Sunday, November 20, 2011

Islamic finance complexity (Part IIc)

Wakala and murabaha deposits

Reading through the previous posts, I realized that I focused on only two of the four types of Islamic deposit products (qard and mudarba).  The other two--wakala and murabaha--should also receive a quick discussion. The wakala deposit product is very similar to the mudaraba, except that the profit accruing to the bank is determined differently.  In mudaraba, the bank receives a share of profit as mudarib, while in a wakala, the bank charges a fee for serving as the wakil (agent).  In both cases, the losses are supposed to be borne exclusively by the provider of funds (rabb ul-maal under mudaraba and muwakkil under wakala) but in most Islamic banks, there are reserve funds to preserve depositors principal to remain competitive with conventional banks and also to limit the likelihood of a run on the bank.

The other product, murabaha, is a more recent development and is often a commodity murabaha.  On the one hand, a murabaha is a useful product because it is not ambiguous like a mudaraba or wakala, in that the deposit is directly exposed only to the credit risk of being a creditor of the bank, rather than existing in a middle ground of being exposed to the risk of the investments made by the bank, but in practice, relying on the bank prudently creating a reserve fund to protect depositors funds.  On the other hand, the use of murabaha in deposit accounts further entrenches the product which is seen by many as less than desirable because it further enforces the idea that Islamic banks develop products that replicate conventional bank products.

Islamic Deposit Insurance

However, the main issue I have not yet addressed is Islamic deposit insurance.  The idea of deposit insurance is at first glance anathema to an Islamic banking system that is based (at least in rhetoric) on profit-and-loss sharing.  There are benefits to making rewards related to the risks, but in a bank, putting risks on depositors shoulders when those banks are competing with conventional banks is likely to hurt their competitiveness when there are no protections to depositors like deposit insurance (or to a lesser degree reserve accounts).

Depositors are generally focused on safety of their deposits and immediate access to their funds on demand, with returns (to keep pace with inflation) being secondary for most depositors with current (demand) deposit accounts.  Time depositors sacrifice immediate access to their deposits for some return to offset inflation, but  generally are not focused on high returns, especially if those returns put their principal at risk.  For both demand and time depositors, the safety of their principal is important and without some form of Islamic deposit insurance, a proportion of these depositors would move to conventional banks that can offer deposit insurance.

Without deposit insurance, the security of depositors' money is reliant on their faith in the solvency of the bank and its ability to properly accumulate enough reserves to offset the losses of funds that are invested on behalf of the depositors.  However, the confidence in the bank and its reserve accounts are likely to be highly correlated with depositors' faith in the solvency of the bank and if one is put at risk, there is a possibility for a bank run to start, which will turn doubts of confidence into a self-fulfilling prophecy (in some, but not all, cases).  Thus the need for deposit insurance.

There is limited experience with Islamic deposit insurance.  Most of the Islamic deposit insurance programs (detailed in a survey by the International Association of Deposit Insurer's (IADI) Islamic Deposit Insurance Group (IDIG) conducted in 2009) are either part of a conventional deposit insurance program entirely or are done with small changes to be Shari'ah-compliant.  The only fully Islamic deposit insurance program is Sudan because the banking system is (or was at the time) fully Islamic.

Two deposit insurance programs which I looked at were Bahrain's (run by the Central Bank of Bahrain) and Malaysia's (run by the country's deposit insurance agency PIDM).  The deposit insurance systems are different.  Bahrain's covers deposits, not including mudaraba deposits or other deposits not involving safekeeping or custodianship where the depositor would be entitled to share in profits and losses.  It is post-funded (i.e. deposit insurance assessments are only collected from banks when there is a failure) so there are no issues with how the deposit insurance premiums are invested (although the CBB website does indicate that a new deposit insurance program is under construction that would shift it to being pre-funded raising the issue of investing the premiums collected by the Central Bank).

PIDM, in contrast, does both collect premiums (it is pre-funded) and does cover mudaraba depositors in addition to deposit contracts based on custodianship or safekeeping (e.g. wadiah).  The deposit assessments are calculated in a similar way to conventional banks, but the premiums are held in a separate fund from those collected from conventional banks and are invested only in Shari'ah-compliant government investments (e.g. bonds, notes, bills issued by the Government or Bank Negara Malaysia, the central bank).

Since PIDM's deposit insurance program does cover mudaraba, it would be natural to assume that it limits the profit-and-loss nature of mudaraba deposits, but the deposit insurance program does not cover regular losses that would accrue to mudaraba depositors.  It only comes into play when a bank that is a member of the deposit insurance fund fails.  In order to not place return-generating accounts above those that do not generate a return for depositors, the wadiah and qard depositors are placed ahead of mudaraba depositors in the seniority of creditors of a failed bank.

The deposit insurance issue should be more aggressively developed now that the Islamic finance industry has the experience of surviving a global financial crisis.  It is probably luck more than just about anything that there were no bank runs on Islamic banks during the crisis, and in part also due to the ad hoc interventions by governments.  A deposit insurance program (operating under kafala bil ujr, a guarantee provided for a fee, like Malaysia's) is essential if Islamic banks want to compete with conventional banks while also avoiding being covered by conventional deposit insurance programs (which may lessen perception of their Shari'ah-compliance).

As the Malaysian program shows, deposit insurance programs do not offset any profit-and-loss sharing of mudaraba deposit accounts, except if the bank fails.  This is probably prudent because while depositors are likely willing to risk small fluctuations of their deposits in rare occasions (where the reserve accounts are not large enough), they are unlikely to accept the total loss of their deposits, and will move to conventional banks if that possibility is shown to be real by the failure of an Islamic bank somewhere in the world.

The existence of Shari'ah-compliant deposit insurance (deposit takaful?) will, I think, increase, rather than decrease, the profit-sharing nature of Islamic banks by taking the 'tail risk' away from mudaraba depositors. They will still have to have faith in the bank adequately maintaining a reserve account (something that the bank regulators should focus on), but it will make the returns generated from a mudaraba account seem worthwhile, even if small, because the unlikely event that they suffer a large loss has been removed.  For proponents of a profit-and-loss sharing bank system, this should be a priority, especially before murabaha deposits become the norm rather than qard, wakala or mudaraba that prevail today.

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Paramount said...

I agree with you regarding mudaraba

Paramount said...

I agree with you regarding mudaraba