Islamic banks are said to be already taking steps to convert their existing mudarabah deposits into either commodity murabahah or wadiah deposits in compliance with the IFSA.

ISLAMIC banks could experience a potential spike in operating costs and see further pressure on net interest margins (NIM) once they comply withBank Negaras move to reclassify Islamic deposits as either principal guaranteed or investment accounts. Islamic banks or conventional banks with Islamic banking subsidiaries are given until June 30 next year to comply with this requirement under theIslamic Financial Services Act (IFSA)2013. This means that products with mudarabah (profit sharing) orwakalah(agency) features are considered investment accounts and are not-principal guaranteed and hence not protected by theMalaysia Deposit Insurance Corp (PIDM). The classification aims to provide greater legal clarity on the types of syariah financial contracts. Customers will have a choice and will be able to differentiate between products that are principal guaranteed and those which are not that provide potentially higher risk returns like mudarabah. Mudarabah is a contract between a depositor and an entrepreneur (bank), whereby the latter can mobilise funds for its business activity. Any profits made between the two will be shared according to an agreed ratio while losses are borne solely by the depositor unless the bank is negligent. Islamic deposits, on the other hand, like wadiah (custodian), qard (loan) and tawarruq (sale) are principal guaranteed. Currently, all Islamic deposits are protected by the Malaysia Deposit Insurance Corp (PIDM).

About 50% of Islamic deposits in the banking system falls under the investment account category. Based on PIDMs latest statistics for the assessment year in 2012, total insured deposits for the Islamic banking business totalled RM50.2bil, compared with RM40bil the previous year. Although discussions on the reclassification are still on-going with the central bank, banking analysts and players feels the likely one would be the conversion of investment-based mudarabah (profit sharing) accounts to commodity murabahah (cost plus). This will potentially lead to higher operating cost and further compress NIM for Islamic banks, according to analysts. Under the commodity murabahah principle, the customer purchases an asset (commodity) from the vendor on a cost-plus mark-up basis where profit margin has to be agreed upfront.In Malaysia under this principle, the banks use the funds received from depositors to buy commodities either from theLondon Metal Exchange (LME)or from Bursa Malaysia.At this stage, banking analysts contacted byStarBizWeekagree that commodity murabahah is the most viable option. A banking analyst fromMIDF Researchsays Islamic banks in his view are already taking steps to convert their existing mudarabah deposits into either commodity murabahah or wadiah (custodian /safekeeping) deposits in compliance with the IFSA. The conversion, the analyst says, from mudarabah into commodity murabahah would attract transaction cost, adding that competition for the latter was expected to be more intense moving forward.

CIMB Researchanalyst Winson Ng says the reclassification will be detrimental to banks margins as banks earn smaller spreads from investment accounts than Islamic deposits. At this juncture, he says the research house is not able to quantify the impact as the percentage of Islamic deposits that will be reclassified as investment accounts is unclear, since it will be determined by depositors. This, he notes, will add pressure to Islamic banks cost of funding and impact their NIM.

Maybank IB Researchin a recent note says that in view of the parallel banking system in the country, the conversion will mean that Islamic banks would have to compete even more aggressively with conventional banks for funds. As for wadiah accounts, the restrictions on promotional activity and rate advertising may place Islamic banks at a disadvantage to conventional banks especially in terms of their current accounts-savings accounts gathering efforts.

