Operational Details in Mudharabah Contract for Islamic Liquidity Management

Mohd Nasiruddin bin Mohd Kamaruddin

Standard Chartered Saadiq

 Objectives 1. Definition of Mudharabah 2. Banking Products Using Mudharabah 3. Managing Rate of Return in Mudharabah 4. Treasury Products Using Mudharabah 5. Managing Risk in Mudharabah 6. Suitability as Liquidity Management Instrument

 Definition of Mudharabah It is a partnership whereby one party provides the capital (rab al-maal) and the other party as the entrepreneur provides professional services (mudharib)

 Definition of Mudharabah Profit will be shared between Raab Al Maal and Mudharib at a pre agreed ratio.

 Definition of Mudharabah Loss if any will be treated as follows; 1. Raab Al Maal will bear capital loss. 2. Mudharib will bear labor related loss (staff salary, use of computer system, use of office furnitures and premises and etc).

 Banking Products Using Mudharabah 1. Mudharabah Term Deposit 2. Mudharabah Interbank Deposit and Placement 3. Mudharabah Corporate Deposit and Placement 4. Mudharabah Savings 5. Mudharabah Financing?

 Mudharabah Term Deposit

Mudharabah Deposit Modus Operandi

Financial Institution (Raab Al Maal)

1. Enter into Mudharabah transaction at pre-agreed profit sharing ration and tenure

Customer (Mudharaib)

3b. Distribution of capital loss to Raab Al Maal and labor loss to Mudharib

Loss

2. Invest Investment activities

Profit

3a. Profit distribution based on pre-agreed ratio

 How profit is distributed?

Pre agreed profit Sharing ratio where C is customer and B is Bank Portfolio yield determined Portfolio Profit/Deposit Base = R% Customer profit = Deposit Amount x R% x 0.C C:B

 Example
Customer place a RM1 million Mudharabah deposit for 12 months Pre agreed profit Sharing ratio between customer and Bank is 55:45

Portfolio yield is 10%

Customer profit = RM1 mio x 10% x 0.55 x 12/12 = RM55,000

 How portfolio yield is determined?

Portfolio Profit/Deposit Base = R% (R rate) Portfolio Profit
1. 2. 3. 4. Profit from Home Financing Profit from Interbank Placement Profit from Corporate Financing Other Profits

Deposit Base
1. Retail Mudharabah 2. Treasury Mudharabah

 Managing Rate of Return in Mudharabah

1. Inherent feature of Mudharabah arrangement profit varies and is not certain 2. Profit Equalization Reserve 3. Hibah from Bank to Customer 4. Issues in Managing Rate of Return in Mudharabah

 Inherent feature of Mudharabah arrangement profit varies and is not certain

1. Profit on Investment Fluctuates 2. Deposit Base Fluctuates

 Profit Equalization Reserve (PER)

1. Stabilizes Profit from Mudharabah portfolio 2. Allocate Profit from Mudharabah portfolio to PER when R rate exceeds expected payout rate (Credit PER) 3. Draw Profit from Mudharabah portfolio from PER when R rate is below expected payout rate (Debit PER)

 Hibah from Bank to Customer

1. PER may dry up and may not be sufficient to support expected return 2. Bank may give Hibah to Customer to the level of Expected Return if R rate is lower than expected.

 Issues in Managing Rate of Return in Mudharabah

1. Amount allocated to PER is govern by certain rules not to exceed 15% of gross monthly income. 2. Total amount in PER must not exceed 30% of capital. 3. Hibah is only 1 way Hibah from Customer to Bank will require Customer consent. 4. Items such as Collective Impairment Provision (General Provisions) and Individual Impairment Provision (Specific Provisions) both Additions as well as Releases will affect PER calculation. 5. Market pressure, including from conventional banks.

 General Investment Deposit Account

1. Portfolio Yield Derived from Common Investment Pool 2. Profit Sharing Ratio non-negotiable 3. Profit Sharing Ratio applies board rate

 Special General Investment Deposit Account

1. Portfolio Yield Derived from Common Investment Pool 2. Profit Sharing Ratio negotiable 3. Profit Sharing Ratio does not apply board rate

 Specific Investment Deposit Account

1. Portfolio Yield Derived from Specific Investment Pool ie. Home Financing Portfolio 2. Profit Sharing Ratio negotiable 3. Profit Sharing Ratio does not apply board rate

 How portfolio yield for SIA is determined?

Portfolio Profit/SIA Deposit Base = S% Specific Portfolio Profit
Only Include Specific Portfolio
Ex: Sukuk Investments in Real Estate

(S rate)

SIA Deposit Base

Only include SIA deposit

 Early Termination
1. Original feature of Mudharabah Mudharib can withdraw fund at any time. 2. However, for term deposit since tenor arrangement has agreed upfront, Customer will only be entitled to original investment amount (principal amount). 3. Bank may grant Ehsan Profit for cases of early termination.

 Treasury Products Using Mudharabah 1. Mudharabah Interbank Deposit and Placement 2. Mudharabah Corporate Deposit and Placement

 Features

1. Mostly on are Special General Investment Account where; Investment is in general pool PSR is negotiated

Sample Confirmation

 Managing Risk in Mudharabah

Predominantly Market Risk 1. Rate of Return Risk 2. Systemic Risk

Managing Risk in Mudharabah

Fluctuating R Rate

Rate Risk and Islamic Banks

Given extensive linkage between the two systems, when interest rates change in the conventional systems, profit rates must change within the Islamic banking system This is inevitable since, the absence of corresponding changes in Islamic bank deposit rates, rate differentials will prevail leading to easy arbitrage opportunity

Managing Risk in Mudharabah

Systemic Risk Issue in Mudharabah

Mudharabah accounts are non-principal protected accounts - can the industry sustain the confidence if 1 institution fails to return the principal amount on maturity of the deposit?

Suitability as Liquidity Management Instrument

1. R rate cannot be Guaranteed 2. R rate Fluctuates 3. Principal cannot be Guaranteed

Suitability as Liquidity Management Instrument

R rate cannot be Guaranteed R rate Fluctuates
- how do we mitigate? tenure less than 1 month do not transact on R Rate revision date - how to maintain a more stable R Rate?

Suitability as Liquidity Management Instrument

Profit cannot be Guaranteed
- how do we mitigate?

Interbank Mudharabah Transaction

300.00 250.00 200.00
RM billion

150.00 100.00 50.00 0.00 2005 2006 2007 2008 2009

END