by depositors.

Usually, the deposits level is kept slightly or certain percentages above the lending and investments level to ensure the bank has adequate cash reserves to meet expected withdrawals and also recurring withdrawals. The cash reserves are called Liquidity Reserves.

How a Bank Mobilises Deposits?

Bank receives deposits from individuals, organisations and businesses, initially by opening an account with the bank itself. Based on the types of deposits, minimum initial deposits are set together with the rules and regulations governing the accounts.

Depositors maintain deposits with specific banks due to many factors, but in particular trust and confidence with the banks are the major factors. Once these are established, the banks continuously attract depositors and deposits by providing convenience banking, quality services, excellent brand association and higher interest/profit payout.

However, there are instances where depositors put their money into the banks mainly for security purposes, i.e. the banks to protect their money from loss and theft and also warrant the deposits from investment loss. As such in Malaysia the government provides guarantee upon deposits placed with commercial banks.

The banks must have adequate deposits to meet the lending volume required by the public and at the same time maintain extra cash for withdrawals by depositors.

The withdrawals made from the reserves are oddly-offset against new deposits which the banks should continuously mobilise. The inability to get sufficient deposits could result in negative fund situation.

The level of deposits growth also indicates the bank’s performance in relation to customers’ satisfaction on interest/profit payout and services rendered.

Deposits are made mainly in cash, the most liquid asset for banks. Once withdrawal requests are made by depositors, banks must immediately provide cash for that particular purpose. As compared to other liquidity components such as short term investments which take time to be converted into cash, it is rather wise for a bank to simply get more deposits beyond the withdrawal amount.

However, the percentage of the cash reserves must be kept at optimum level. Idle cash does not create profit, but in fact, brings additional costs in terms of storage and insurance. Therefore, by maintaining cash reserves at optimal level enables bank to generate maximum profits from lending and investment activities.

The costs for cash reserves are mainly on the storage and insurance. The storage of cash reserves involves the requirement for adequate vault rooms, cash in-transit security and cash handling at branches. The insurance costs are to cover the amount of cash available anytime at branches or in-transit from loss, fire and theft. It generally covers the maximum cash amount allowed at branches or in-transit.

Deposits placed with conventional banks are considered low-risk and low-return investments. Perhaps, the risks to depositors are almost zero considering that the return is guaranteed and the banks shall absorb any unexpected loss derived from investments or lending activities.

Internet technology and high security features allow banks to introduce internet banking services to their customers especially for tech-savvy youngsters and middle-aged professionals. Internet banking provides mobility convenient and time freedom for accountholders to perform related transactions anytime anywhere.

Among the transactions that can be performed are fund transfer, balance enquiry, other enquiries, bills payment, loan and credit card payment, ad-hoc statement printing and cheque book request. Through internet banking, depositors can communicate with their bankers using emails from anywhere.

Mobile banking   Mobile banking uses the mobile phones as

medium to perform limited transactions and enquiries onto depositors’ accounts. Among the transactions that can be performed are fund transfer, balance enquiry, other enquiries and loan payment.

Corporate desktop Corporate desktop is provided for subscribed corporate

customers only. Desktop computer(s) and dedicated computer line are provided within customers’ office to assigned officers to allow them to perform related transactions with the bank.

  Among the transactions that can be performed are fund

transfer, balance enquiry, other enquiries, FD placement request, bills payment, loan payment and cheque book request.

The following are the costs related to deposits;

Deposits maintenance cost   Deposits maintenance cost in general refers to the cost of

manpower and facilities provided by banks to facilitate all transactions performed on deposits accounts, including the direct promotional activities and deposit retention programmes. These costs are classified under bank’s overhead costs. The cost includes security and insurance coverage on hard-cash.

Interest payout/Profit payout

Savings and fixed deposits accounts are interest-bearing accounts. Therefore, for every dollar received under these accounts banks must pay the interest rate upon maturity or periodical basis based on the promised interest rate.

Al-Wadiah The Bank accepts deposits for Savings

Account under the Islamic principle of Al-Wadiah.

Definition It is a contract between two parties i.e. the

owner of goods and the custodian of the goods to ensure the safe custody of the goods from being stolen, lost, destroyed etc.

