Sunday, November 06, 2011

Islamic finance complexity (Part IIb)

After my summary of the ideas behind the deposit accounts of Islamic banks, I went and did a very unscientific survey looking at two Islamic bank's deposit accounts (Dubai Islamic Bank and Meezan Bank) to see how they actually operate in practice.  As I expected, the deposit products are similar to what one would find in conventional banking.  There are a mix of demand deposit and savings products offered by each bank.

In the case of Meezan bank, the deposit accounts offer a mix of demand deposit accounts based on qard, where "the Bank is liable to pay your money back on demand".  One interesting point is that, in contrast to the mudaraba deposit accounts, the qard accounts does not discuss the conditions in which the depositor could lose his or her money, even though there is no one would expect depositors placing their money under qard to be below those placing them under wadiah to be in a lower position in the bank's capital structure.

The Meezan savings accounts were all based on mudaraba, which one would expect from an Islamic banks and all stipulated that the deposits would be invested in Shari'ah-compliant contracts like murabaha, ijara, istisna'a and musharaka to generate a return, although "in case of a loss, as per the rules of Mudarabah, the Rab-ul-Maal shall bear the loss in the ratio of their investment".

When I looked at the Dubai Islamic Bank's products, the descriptions looked much more like conventional bank accounts.  Some accounts had profit-sharing features, while others did not.  The contracts under which the accounts operated were not specified, so one can reasonably assume that the ones providing profit-sharing were based on mudaraba while the ones which did not were based on wadiah or qard.

One troubling feature of the DIB accounts was that in neither case of the mudaraba or wadiah/qard was the prospect of loss presented.  When I searched the DIB website for 'loss' or 'lose', the only page that I found was an FAQ page describing in general terms how Islamic finance works without  presenting any risk statement that one would expect from a bank (especially one of the oldest Islamic banks in the world). 

My survey was not representative in any way, but it did find a troubling lack of disclosure of the risks associated with Islamic deposits from one of the banks I surveyed.  When a consumer looks to place funds with a bank, as I discussed in an earlier post, there are three key things he or she expects: safety of the deposits, a return on deposits to offset the costs of inflation, and access to the money deposited.

Both banks provided good access to funds for their depositors, with the note that some products offer limited access by design (similar to conventional Certificates of Deposit).  In terms of a return in excess of inflation, it is unclear.  Not all of the products offered concrete terms or histories of the accounts in terms of whether the deposits were paid returns in excess of inflation, but this is to be expected in Islamic banking.

However, with regards to the safety of the deposits, one bank offered clear disclosure that the account holders could lose their deposits if the investments made with those funds were money-losing.  The other bank did not make any reference to the potential for losses.  Perhaps this lack of disclosure is due to a leniency of regulations in one country versus another, but if Islamic banking is to use mudaraba as a means for raising deposits, there is a clear moral imperative that the costs and benefits of the product be clearly disclosed.

This is especially the case for a bank like DIB where the financial statements for 2010 report a provision against the depositors, albeit one that is outweighed by a far larger transfer from the profit equalization reserve account.  The fact that a bank pays returns based (somewhat loosely) on the returns from its own assets funded by the deposits and shares the risks from those investments with depositors should be clearly stated.  This should be even more pressing an issue for a bank like DIB which still holds a wakala liability to the UAE Ministry of Finance from the recent bank bailouts in Dubai.

Leaving aside the institutional differences between the banks surveyed above, I see a few lessons.  First, Islamic banks should disclose the full risks of their products, including the position in the capital structure based on the type of deposit.  Second, Islamic banks should provide full disclosure that the profit paid on their deposits are totally based on the return on those investments and that they are liable to bear the loss on those investments unless there are funds available in the profit equalization reserve to cover the losses.

It is commendable for Islamic banks to smooth the returns on mudaraba deposits to essentially store up reserves so that depositors can not worry that they will lose their deposits.  However, it is essential that they be fully aware that the reserves put aside to safeguard their deposits may run out and they could lose their deposits.

See the index of other posts:

No comments: