The main functions of a modern commercial bank include receiving deposits of various natures, granting short- and medium-term loans by way of overdrafts, discounting of bills and commercial papers, advances against securities for business and households, long-term mortgage financing and investments in capital markets. In some markets, commercial banks are also undertaking merchant banking. All this fund-based business is conducted on the basis of interest that is charged from the fund users and paid to the depositors/investors. Commercial banks also deal in foreign currencies, money changing and perform a number of services like issuing letters of credit (L/C) and letters of guarantee (L/G), payments made / received on behalf of their clients, safe custody of valuables and a number of advisory services against service charges or commission. However, all commercial banks might not be undertaking all of the above functions, and the majority of them undertake the business of deposit-taking with an open checking facility and lending for short periods for providing running finance to business and industry. Medium- and long-term financing is mostly arranged by investment banks by way of direct intermediation between the investors and industry/business.
All deposits in conventional commercial banks are the liability of the banks, because the amount of deposits has to be paid back with or without a return. Current accounts that are normally maintained by the business and corporate sectors carry no return and are used for managing their cash flow. Savings, term, notice deposits and certificates of investment/certificates of deposit (COIs/CODs) are remunerative deposits for the short, medium and long term. A brief explanation of the deposits side of banks follows.
These are a basic type of account maintained mainly by corporate clients and by individuals for availing credit facilities from the banks/financial institutions. As indicated above, normally such accounts are non remunerative; however, many regulators allow payment of interest on such accounts and some banks give a little return as a part of their marketing strategy. Hence, a current account in the conventional system may or may not be remunerative.
These are the normal checking accounts that commercial banks offer for fund mobilization against the payment of interest; savings accounts may have a minimum balance requirement. Different types of savings accounts offer different interest rates depending on the deposit amount. The concept of daily product is used for the entitlement of return to various depositors. Saving deposits, and to some extent term deposits, are collectively known as “demand” deposits, because one can, at any time, draw the amount without any notice.
In term deposit accounts (as captioned above), the deposit holder agrees to lock in the money for a fixed period of time while the bank commits to pay an indicated interest rate depending on the term of the deposit – the longer the term, the higher the interest rate. Some banks charge a penalty in the event of premature encashment – some banks charge a pre-specified penalty over the remaining period of deposit, while others use the period for which money has been with the bank. In financial markets with open competition, the return already given is adjusted in the case of early withdrawal, keeping in mind the investment and the remaining periods. Term deposit receipts (TDRs) are issued at par or discounted value. A typical TDR issued at discount is issued at a value below its par; it grows up to the par value in the agreed timeframe. TDRs may have a life ranging from an overnight deposit to five/six/seven years, though by custom, it varies from seven days to five years. This type of deposit is also called a certificate of investment (COI) by investment banks and NBFIs. A typical COI is issued at its par value with return payment made at agreed intervals ranging from one month to the time of maturity.
Annuities are normally built on savings accounts for commercial banks. NBFIs use COIs to offer annuities. The depositor is entitled to withdraw the amount after the deposit period. However, frequently the annuity converts itself into perpetuity at maturity, i.e. the deposit holder is allowed to withdraw an agreed amount indefinitely at an agreed timeframe. These products are also offered by life insurance companies. Products of such a nature exist in the mutual fund industry and share markets as well, and are called “dividend reinvestment plans.”
In these types of product, the anticipated amount of profit is discounted and paid up front. In essence, this is similar to a term deposit receipt issued at discount.
Historically, the NBFIs, and particularly the investment banks, used to maintain cash management accounts. But over the last decade, commercial banks have also been increasingly offering discretionary or nondiscretionary cash management and fund management accounts. A typical CMA entails the deposit of money with the bank for an agreed period that carries either a fixed rate of return or any rate linked with any other activity in capital markets. In the case of nondiscretionary accounts, the client instructs the bank about the type of investment as well. In most such cases in conventional banking, a fixed amount of return is paid. In rare cases, funds are invested on the basis of a fee, remitting all profit to the depositors.
