Thursday, November 03, 2011

Islamic finance complexity (Part IIa)

The goal of this thought exercise is to understand whether Islamic banks meet the financial needs of their customers and structures products that are both readily understandable to customers and competitive in price to conventional alternatives (where they exist).  The first, and most basic, need among consumers is to have access to a safe place to put their money that can earn a return, as well as a place they can turn to for a loan (whether a consumer or a business).  This is a bank.

On the most basic level, a bank is an institution that collects savers' money and invests these funds into loans that earn a return sufficient both to pay a competitive return for depositors and at the same time keeping the depositors' funds safe.  The function of the bank is to turn short-term deposits into long-term loans--to manage the maturity mismatch between the liquidity needs of depositors and the need for long-term funding for borrowers.  In addition to the depositors' money and the loans provided, the bank holds some degree of equity, that for regulatory purposes is separated by how much it is able to absorb losses so they do not need to be passed onto depositors.


For depositors, the underlying need is for a safe place to store money with the requirement that they be able to access their money when they need it, that they can earn a return sufficient to offset the effects of inflation and to provide depositors a way to use their money.

The theoretical idea of an Islamic bank where depositors place their deposits under mudaraba conflicts with the idea of safety of the deposits from loss, which (among many reasons) is probably why a pure mudaraba is not used in Islamic banking today.  However, the alternative--wadiah--does not succeed in generating a return sufficient to offset the costs of inflation of deposits by reducing the purchasing power of the deposits held at banks.  Abstracting from the mechanics of how a debit card works, which may not fully comply with the current standards of Shari'ah-compliance, the issue of accessing the funds is not any different between an Islamic bank and a conventional one. 

The solution to two needs (protecting depositors from losses and still providing a return necessary to offset the costs from inflation) that Islamic banks have adopted is that the mudaraba accounts are made liable for losses of the bank, but the profits accruing to equity (who would in theory be on par with depositors) are voluntarily made subordinate to the return of depositors' principal.  In addition, through reserve accounts, the depositors' profit is 'smoothed' by setting up reserve accounts where excess profits are stored to maintain profit payments when the profits generated fall below the market interest rate on deposit accounts.

The arrangement is not optimal because the equity investors are basically making their investment as a mudaraba (they provide the capital and the bank provides the management expertise to generate a return on that equity).  Therefore they should not have to 'voluntarily' sacrifice their return in order to prevent losses on other mudaraba capital, although when the they can capture additional upside from higher profits than depositors can, where excess profits beyond the deposit rate are stashed away in reserve accounts, there is at least the potential for equity investors' return to be higher than depositors, in compensation for the additional risk they are taking.

The wadiah account holders are essentially sacrificing one goal (protection from returns against inflation) to promote the other goals (safety of principal and ability to use their money when they need it).  Their principal is guaranteed, even if inflation erodes the purchasing power of the deposits, and through checks, debit cards or wire transfer, is able to use their deposits as they see fit. 

On a basic (and grossly oversimplified) analysis of the depositors position, the basic Islamic banking model does make sense, although there are trade-offs, which could arguably be used as evidence that Islamic banking both does not suit the needs of both depositors and equity investors in the banks.  However, there are always trade-offs between risk and return and linking risk and return is often described as a key feature of Islamic finance.  While it is not optimal to have mudaraba depositors implicitly subsidized by (mudaraba) equity holders, the potential higher returns for equity investors should assuage some criticism that they are forced to bear greater risk than depositors than they would in a theoretical mudaraba-based Islamic bank.

This analysis does not necessarily cover the actual products offered by Islamic banks for depositors, but that will have to wait for a later post.

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