Types of Goods The ‘goods’ can be referred to anything that

is of value such as: Fixed assets Money Jewels Certificates

There are two (2) types of Al-Wadiah: a) Al-Wadiah Yad Amanah (Trust) b) Al-Wadiah Yad Dhamanah (Guarantee)

Discretionary Reward Under the principle of Al-Wadiah, The custodian i.e. the Islamic bank is not allowed to

mention or to promise any rewards or return. The customers/depositors, on the other hand, are also not

allowed to demand any rewards or return on their savings. Any promised rewards given under the contract of Al-

Wadiah is considered as ‘riba’ which is strictly prohibited. Rewards do not only referring to monetary items. It

includes also other forms of incentives such as coin boxes, clothes etc.

Rewards cannot be promised earlier but as and when the Islamic bank wants to reward his customers, the bank can always do it on its own discretion.

Concept of Returns/Profit  Islamic bank is not obliged to give

return/profit to customers Returns/profit is merely on the discretion of

the Islamic bank. All eligible depositors must get equal

percentage of returns Profit given to customers in the past can be

declared by Islamic bank as percentage of returns per annum.

 Al-Mudharabah The Islamic bank accepts deposits for

Investment Deposits Account under the Islamic principle of Al-Mudharabah.

 Definition  Al-Mudharabah is a contract between two parties, i.e., the

owner of capital and the entrepreneur of the proposed project where both agree to share the profits based on the agreed ratio while the losses, if occurs, is to be borne by the owner of the capital.

Profit From Investment Account  i.In terms of profit sharing, it will be distributed

between the owner of the capital (investment depositor) and the entrepreneur (Islamic bank) in an agreed predetermined profit sharing ratio (PSR) i.e. 70:30 (Depositor: Islamic Bank)

The profit sharing ratio must be agreed and stated in the contract, i.e. in the investment certificate

The Islamic bank can always give a higher return to the depositors than the agreed PSR.

Returns to the depositors can be based on gross or net profit subject to the agreement between both parties involved.

Profit on Premature Investment◦ According to Shariah Principles, once the Bank has

utilized the deposits, profit gained must be shared with depositors even though the investment is withdrawn prematurely.

◦ For convenience purposes, the Bank can impose the following conditions:-

For amount RM5000 and above, profit will only be distributed if the investment is made for at least 1 month.

For amount lesser than RM5000, minimum RM500, profit will only be distributed if the investment is made for at least 3 months.

The importance of cost of fund The banks’ awareness on the cost of

deposits or cost of funds at all times is basically to continuously identify the cost of doing business. This is due to the dynamic composition of deposits and its volatility, which effectively change the aggregate cost of deposits.

However, nowadays banks become major establishments with branches nationwide and overseas offering a variety of products and services to their customers. And the banks are aggressively competing to maintain existing depositors and attract new clients. Normally, banks resort to offering better services and higher returns which effectively increase the cost of deposits

Literally, to satisfy both the higher interest /profit rate to depositors and higher dividend payout to shareholders, banks need to price the loan/financing relatively high and invest in high-return investment products. But, this cannot be true considering that the banks also struggle to compete for loan/financing customers especially for high net worth corporate customers and high-return investment products are quite limited in the market.

In summary, the cost of deposits is the key factor that determines the loan/financing pricing and targeted investment income, which consequently provides the bank’s profit. Without a prudent cost of deposits management, the bank could lose its competitiveness.

Liquidity reserves comprise of statutory reserve and float reserve. The statutory reserve is set by the central bank, now around 2.5% of total deposits. The float reserve is based by the bank’s policy on additional liquidity as a buffer to statutory reserve, for e.g. 8% of total deposits.

Therefore, for every dollar received on deposits, a portion must be set aside for liquidity reserves, as explained by the following equation;

  Net investable deposit = Principal

deposit – liquidity reserves

For example, the liquidity reserves are set at 15%.

  Net investable deposit = RM1 –

(RM1x15%) = RM1 – RM0.15 = RM0.85.