Maybank Islamic, in responding to queries, says it will continue to offer mudharabah deposits alongside wadiah and commodity murabahah until June 2015. In line with IFSA, by June 2015, the bank says it will be introducing an investment account based on mudharabah structure that targets to give a more competitive rate to customers. Meanwhile, Maybank IB research analyst Desmond Chng says the most viable alternative at this stage after having spoken to several industry players was the conversion of mudarabah accounts to commodity murabahah.Chng in his recent report said the downside to commodity murabahah was that it was a slightly more expensive alternative to mudarabah as it involves a transaction fee of RM15 that would be levied on every RM1mil transaction on both the buy and sell side. This, he says, would increase the operating costs to a bank that decides to pursue this route, noting that this transaction fee would be treated as an operating expense.Additional operating costs could include issuing investment prospectuses and preparing regular updates on the performance of the assets if mudarabah accounts are converted to investment accounts. At the same time, IT systems may have to be upgraded to ensure the proper tagging of assets to liabilities, and additional personnel may have to be employed to cope with the increase in transactional activity, Chng says. Industry observers concur that there will be opportunity costs if depositors decide to opt for conventional banks.He says the financial impact would vary from bank to bank depending on the strategy adopted and frequency of deposit churned. Based on general parameters, he says he expects the additional transaction costs would average just about 5% of pre-tax profit for Islamic banks. Since these banks account for less than 16% of their respective financial groups earnings, the impact at group level is even more marginal, at below 1%. However, he says the impact toBIMB Holdingswould be larger since bank Islam accounts for 81% of group pre-tax profit. Even so, Chng RIA refers to a type of investment account where the investment account holder provides a specific investment mandate to the bank with regard to the purpose, asset class, economic sector and period of investment. Whereas, URIA refers to a type of investment account where the investment account holder allows the bank to make the ultimate investment decision without specifying any particular restriction or condition. Feels the impact would still be manageable at just minus 4%. Many analysts, however, feel that besides seeing NIM compression and hike in operating costs due to the reclassification and conversion, also agree that it could see a reduction in the size of bank balance sheet.Commenting on this point, Chng says if mudarabah/wakalah accounts are taken off-balance sheet, banks asset size will contract as these accounts makes up about 43% of total assets of Islamic banks. However, he feels the impact is likely to be marginal if only restricted investment accounts (RIA) are taken off-balance sheet, for these make up a much smaller proportion of deposits. He says whether an investment account has to be taken off-balance sheet or not has not been clearly spelt out yet by the central bank, adding that it could eventually depend on whether the account is a restricted investment account (RIA) or unrestricted investment account (URIA).

Differences between Wadiah, Mudarabah and MurabahahAl-Wadiah Deposits (Savings & Current Account)Shariah principles applicable to savings account are Al-Wadiah, Mudharabah and Al-Qard. However, Al-Qard is commonly offered by Islamic banks in the Middle East. Let's us examine the principle/concept and brief operation aspects of each type of deposits.Al-Wadiah is a contract (akad) between the Owners of good and the Custodian of the goods. The role of the Custodian (in banking perspective, the bank) is to protect the goods from damaged, destroyed, stolen etc. Basically, the contract is entered between both parties to ensure safe custody.In Malaysia, SAVINGS ACCOUNT offered by Islamic banks is under the contract of Al-Wadiah Yad Dhamanah (Guaranteed Custody). The core of this arrangement is that the bank has authority to use the depositors' money and guarantee to return the same when the depositors need it. Most Islamic banks (particularly in Malaysia) require the depositors to give their consent for the bank to use the depositors' money but for some Islamic banks, they kept it silent i.e. no consent is required.As trustee under this Guaranteed Custody contract, the bank is not allowed to mention or promise any rewards in the form of profits or gifts (hibah) on the deposits it received. Similarly, the depositors too cannot demand any reward or return from the Bank on their savings placement. It seems, BNM National Shariah Council (NSC) had made decision disallowing payment of profit or "hibah" for Al-Wadiah deposits. However, in practise, Islamic banks in Malaysia (except the International Islamic banks or IIB) are giving "hibah" in monetary form (as gesture of appreciation by the bank to the Depositors) and somehow, the Shariah Committee (SC) of the individual Islamic bank does not prevent but kept silent about this "hibah" issue. Perhaps, the SCs allow payment of "hibah" due to "maslahah" (public interest) in order for Islamic banks to compete as alternative to the conventional savings deposit account where paying "interest" is standard for all types of savings deposit accounts. The Writer opines that as long as the Islamic banks maintain this view, we may not be able to clearly differentiate between the Islamic from the conventional savings deposit. We have to make a stand when it comes to Shariah compliant issue. Anyhow this is just the personal view of the Writer. Perhaps, Shariah scholars can share their views to clarify this issue.What are the differences between Islamic from conventional savings account. In summary, the differences are as follows:-Chart 1;

