Once the amount for the overall distributable profit for a certain period has been determined, the Islamic bank shall arrive at the total amount it is entitled to receive as the Mudarib and the amount which is required to be distributed among Mudarabah depositors. As explained earlier, both amounts shall be based on a pre-agreed distribution ratio for the period.
Some customers may have placed funds for the maximum period (say one year) while others for one or three months. Also, the deposit amount by some customers may be large while for some others it may be just equal to the minimum threshold the bank has set to receive the term deposits. The question is, will it be fair to treat all types of deposit clients in the same manner?
Let us look at it from another angle. Being the Mudarib, it is the responsibility of the Islamic bank to attempt to get the best profit for the Rab Al Maal (fund provider). This approach not only benefits the depositors but also the Islamic bank.
However, if the Islamic bank comes across certain investment opportunities or trade transactions where the return is attractive but the lock-in period is long, for example six months to one year, it will be difficult for the Islamic bank to deploy short-term deposits of say one to three months to undertake such transactions due to their maturity being shorter than the required investment period. This is despite the fact that these deposits may have been with the bank for quite some time and being rolled over at each maturity since technically they are there for only one to three months. In this situation, the bank will have to rely on the deposits having a longer term maturity of six months to a year.
In view of the foregoing, the Islamic bank is allowed to introduce some sort of an incentive mechanism to encourage depositors to opt for longer deposit periods to enable the Islamic bank to effectively utilize the deposit amounts for the mutual benefit of all stakeholders, ie depositors, the Islamic bank and the customers needing funds. This approach also helps to minimize the mismatch between the investment tenors and the term deposit maturities (conventionally referred to as the asset liability mismatch).
The mechanism is called the deposit scoring or deposit weight system through which the term deposits of different maturities are given certain weights. For example, a term deposit of a one-year maturity may be given 100% weight whereas a deposit of one month is allocated 40% weight by an Islamic bank.
The weights signify the effectiveness of a deposit for the Islamic bank from a deployment perspective, hence the higher the effectiveness of a deposit to the Islamic bank, the higher the share of the profit allocated to such a deposit. The weights allocated to each category of deposit must be approved by the Shariah board of the Islamic bank and must be advised to the customer at the time of the deposit placement by the customer with the Islamic bank.
In some jurisdictions, an Islamic bank is allowed by the apex bank to transfer a certain amount out of the periodical profit to different types of reserves. Such a practice is called the smoothing of the profit. These reserves are called the ‘profit equalization reserve’ and the ‘investment risk reserve’ with the objective of setting aside some amounts as a precaution for future years when the Islamic bank may not be able to generate the anticipated profit due to market downturns or any other unfavorable circumstances.
It is possible that these reserves are created out of the overall distributable profit for the Islamic bank and depositors together, or merely from the profit attributable to the depositors. The amounts of such reserves are ploughed back into the common pool and the resulting benefit is provided either to both parties, ie the Islamic bank and the depositors if the reserves were meant for both, or only to the depositors if the reserves were carved out of their share of the common pool profit.
In situations where the actual profit earned by the Islamic bank is below expectations, or in a loss situation, the Islamic bank shall be allowed by its Shariah board to dip into these reserves in order to arrive at the distributable profit for itself and/or depositors (whatever the case may be). This may bring the profit distribution closer to the one made by the bank in the recent past.
Readers should note that the statutory reserve is not included while transferring the amount to the profit-smoothing reserve accounts. This is for the reason that the statutory reserve is the sole responsibility of the Islamic bank in its capacity as the corporate entity and not as the Mudarib. As such, the Islamic bank builds the statutory reserve until it reaches the legally stipulated level of the paid-up capital out of its own share of the profit and not from the common pool profit.
The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.
Sohail Zubairi is the projects advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected].
Next Week: Conclusion of the discussion on profit distribution by explaining a few final points.