Today, we are going to wrap up the discussion on profit distribution between the Islamic bank and its depositors so that we could move on to our next topic.
Last week, we talked about the weights allocated to the term deposits based on their respective tenors and also that the effectiveness of a term deposit is linked to its longer tenor since it provides greater deployment and redeployment flexibility to the Islamic bank and that the higher the effectiveness of a deposit, the higher the share of the common pool profit for it.
An important aspect which needs to be understood on this point is that at the time of the deployment of term deposit funds to a particular financing transaction, the Islamic bank does not literally tie up the maturity of a deposit with the expiry of a certain funding transaction. This will not be practically possible and besides, the Islamic bank has accepted the term deposit on an unrestricted Mudarabah basis and hence, it is free to utilize the funds as it deems appropriate. Therefore, the weight system is applied on a notional basis as a tool by the Islamic bank with a view to striving for longer tenor deposits.
Another point that needs to be explained in respect of the deposit weight is the practice of profit-smoothing. Here, the amounts of the profit equalization reserve and the investment risk reserve, which are ploughed back into the common pool, are allowed to enjoy highest weight decided by the Islamic bank’s management and approved by the bank’s Shariah board. This is because these funds will continue to remain invested in the common pool for an unknown and longer period of time, sometimes exceeding the lengthiest deposit tenor the bank offers.
A question arises if that is the case: what about the weight given to the shareholders’ equity which remains endowed in the common pool on a perpetual basis? Well, any remaining amount of the paid-up share capital, pursuant to the spending on completing the brick and mortar part of the head office and branches and the entire setup and the human resource costs, which is invested in the common pool, is also accorded the highest weight owing to being a permanent investment.
The allocation of distributable profit to a deposit which has remained invested in the common pool from the beginning until the end of a profit period should be a straightforward task. However, what if a deposit was made in the middle of the profit period? Or, how does an Islamic bank treat a deposit which matured during the profit period and the original amount was redeemed to the customer? Also, how does an Islamic bank accommodate the premature encashment of a term deposit? We shall look into all these situations one by one.
With regards to the introduction of a new deposit to the common pool in the midst of a profit period, it shall be allocated the profit amount based on the relevant deposit weight from the deposit-making date until the completion of the profit period. For example, if it is a six-month deposit and the bank’s profit period is based on a quarterly basis and that the deposit was made 20 days prior to the completion of the current quarter, the customer will receive the pro-rata amount of profit for the period the deposit amount remained invested in the common pool based on the six-month weight.
If a deposit reached maturity in the middle of a certain profit period, the bank will only redeem the principal amount of the deposit to the customer on maturity and the relevant profit amount shall be credited to the customer’s account only after the bank has closed the profit period and determined the profit amount eligible to the customer based on the appropriate weight.
On the premature redemption of a term deposit at the customer’s request, the Islamic bank shall pay the principal amount of the deposit to the customer forthwith but he or she will have to wait for the completion of the profit period in order for the Islamic bank to ascertain the customer’s eligibility for the profit related to the broken period. For example, if the deposit was made for one year but it was taken away by the customer in six months, the bank shall downgrade the weight of the deposit from one year to six months. Also, since the Islamic bank must have paid the profit for the last period based on a one-year weight, the bank will have the right to readjust the paid profit, keeping in view the now corresponding lower weight, and deduct the excess profit amount paid at the time of cashing the deposit.
An Islamic bank does not deduct Zakat from the customers’ term deposits or savings accounts. However, an Islamic bank is required to pay the Zakat on the shareholders’ annual net profit which is comprised of their share from the common pool profit (as the Mudarib) as well as the non-funded income (fee earnings from various services).
It is important to note that the shareholders do not need to pay Zakat on the dividend amount received by them since it is already ascertained and deducted by the Islamic bank; however, they do need to pay Zakat on the market value of the shares they hold.
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: Our new subject of discussion from next week shall be corporate governance in Islamic banks.