The most basic service a bank can provide to members of the public is to act as a depository for their money. This is the essence of commercial banking. The public generally holds its deposits with banks in the form of accounts. The most basic accounts are the savings account and the current account. Both these are considered demand deposit accounts, because they are payable on demand, either by withdrawal or by the customer instructing the bank to make payment to a third party. The relationship between the customer and the bank, in the conventional sense, in relation to the demand deposit accounts, is fundamentally that of creditor and debtor. SYED ALWI MOHAMED SULTAN explains more in this article.
In Malaysia, under the previous Islamic Banking Act 1983, Islamic banks used to offer demand deposit accounts through two Shariah contracts, the Mudarabah and Wadiah Yad Dhamanah. However, with the coming into effect of the Islamic Financial Services Act in 2013 and Shariah policy documents for specific Shariah contracts issued by Bank Negara Malaysia (BNM), Mudarabah has already been phased out from being offered as a deposit product while Wadiah Yad Dhamanah will be phased out by July 2018 to be converted into Qard as stipulated in the Qard policy document (dated the 3rd August 2016).
Salient features of the Qard policy document (issued by BNM)
Qard is a contract of lending or financing involving money. It is a contractual relationship between a borrower and a lender. Under the Qard policy and as per Fiqh rules, a lender is not allowed to accrue any contractual benefits when giving a financing to the borrower. The financing shall unconditionally be repaid in full at par value.
However, there have been instances where the lender would resort to clever multi-layered financial structures where in substance, such benefits will continue to accrue to the lender, yet comply with the direct textual prohibitions of such regulations. One such example is combining a sale contract with a financing contract, where the borrower would be required to enter into a sale contract as part of obtaining the financing. This is known as Bai Wa Salaf. This is prohibited under Shariah principles.
This may occur, either by accident or by design, in an Islamic banking product offering. For instance, if the Islamic bank induces depositors to place money with the bank (under a Qard or financing contract) and promises to provide the depositors profit under a separate commodity Murabahah contract, this will trigger the Bai Wa Salaf prohibition, as enumerated under Clause 14.1(a) of the Qard policy document.
Apart from the prohibition regarding accruing benefits from a financing under a Qard contract, another common practice that is now banned is the pre-agreed periodic rebate on the installment of a deferred selling price which is linked to the Qard contract. Take, for example, a mortgage facility that is popularly known as the FlexiHome product.
Essentially, this type of product allows customers who have taken up a financing facility (ie sale-based financing) the ability to prepay the facility as an advanced payment yet make such prepaid funds available for redraw such as withdrawing funds from the advance payment pool of funds (technically this advance payment has features of a Qard contract).
This prepayment will be applied directly toward reducing the principal outstanding amount, thus offering rebates on the daily profit accrual of the financing. While this structure facilitates the acceleration of debt settlement, it is now clearly disallowed as stipulated under Clause 14.1(b) of the Qard policy document.
Another common practice by Islamic banks is to offer certain incentives and benefits to customers who open a current and savings account (CASA) with the Islamic bank. Some benefits may be in the form of gifts, prizes, reward points and even waivers from MEPS charges for using the ATMs of other banks. These benefits will no longer be allowed for customers who open a CASA based on Wadiah (or Qard) as stipulated under Clause 14.1(c) that restricts “any form of incentives based on a binding promise”.
Clause 14.1(c) also impacts the practice of banks in offering affluent or premier banking services to customers who maintain a minimum deposit balance with the bank. Such exclusive benefits, if offered to Qard or Wadiah-based deposit accountholders, will not be allowed under this standard.
Another common product offering that will find a limited shelf life is the Islamic credit card using Qard and Ujrah concepts. Effectively, under this credit card, the credit utilization is based on Qard, while the bank charges fees on the basis of Ujrah. Under Clause 15.3 of the Qard standard, such practices will no longer be allowed.
Tawarruq as the alternative solution to CASA
As a result of the aforementioned disruptive issues posed by the Qard policy, the optimal solution for Islamic banks is to consider structuring CASA products based on the concept of Tawarruq. The Shariah policy document for Tawarruq (Tawarruq Standard) was issued by BNM on the 17th November 2015 and came into effect on the 1st July 2016. Technically, the Tawarruq Standard covers all products that utilize the contract of Tawarruq including deposits, financing, trade finance and derivatives.
