Lessons of Cyprus and Depositor Liability in Islamic Banks

There is a common explanation that Islamic banking can alleviate the European debt crisis, or could have prevented the financial crisis. Normally, these claims are not thought through enough to provide specific policy recommendations, and they instead just form the normal cheerleading heard at many Islamic finance conferences.

However, with the ‘bail-in’ of depositors in Cyprus, Islamic banking may have a specific recommendation for conventional banks based on the products used by Islamic banks. Rather than just lump creditors together an encourage complacency around the potential losses, make these explicit by dividing them into ‘safekeeping’ deposits and ‘profit-sharing and loss-absorbing’ deposits, and connect them with the specific pools of assets within the bank to provide increased transparency.

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Islamic finance complexity (Part IIh)

It has been a while since I added to the Islamic finance complexity series of posts, but I was reading an article that I thought would provide a return to the series (and also back to the liabilities side of Islamic banks' balance sheets).  The IFSB is beginning work on its standards for capital adequacy to incorporate changes in Basel 3, which prompted me to look at one of their Guidance Notes already out there (IFDB-4 [pdf]), which deals with capital requirements around profit-sharing investment accounts (PSIA), which are a large part of Islamic banks' liabilities (equivalent to deposits).

The standard from IFSB provides guidance to regulators to determine the treatment of liabilities (and the assets they finance) for capital adequacy calculations.  What is at issue with the PSIA is whether the assets financed by PSIA should be given a risk-weighting in the capital computation greater than zero (i.e. there should be some capital set aside for the assets they finance).

The theoretical proposition with PSIA is that the assets the bank invests the PSIA funds in should not be treated as assets needing capital set against it.  The logic is that since PSIA investment account holders (IAHs) are liable as rabb ul-mal (in a mudaraba) or muwakkil (in a wakala) to bear any loss and the bank only gets a share of profits (if any) or a fee, respectively, that are generated by the assets.

However, since most Islamic banks--either by choice or because they are required to by their regulators--set up profit-equalization reserves and investment risk reserves, and also can "[forego] all or part of its Mudārib share of profits on investing UIAH [unrestricted IAH] funds, or donating to the UIAH part or all of the profit on investments financed by shareholders’ funds, so as to enhance the profit payout to the UIAH".

As a result, the bank is bearing some displaced commercial risk from the investments financed by IAHs because they will--to some degree--bear the risk of loss in the funds invested that were provided by IAHs.  As a result, while the contracts in their pure form would not expose the bank to possible losses, in actuality the bank has to set aside some capital to pay for these losses.  The IFSB guidance note provides guidance to regulators to determine the calculation of what portion of assets financed by IAH depositors should be considered "at risk" (thus needing a risk weighting based on their own structure).

One of the more interesting discussions in the guidance notes was surrounding the status of IAHs, in terms of how the regulators expect depositors to be treated should the bank become insolvent:

"In practice, there is considerable ambiguity in  the nature and characteristics of UPSIA, which vary among IIFS and jurisdictions. At one extreme, IAH are highly protected so that UPSIA tend to be deposit-like products where the returns are 'stabilised'". 

At the other extreme:

"UIAH have no claim as creditors over the assets of the IIFS (as do conventional depositors). Instead, they have a claim to the assets financed by their funds (including their share of any undistributed profits and less any losses), including their share of assets financed by commingled funds, in respect of  which they rank  pari passu with the shareholders after taking account of the fact that the latter are liable for amounts deposited by current account holders and other creditors."

One note here is that current account holders are depositors under, for example, qard hasan, who have their principal guaranteed, but are not entitled to profit.  Between the two extremes, there are any number of possibilities where depositors are neither treated like current account holders or fully liable to lose the full value of their principal.  The qualification of UIAH (unrestricted IAH) is done because a restricted IAH would have specific assets financed using their funds and therefore would have their funds at risk of loss based on the performance of the assets they finance. 

The distinction in regulatory treatment of mudaraba and wakala depositors across jurisdictions provides another example of how it is not necessarily as simple as arguing whether Islamic banks' deposits should be fully pass-through (a pure mudaraba) or not.  It also highlights the fact that the regulatory environment facing Islamic banks is not uniform and also not necessarily easily transferable to how Islamic banks work. 

UPDATE: I just saw an article which describes some of the different factors that affect whether PSIAs will impact Islamic banks' capital requirements, from the IFSB seminar in Malaysia. 

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

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.

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

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: http://investhalal.blogspot.com/2011/11/islamic-finance-complexity.html