It is interesting to note that although payment of "hibah" is somehow practise in Malaysia, NSC decision that NO free gifts or inducement items (e.g. free umbrella, coin box etc) should be given to new depositors is being strictly adhered by Islamic banks. So, unlike conventional banks where new savings depositors are given free gift such as an "umbrella with the bank's logo", new Al-Wadiah savings depositor normally do not enjoy such gift.There is a Shariah opinion allowing Islamic banks to give gifts to loyal depositors whom have maintain their accounts with the bank for example, more than 6 months. If such gifts are given, it should be given without any differentiation or category such as special gift to those whom maintain deposit amount of more than RM10,000 and the like. It should be given to all depositors whom meet the same criteria irrespective the balances in their accounts.As for CURRENT ACCOUNT, it is also offered under the principle of Al-Wadiah Yad Dhamanah. Unlike savings account holders whom are given passbooks, Current Account depositors are given cheque books where it can be issued to pay 3rd parties or withdraw cash for own use.Technology has changed the operations of banks in Malaysia where previously banking counters/banking halls are the busiest place in a bank, nowadays withdrawal of cash, transfer of funds, bills payment etc can be done through the Automatic Teller Machine (ATM) or deposit cash via the Cash Deposit Machine (CDM). Banking transactions can also be done on-line through Internet banking services and now fund transfer can also be done via mobile phone. To-date there is no Shariah issue relating to services using technology but it would be interesting to observe what Islamic banks will do when one day, conventional bank grant loans such as overdraft without requiring the customer to sign any agreement or go to the bank, suffice with just an application via the Internet.Al Mudharabah Savings.Another popular savings account offered by Islamic Bank is Al-Mudharabah savings accounts. Under this concept, the depositors shall entrust the bank to utilize the deposits for its financing and investment activities without any interference from the depositors.Profit earned from the banks investment will be shared between the Bank and depositors in accordance with the agreed profit sharing ratio (PSR). It is interesting to note that under Mudharabah savings, the profit-sharing-ratio (PSR) is only valid for one (1) day. At end of the day, whatever PSR during the day is terminated but it will be automatically renewed the next day. To operate in this manner, the Bank need to seek consent from the Depositors on this automatic profit sharing renewal arrangement on condition the PSR remained unchanged.If the Bank decides to change the PSR, it still need to advise the depositors in writing by giving sufficient time such as 14 days to object the change in the PSR. Without any objection, the bank can change the PSR without any written acknowledgment or consent from the depositors. If the depositor objected to the change in the PSR, the bank reserves right to request the depositor to withdraw the money.This type of arrangement must be clearly explained to depositors to ensure transparency. So when a new depositor intends to open a Mudharabah savings account, the depositor MUST BE VERBALLY advise by the counter staff of this arrangement before opening the account instead of just asking the depositors to read the fine line (most depositors do not read the standard terms) in the application form.Since this savings account uses Al-Mudharabah principle, the depositors are exposed to risk i.e. losses (if any) is to be borne by the depositors. Likewise, this possibility must also be highlighted to the depositors. To match risks with rewards, profit rates payable to Mudharabah savings account holders are normally higher than conventional savings deposits rates.Looking at the above conditions, what is so attractive about Al-Mudharabah savings deposits? Compare to Al-Wadiah Savings where granting of "hibah" is an issue, there are no profit payment issue under Mudharabah Savings products. In addition, depositors under Mudharabah savings account enjoy MULTI-TIER profit sharing ratios normally structured as per Chart 2 below:-