Commercial banks deploy depositors’ funds for short-term (a year or less than one year), medium-term (one to three years) and long-term (over five years) loans and advances on the basis of interest. A prudent banker is supposed to take into consideration the character and business integrity of the borrower, his cash flow and capacity to repay, the purpose of borrowing and the security offered as collateral. The following are the possible forms of loans: Productive loans: for trade, industry and other businesses and in most cases also for housing. Consumption and consumer durable loans: for household goods, automobiles, etc. Clean advances: on the personal surety of the borrower or of any third party, no collateral. Discounting of commercial papers like notes, bills of exchange, etc. Cash credit like overdrafts: customers are allowed to draw from a limit given by the bank. The financing operations of commercial banks for various purposes in respect of industry and commerce are briefly given below: Working capital finance: the working capital requirement of various sectors is met by banks through grants of cash credit, overdraft facilities, demand loans, opening of L/Cs and through discounting of bills of exchange. Trade financing normally involves the issuance of L/Cs by commercial banks. Sight L/Cs are simply fee-based instruments issued to facilitate trade while usance L/Cs also involve financing by banks against payment of interest. L/Gs are issued by banks to ensure, on behalf of their clients, that the payment will be made when due or action taken as and when required in the contracts in the background. Thus, the bank acts as guarantor of the client’s liability towards the counterparty. Banks get commission for issuing L/Gs, but if they are required to perform the guarantee, they have to pay the related amount for which they charge interest. Agricultural finance: commercial banks provide production and developmental loans to farmers. Short-term finance is required by farmers mainly for the purchase of seed, fertilizer and pesticides, while medium- and long-term finance is needed for land-levelling, tubewells, tractors, setting up of poultry/dairy/fish farms and construction of storage facilities. Fixed investment finance: this is provided by way of term loans or purchase of debentures or participation in underwriting and “bridge financing” arrangements. Treasury products – liquidity and fund management: this involves money and capital market operations, foreign exchange operations, inter-bank borrowing and lending money on interest linked to tenor, credit considerations and liquidity amongst other factors. Treasury products are used to manage mismatches in liquidity position and to get returns. The entire activity is based on interest receipts or payments. Repo and reverse repo operations involve selling / purchasing and entering into a back to back transaction for purchasing/selling. The objective is to manage liquidity and enhance interest income. Nostro accounts, maintained by banks overseas to undertake trade finance activity and correspondent banking. Interest is paid and received on the balances maintained and the amounts overdrawn.
In the fast-developing world of finance, Islamic banks are obliged to innovate a set of techniques to mobilize deposits, keeping in mind the priorities and risk preferences of various categories of depositors. They will also have to cater for safeguarding the depositors from loss on PLS deposits. Recent developments on the deposits side reveal that Islamic banks, in addition to the general categories of savings and investment deposits, have started offering commodity funds, leasing funds, Murabaha funds and COIs. The funds thus mobilized are used in lease or Murabaha operations, giving fees or fixed margins of profit to the banks. Thus, savers are in a position to get a quasi-fixed return. However, this fixity of return may create ambiguity with respect to their Share’ah position unless strict Share’ah controls are applied to the operations and distribution of returns thus achieved. The majority of authors allow third party guarantee to depositors to the extent of a nominal amount of deposits. However, for enhancing confidence of the depositors and to avoid any scares or chaos, any Takaful scheme for deposits would be desirable. This is because the provision of third party guarantee has some objections, both from practical as well as Share’ah aspects. On the deposits side, Islamic banks will provide the products discussed below.
Generally, no return is given on current accounts on the grounds that such deposits take the form of loans given to Islamic banks and the loans cannot carry any return. They are kept as Amaanah; but if the proceeds of such accounts are used by banks in their business, they are treated as loans that have to be paid back without any increase or decrease. Banks shall guarantee the principal amount of deposits. Subject to agreement, banks may have the option to use such accounts at their discretion in permissible business activities. The relationship of debtor and creditor between the bank and the depositor will continue. The bank and the depositor shall agree at the time of account opening whether the bank is allowed to use the money in its business or not. There will be no need to develop and implement a weightage system for this type of account. However, some writers favour giving a gratis return even to current account holders. They add that it can be only at the discretion of the banks and the depositors should not have any entitlement. A further condition for such an incentive is that they should not be offered regularly. This is because, with the passage of time, the practice will become customary and, in turn, take on the ruling of benefits stipulated in a contract of deposit.
