Islamic finance complexity (Part IId)

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I was just reflecting on the types of deposit products available from Islamic banks and there are generally four: qard, mudaraba, wakala and murabaha.  There are costs and benefits associated with each, both from a theoretical perspective as well as in practice.  

In much of the theory of Islamic banking, the mudaraba deposit product is widely viewed as being superior because it is a profit-and-loss deposit.  On similar lines a wakala deposit also requires the deposit to bear losses on the investments for which their deposits are used to fund.  A qard deposit is also in theory perfectly acceptable because no return is provided on the funds in exchange for the safety of the principal amount.  A murabaha deposit would be viewed in this light as being inferior because it replicates a conventional time deposit where principal is guaranteed (at least as far as the bank stays in business) and a return is provided to the deposit.
However, the way Islamic banks operate change the equation.  The qard product is not affected; it works the same way with no return and safety of principal, and is not too different from how many demand deposit accounts function today with the global zero or near zero interest rate environment.  In a more normal situation, the qard deposit product would probably be viewed as less competitive because of its zero return and would not provide a sustainable funding base for Islamic banks because it would be hard to gather qard deposits except from people who want to have a safe place to keep their money and don't want to engage with a conventional bank (it is a great deal for the banks who receive a free source of funding, apart from the potential liquidity management issues that it creates).  

As things work, a mudaraba and wakala account does not function in the way it was envisaged because depositors are unwilling in general to bear risk of loss of their deposits.  Islamic banks have therefore used reserve accounts to even out the profit payments and protect the depositors from loss.  There is also an informal (as far as I know it is informal) promise by shareholders of the bank to subordinate their claims over profits to the depositors, so that any shortfall in profits would come out of the profits accruing to the bank to keep the deposit rates competitive in comparison with conventional banks.  There is, therefore a deposit product that is designed to be profit-and-loss sharing but in practice works more like a conventional deposit account where principal is protected and returns are stable over time.  

In contrast, a murabaha deposit account is not viewed as theoretically preferable, but in practice may be superior to mudaraba or wakala because the theoretical idea of murabaha (at least of a commodity murabaha) bears more similarity to how the murabaha deposit account works in practice.  Depositors lend money to the bank through a purchase and re-sale of commodities with repayment on a future date (which could be daily, weekly, monthly or any other frequency to meet the depositors' desire for liquidity).  However, the position of the depositors as creditors and the bank as debtor is much more similar to how Islamic deposit accounts actually operate than the more appealing (to many) wakala and mudaraba deposit.  However the same problems arise with murabaha in deposit accounts as in the rest of Islamic finance because it becomes more and more a replication of conventional banking products rather than a new way of thinking of the banking relationship.  

The picture is slightly different when there is an Islamic deposit insurance system, which I described in a blog post earlier today, where the deposit insurance can take away the tail risk of large losses for mudaraba or wakala depositors and make these more appealing than murabaha deposit products.  

 See the index of other posts: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html