Even though Tawarruq is available as an alternative solution to designing CASA deposit products, there are specific fundamental challenges that need to be taken into consideration as shown next.
Customer-bank relationship in deposit products
The relationship between the customer and the bank, in the conventional sense, in relation to demand deposit products, is fundamentally that of creditor and debtor. This enables the bank to treat the money deposited with them as their own. Banks are thus obliged only to return an equivalent amount upon demand.
However, under the Tawarruq contract, the relationship between the customer and the Islamic finance institution is that of a seller and purchaser, ie the customer becomes the seller of certain Shariah compliant commodities while the Islamic finance institution acts as the purchaser.
The bank only receives the money, purportedly the deposit funds, by way of on-selling the commodities to a third party on a spot basis subsequent to purchasing the commodities from the customer. As a result, the entire deposit transaction is structured through a set of sale and purchase contracts.
On one hand, the transaction costs due to the involvement of Shariah compliant commodities, make the product structure inefficient from a cost perspective.
On the other hand, in structuring this deposit product, proper attention needs to be paid to the legal documentation to ensure that the rights, obligations, interests and benefits of the respective parties are elucidated as per the Shariah contracts utilized and not blindly adopting terms that relate to the conventional form of a creditor and debtor.
Is the deposit truly on demand?
To that effect, the obligation of the Islamic finance institution to return the depositors’ money is established under a sale contract with a deferred payment obligation. However, the Islamic finance institution is not under any obligation to return the money to the depositors on demand. Instead, the customer may request for the funds on demand at a date earlier than the deferred maturity date of the original sale contract, but this will be construed as an acceleration of the repayment of the deferred selling price, which is a break from the contracted terms. So technically, the customer has to break the agreed terms in order to fulfil a fundamental requirement of the deposit account – money at demand.
Right to grant rebate (Ibra)
The next issue concerns the calculation and payment of profits. To be clear, the use of Tawarruq under a fixed term or fixed deposit product is easy to execute because the amount of the deposit and the tenor are fixed, which enables the computation of the selling price and the profit with certainty.
However, in a savings accounts (and in some instances, current accounts that pay profits), the computation of the profit is a challenge because by nature these demand deposits will have inflows and outflows which are quite random without a fixed tenor. To address this issue, typically Islamic finance institutions will resort to designing the Tawarruq-based CASA with a synthetic tenor, say one year or five years and a ceiling profit rate to facilitate the computation of the selling price.
Subsequent to that, the effective rate and actual profit will be calculated by taking into consideration the actual amounts and actual number of days that the deposit remains in the account. The difference between the profit computed using the ceiling rate and the actual profit shall be granted as a rebate. However, under Shariah rules, rebate (Ibra) shall only be granted at the discretion of the creditor or the seller. In a Tawarruq-based CASA, that right resides with the customer!
From the view of the Islamic finance institution, handing the decision on a rebate in the hands of the customer will not sit well with the Islamic finance institution’s risk committee. The reason for this is because the Islamic finance institution may end up paying the ceiling profit computed at the synthetic tenor, if the customer refuses to grant such a rebate.
Clause 20.2 of the Tawarruq Standard mentions that “a rebate clause shall be incorporated in a sale and purchase contract when it is imposed by the relevant authority”. But to the knowledge of the author, there isn’t any regulatory authority imposing depositors to grant rebate to Islamic finance institutions under a sale and purchase contract. This may need to be scrutinized properly in the legal documentation offering Tawarruq-based CASA products.
CASA Tawarruq – a game changer
The observations here are not exhaustive as there are other issues that will also require diligent inspection in designing Tawarruq-based CASA products. This simply demonstrates that diligent structuring expertise is needed in order to ensure that the interests of the Islamic finance institution and the expectations of customers are properly managed.
Yet, the Tawarruq-based CASA will possibly be a game changer in the Islamic banking industry. As such, getting the design right by balancing between commercial viability and regulatory compliance is of paramount importance in order to compete effectively in the present banking landscape.
The views expressed here are entirely the author’s own.
Syed Alwi Mohamed Sultan is the executive vice-president at Bank Muamalat Malaysia. He was formerly the managing director of Islamic Banking Asia at BNP Paribas. He can be contacted at email@example.com.