Based on the above example, the net investable deposit for every RM1 received is actually RM0.85. The net investable deposit refers to the deposits available to the bank for loan/financing and investment activities, i.e. after deduction of liquidity reserves.

Although the deposit that can be used is RM0.85 for every RM received, the interest/hibah/profit payout onto the deposits is based on full amount received that is RM1. The liquidity reserves (RM0.15) are idle cash which contribute to the cost of deposits.

The level of liquidity reserves is manageable by managing the float reserves. It should be consistent the bank’s Liability Management, i.e. managing the deposits components and its percentage in the overall deposits.

current account requires higher float reserves while fixed deposit in contrast requires smaller float reserves. Therefore an ideal combination of these deposits could result an ideal percentage of liquidity reserves as projected by the bank.

Among the broad classifications are;

Direct maintenance cost  Among the direct expenses to deposits are cash in transit costs, insurance costs,

passbooks, check books and check clearing expenses. These expenses are directly related to accounts and physical-cash handlings by the bank.

Administrative and general expenses 

Administrative and general expenses (AGE) refer to the overhead expenses by the bank incurred in the daily operations. An example is depreciation expenses. 

Staff expenses  Among the staff related expenses are staff salaries, staff benefits and allowances, training, etc.  IT infrastructure and system maintenance  IT infrastructure and system maintenance covers the computer hardware and

software expenses, network infrastructure, electronic banking machines, gadgets, display tools, etc.

Deposit acquisition cost

The deposit acquisition costs are basically the promotion and advertisement costs mainly for attracting deposits

Wadiah deposits  Wadiah deposits aimed for safeguarding of assets

(deposits) with the bank, normally used as underlying principles in savings account and current account. Rather than for investments, the accounts are used to facilitate payments and for safekeeping purposes.

  The return to Wadiah deposits, except for current account,

is in the form of “hibah” or token paid on a regular basis.

Mudharabah deposits

Mudharabah deposits are deposits received for the purpose of investments with the bank, normally used for Mudharabah savings account and Islamic investment accounts (equivalent to conventional fixed deposits). According to the agreement between depositors and the bank, the profit derived from the usage of Mudharabah deposits for Islamic financing and investments activities shall be apportioned according to agreed “profit-sharing ratio” (PSR) agreed upon inception and payable upon maturity date or on a periodical basis.

This is the main difference between conventional banking and Islamic banking. In conventional banking, bank decides upfront how much they are willing to pay depositors for their borrowing regardless of how much the bank receives on its investments. While in Islamic banking, the bank shares the profit received from its investments, or loss if any.

The risk to the bank is when the profit derived is low, the depositors will receive the corresponding low return and may withdraw their deposits.

Financing Pricing Overall, Islamic banking use actual profit to

calculate the costs of deposits, which is historical at the time of calculation. Therefore, the usage of the costs of deposits rates for pricing of financing must be done carefully to ensure it anticipate the future trend of that costs.

Most financing products are fixed rate financing. The fixed rate locked over a span of years may not risk the bank in terms lower profit or loss arising to increased costs of funds, but, it may locked the depositors in low-rate environment should the market trends increase.

In summary, the calculations of costs of deposits in conventional banking system must be done using reliable and fresh data to ensure it anticipates the future trend to maintain its market competitiveness and maximise the profit margin for the bank. Frequent review of cost of deposits may ensure the projections made by the bank’s stakeholders are achievable.

In Islamic banking, although costs of deposits are derived using historical data, the bank can factor in anticipated market rate increase in the financing pricing. However, in an environment of fixed rate financing, the effective profit would have a slower impact since the fresh financing needs adequate momentum to exceed the existing financing level.

On 16 October 2001, Bank Negara Malaysia issued the Framework of Rate of Return as part of the effort to standardise the method on the calculation of rate of return for the Islamic banking industry. The objectives of introducing the framework are to:

Set the minimum standard in calculating the rate of return; Provide level playing field and term of reference for the

Islamic banking players in deriving the rate of return; and Provide Bank Negara Malaysia with better means of

assessing the efficiency of the Islamic banking institutions (IBis) as well as their profitability, prudent management and fairness.

Thank youHave a good day !

Wassalam