If you review Chart 2, higher PSR is given to depositors with high deposit amount. Thus, generally the profit rates for Mudharabah savings are higher than conventional savings "interest" rates.One important aspect of Mudharabah savings deposits is that all depositors MUST SIGN A WAIVER FORM FOR THE CREATION OF PROFIT EQUALISATION RESERVES (PER) account by the Bank. PER is a reserve account (allowed by BNM and an important item in the Islamic accounting ) where the bank places undeclared profit amount i.e. this amount is deducted from the gross profit before distribution and placed in a reserve account i.e. PER, to support the Al-Mudharabah profit rates in conventional bank interest hike situation, to avoid Islamic banks from exposing to what is known as "deposit displacement risk" due to outward movement of deposits from the Islamic banks to conventional banks due to sudden hike in conventional deposit rates. Under such situation, in order to remain competitive, Islamic banks may need to match the conventional savings rate.We have to admit that there are three (3) types of depositors in our banking system as follows:a) those who seek high return and can switch from Islamic to Conventional or vise verse (basically non-Muslims); b) those who only want to deal with Islamic bank; andc) Muslims who are still indifferent on the type of banking system (still does not understand the implication of "riba" to a Muslim) as long as they can get high return on their investment. This type of Muslims behave like (a) above. They are among the group who accuses Islamic banking financing products as expensive and prefers to take "riba" product to enjoy lower pricing. As mentioned in this blog banner, the Writer will provide examples in later session to prove that conventional bank loans are more expensive than Islamic financing products.MurabahahMurabahah is a particular kind of sale where the seller expressly mentions the cost of the sold commodity he has incurred, and sells it to another person by adding some profit or mark-up thereon. The profit in Murabahah can be determined by mutual consent, either in lump sum or through an agreed ratio of profit to be charged over the cost. All the expenses incurred by the seller in acquiring the commodity like freight, custom duty etc. shall be included in the cost price and the mark-up can be applied on the aggregate cost. However, recurring expenses of the business like salaries of the staff, the rent of the premises etc. cannot be included in the cost of an individual transaction. In fact, the profit claimed over the cost takes care of these expenses. Murabahah is valid only where the exact cost of a commodity can be ascertained. If the exact cost cannot be ascertained, the commodity cannot be sold on murabahah basis. In this case the commodity must be sold on musawamah (bargaining) basis i.e. without any reference to the cost or to the ratio of profit / mark-up. The price of the commodity in such cases shall be determined in lump sum by mutual consent.

Comodity Murabahah Programme in MalaysiaAs a part of Bank Negara Malaysias initiative to support Islamic Finance development in Malaysia, Commodity Murabahah Programme (CMP) was introduced to facilitate liquidity management and investment purposes. CMP is a cash deposit product which is based on a globally acceptable Islamic concept. It is an efficient instrument for mobilisation of funds between surplus and deficit units. CMP is designed to be the first ever commodity-based transaction that utilises the Crude Palm Oil based contracts as the underlying assets. CMP transaction with BNM was first auctioned competitively in the Islamic Interbank Money Market (IIMM) via the Fully Automated System for Issuing/Tendering (FAST) on 14 March 2007 and it marked an extensive effort by the country to become a significant player in Islamic Financial Market globally. CMP may also be transacted bilaterally amongst IIMM participants including BNM. The introduction and usage of CMP as liquidity management tool will contribute to realising the vision of making Malaysia as an International Islamic Financial Centre (MIFC).

PRODUCT FEATURES Background The introduction of CMP as a domestic Islamic money market instrument has already been endorsed by the National Shariah Advisory Council. Purpose To offer Islamic financial institutions a new instrument in managing liquidity in the IIMM. Fixed Return CMP provides certainty of returns as it is undertaken based on pre-agreed margin or mark-up from the sale and purchase of the underlying asset. BENEFITS 1. Efficient allocation of resources 2. Effective liquidity management tool 3. Platform for monetary policy implementation 4. Portfolio diversification 5. Risk management facility 6. Global acceptance