All remunerative deposits in Islamic banks, including saving deposits against which banks provide a free checking facility, shall be accepted on a profit and loss sharing (PLS) basis. The ratio of profit distribution between the bank and the depositor shall be agreed at the time of account opening subject to the condition of the Share’ah that a partner may agree on a ratio of profit which is different from the ratio of capital but losses have to be shared strictly in the ratio of capital. Investments/financing made by banks from their own capital and from the monies raised from PLS accounts shall form the “earning asset base”, the returns from which shall be allocated between the banks and their account holders in the agreed ratio. Deposits of longer duration shall be compensated through assignment of higher weightages. Regulators may notify a range within which these allocations could be made. Alternatively, such assignment of weights may be left at the discretion of the banks. The following are the other considerations in this regard: Deposits of the risk-averse clients will be accepted either in current accounts as interest-free loans that will be guaranteed with no share in return from financing operations of the banks or by creating special pools or establishing Murabaha and leasing funds, wherein they will be treated as Rabbul-maal and get the quasi-fixed return out of profits or rentals earned by the respective funds. Risk-prone deposits will become part of the bank’s equity, involving a weightage system (the longer the maturity, the higher the weight) on a daily product basis (DPB). Specific investment accounts can be managed as per savers’ instructions on a Mudarabah or Wakalah basis. Banks can float equity funds on the principle of Mudarabah against a share in the actual profits. However, there may also be an agency relationship, wherein the bank would be managing depositors’ funds against pre-agreed fees and passing on the profit/loss to the depositors. Banks may establish closed/open-ended mutual funds. Inter-bank financing will also become part of the equity of the bank, using appropriate weightage and DPB to calculate profit.
Islamic banking financing practice as of now reveals that the doors are open for utilizing all legitimate modes including those based on Shirkah, trade or lease, whether to finance trade, industry or a budget deficit through domestic or foreign sources. In order to properly manage the risk, the banks should manage diversified portfolios and select the proper modes/instruments. The volume of investment deposits determines banks’ investment strategies – if depositors are risk-averse, banks should also be risk-averse – investing in less risky modes. 2.4.1 Musharakah/Mudarabah can be used for short-, medium- and long-term project financing, import financing, preshipment export financing, working capital financing and financing all single transactions. Banks use Diminishing Musharakah for purchase of fixed assets like houses, transport, machinery, etc. Murabaha can be used for the purchase and sale of automobiles, consumer durables and trade financing, acquisition and holding of stock and inventory, spares and replacements, raw material and semi-finished goods. Buy-back and rollover in Murabaha are not allowed. 2.4.2 Musawamah can be used for the financing of huge single transactions. Salam has a vast potential in financing the productive activities in crucial sectors, particularly agriculture, agro-based industries and the rural economy as a whole for financing agriculturists/farmers, commodity operations of public and private sectors and other purchases of homogeneous goods. 2.4.3 Banks’ subsidiaries as trading and leasing companies can also provide finance on the basis of Murabaha and leasing. They can deal with priority areas not only on the basis of Murabaha, Salam and operating lease, but also on the basis of partnership. Ijarah, or leasing, is best suited for financing of automobiles and machinery. There could also be a combination of more than one mode like Istisna’a plus Murabaha, Salam plus Murabaha or Salam plus Istisna’a for financing of trade and industry. Finance for the purchase and construction of houses can be based on Diminishing Musharakah or Murabaha. Working capital finance canbe provided on the basis of Salam, Istisna’a and Murabaha. Financing of big projects can be made through syndicate Mudarabahs using the modes of Istisna’a or Murabaha. 2.4.5 Appropriate modes of financing, as recommended by experts on Islamic finance, for particular areas and transactions are as given below. Modes for Financing Trade, Agriculture and Industry Murabaha, installment sale, leasing and Salam are particularly suitable for trade, while Istisna’a is especially suitable for industry. More specifically, in trade and industry, financing is needed for the purchase of raw materials, inventory (goods in trade) and fixed assets as well as some working capital, for the payment of salaries and other recurrent expenses. 2.4.6 Murabaha can be used for financing of all purchases of raw materials and inventory. For procurement of fixed assets, including plant and machinery, buildings, etc., either instalments sale or leasing can be used. Funds for recurrent expenses can be obtained by the advance sale of final products of the company using Salam or Istisna’a. Household, Personal Finance, Consumer Banking. Personal finance for consumer durables can be provided through Murabaha, leasing and in special cases by way of return-free loans out of the current accounts or the banks’ own funds (depositors’ money in PLS accounts is a trust in the hands of banks and should not be used for charitable and social purposes without their explicit approval). 2.4.7 Wakalah and Murabaha can be used for cash financing through charge and credit cards. The alternatives for auto finance are Ijarah Muntahia-bi-Tamleek and Murabaha. Housing finance is possible through Murabaha, Diminishing Musharakah and rent-sharing.
