The last article elaborated on how an Islamic bank performs the dual role of being the fund manager (Mudarib) while receiving money from savings and term depositors – who are the fund providers (Rab Al Maal) – and at the same time switches the role by itself becoming the fund provider to the bank’s clients who are seeking the bank to finance or invest with them.
What if such clients fail to meet their commitment to the Islamic bank as a result of incurring losses, or any other reason – genuine or otherwise? Should the depositors bear the brunt since we earlier learned that the bank simply manages depositors’ funds as the fund manager for and on their behalf? What recourse does the Islamic bank have toward such ‘defaulters’? We shall now examine these vital questions in order to be able to clearly fathom the position of a Mudarabah depositor to an Islamic bank.
To refresh, we also covered earlier that the funds lying in the current accounts of an Islamic bank remain guaranteed by the bank since these are not part of the Mudarabah arrangement. This is because Shariah does not allow combining the guarantee and profit at the same time. A depositor can either seek a guarantee from the Islamic bank for his or her funds in which case he or she will not be paid any profit, or opt for a profit-bearing deposit which cannot be guaranteed by the Islamic bank.
The Islamic bank, being the custodian of the common pool where the funds from shareholders and depositors are mingled, holds full discretion to deploy the funds best suited to the commercial acumen of the bank’s senior management employed by the shareholders through the board of directors. A request by a client inviting the bank to invest in its business or finance its inventory or working capital requirements passes through several stages and management levels before it is accepted or approved. It is the Shariah responsibility of the senior management of an Islamic bank to be prudent in deploying the common pool funds to be able to generate Halal and Tayyeb (permissible and pure) profit for depositors and shareholders.
How does an Islamic bank deploy the common pool funds? There are horizontals and verticals through which the bank achieves the recurring deployment. Firstly, the horizontal deployment is segregated among retail and corporate clients, then the bank also invests in the Islamic capital market (such as Shariah compliant stocks, Sukuk or Islamic bond) and in Islamic asset management (Islamic funds). Another special way of deployment is the placement of excess liquidity by the bank’s treasury department with the country’s central bank and/or peer Islamic banks.
Vertical deployment is through the usage of Islamic contracts around which the bank develops certain product offerings for customers. Mainly, the Islamic banks use two types of contracts, viz. the sale-based contracts and the investment-based contracts for product development. Sometimes, a product is also structured based on the combination of the two or more contracts but that is not a common practice so we will not discuss it here.
The difference between the two types of contracts is that in sale-based contracts, at the outset the bank comes to know of the profit it will make from a transaction whereas in investment-based contracts, the profit is only estimated and the actual profit (or loss) amount remains unknown until the maturity of the transaction.
Another difference between the two types is that in the products which are based on sale contracts, the bank remains exposed to credit risk, having sold certain goods, commodities or assets on a deferred basis. However, in the products based on investment contracts, the nature of the bank’s risk is the equity or the ownership. We shall discuss in detail the Shariah nominate contracts and the Islamic banking products which are developed around them when we reach that stage in this series.
On a daily basis, an Islamic bank routinely deploys common pool funds through a mix of sale and investment-based products to hundreds of retail and corporate clients which leads to cash outflow. At the same time, scores of transactions mature on a daily basis and the originally deployed funds are retrieved with profit. The maturity could be partly in nature, ie in the case of retail clients it could be the monthly installments, or in full which is normally found in corporate client transactions. The entire cash outflow and inflow movement is managed by the bank’s treasury department.
Let us assume on a given day, out of 25 matured transactions, the bank realized only 20 and the rest were not realized, or became past-due in banking terms. There could be two reasons for the Islamic bank not getting these five settlements realized: either they will be paid albeit with a delay, or the bank will not be able to recover these amounts. What shall be the Shariah application in both the situations? We shall discuss it next week.
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: Continuation of the discussion on an Islamic bank handling a loss situation.