Liquidity management means ensuring that the bank has sufficient liquid funds available for a smooth running of its operations and to meet short-term financial obligations as and when due. It has to invest surplus funds, match maturity of assets and liabilities, accommodate decreases in deposits/liabilities and increases in assets in an efficient and economic manner. Fund management refers to securing and managing funds for the development of business. Islamic banks may sell and purchase SharA„A±A´ah – compliant money and capital market instruments like stocks and Sukuk. Direct placement or acquisition of funds (in the inter-bank funds market) on the basis of Mudarabah and Musharakah is also possible. The deficit bank agrees to give a share of its profits according to a Mudarabah ratio that can either be negotiated according to the market conditions or recommended by the central bank, for the duration of the contract. In the case of Mudarabah, the following process can be adopted: A Mudarabah relationship will be created. Funds received will be allocated to pools. Weightages will be assigned periodically, based on different tiers/categories. Profit earned will be allocated according to weightages assigned at the beginning of the period. The bank will charge a pre-agreed Mudarib fee as a percentage of the realized profit; the bank can pay additional profit from its own share. The investor will bear a loss unless it arises from misconduct or negligence of the Mudarib. Islamic banks may also agree to an arrangement with the central bank serving as a lender of last resort. One option is financing on a Mudarabah basis; the central bank may agree to provide liquidity for, say, a three day grace period with ceilings, followed by a Mudarabah with profit-sharing ratio heavily favouring the central bank to discourage the Islamic bank from resorting to the central bank’s funds for longer periods. Another option is the sale and purchase of SharA¯A„A±A´ah-compliant certificates/Sukuk. Sukuk are important for liquidity management. In Sukuk, an investor gets returns on the basis of ownership rather than interest. Ijarah Sukuk are more common instruments in this regard and are issued against assets for rental. To generate liquidity, Sukuk can be sold/purchased in the secondary market. If the regulatory structure allows, Islamic banks can sell the Sukuk to the central bank to generate liquidity. Sukuk can be structured on an amortizing or bullet maturity basis.
Exchange of currencies and monetary units has to be subjected to the rules of Bai’ al Sarf, i.e. it must be simultaneous. Accordingly, spot purchase and sale of one currency against another currency is allowed; forward purchase and sale is not allowed. However, IFIs can enter into a promise to purchase and sell agreement. On this principle, foreign currency forward cover is allowed with certain conditions. In order to ensure that the transaction actually goes through, parties may stipulate any earnest money. Negotiation of export documents is partially allowed.
Government and public sector enterprises can obtain finance by way of Mudarabah or Musharakah certificates, which can be issued to purchase equipment or utility-generating assets in order to lease them to public sector corporations. Ijarah and Istisna’a are best suited for infrastructure projects in the public sector. Recently, Ijarah Sukuk have emerged as the most crucial instruments for financing of the public sector. Through syndication arrangements, Islamic banks can supply goods/assets of enormous value to government entities or corporations on a Murabaha basis by setting up joint Murabaha funds. In such cases, ownership of Murabaha funds can also be securitized to offer equity-based investment opportunities to the investors and the banks themselves. Returns on these funds would be distributed among Sukuk/certificate holders on a pro rata basis.
For the inflow of foreign resources, the instruments of portfolio investment through stock markets, flotation of various categories of Sukuk and direct investment by foreigners can be used. Public as well as private enterprises can issue Musharakah and Ijarah Sukuk to finance projects, especially development projects. Sukuk can be denominated in foreign as well as domestic currencies and carry a predetermined proportion of the profit earned by their respective projects. The Sukuk issued can be restricted to a particular project or earmarked to a group of projects. Various funds can be established to finance the economic activities of public and private enterprises on equity, partnership, leasing, Salam and mixed asset pool bases. Funds can be established to finance a specific sector, for example, agriculture, industry or infrastructure; a particular industry, for example textiles, household durables, etc.; or general types of projects.
Mr Muhammad Ayoub, Director Training, Development and Shariah Aspects of Institute of Islamic Banking and Insurance (IIBI)London, has written a book with the title of “Understanding Islamic Finance” in the year 2007. This book was published by the John Wiley & Sons. In the Chapter 8 of the book Mr Ayoub stated about the Overview of Financial Institutions and Products: Conventional and Islamic. In the chapter it is stated that what are the different products are being offered by the conventional and Islamic financial institutes being the alternates to each other. The text of the book was presented here as the literature of the assignment statement.
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