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Opalesque Islamic Finance Intelligence

Featured Structure: Towards a Universal Islamic Deposit Insurance System
By Mohammed Khnifer

Thursday, December 16, 2010

Mohammed Khnifer

Mohammed Khnifer is regarded as part of a second generation of Islamic banking practitioners who have a solid academic background in Islamic finance. He is a holder of an MSc. in Investment Banking & Islamic Finance from Reading University and is a Chartered Islamic Finance Professional (CIFP) from INCEIF. He is one of the most prolific and well-known journalist specializing in Islamic Finance today. For the past six years he has been in charge of the editorial content for the Islamic Banking section of Al Eqtisadiah (Kingdom of Saudi Arabia). By 2011, he is expected to earn his MBA in Islamic Banking & Finance after he won the Silver Scholarship Award from Bangor University. He has authored various papers and articles on Islamic finance (see reference link).

The concept of deposit insurance in the Islamic finance industry is still relatively new as practitioners are struggling to comprehend whether it conforms to Sharia. Very few countries with Islamic economies have an Islamic deposit insurance system in place as it is a complicated balance between maintaining profit-loss sharing Sharia principles and protecting bank customers (Baeshen, 2010). Islamic deposit insurance is a Sharia-compliant system that provides protection to depositors against the potential loss of an Islamic bank's failure (Arshad, 2009).

In this research I try to highlight how the concept of Islamic Deposit Insurance (IDI) developed in the Muslim world. Over the past 10 years, the concept of insuring Islamic deposits started in the Gulf Cooperation Countries (GCC) until the concept reached its maturity after it was institutionalized and adopted in Malaysia.

Due to the absence of guidelines and papers on this topic, it is imperative to point out the controversial areas in designing Islamic deposit insurance system and how they were resolved. The Malaysian model is being heavily reviewed and the researchers at the International Association of Deposit Insurers (IADI) are trying to understand whether such a system can enhance the stability of the Islamic financial system. Therefore, it makes sense for this research to examine the Malaysian IDI system and to look into the possibility of its adoption in the GCC.

First stage: a concept in the making

Segregation of funds - Between 2000 and 2004 researchers started to debate whether there is a need to insure some types of Islamic banking accounts. Banks with Islamic windows used to commingle the Sharia deposits with conventional funds (and used for conventional purposes) or provided Islamic returns that may have been derived from such commingled sources. Some Sharia scholars observed this and asked commercial banks to establish appropriate controls to avoid commingling of Islamic and conventional funds.

In operational terms, this required banks to establish different capital funds and separate accounts, books and reporting systems evidencing the complete segregation of funds (Yaquby, 2000). Indeed, before designing any Islamic deposit insurance scheme, it is a requirement to separate streams of cash flows and block any leakages. This separation of funds caused the first thoughts about deposit insurance for sharia-compliant accounts.

Determine the Guaranteed Deposits - Sources of funds in Islamic banks can be grouped into four general categories, 1) Islamic banking funds, 2) customers' deposits, 3) corporate banking activities, and 4) treasury activities or placements (IADI, 2006). It is estimated that the financial institutions offering Islamic products now collectively hold US$750 billion of assets. Of this, US$350 billion is held by fully Islamic financial institutions and the remaining US$400 billion by conventional banks that offer Islamic banking services (Sabourin, 2009).

In early 2000, there was a healthy debate over which of the customer's deposits should be guaranteed. Before we examine these deposits, we need to point out that Islamic banks do have demand deposits, savings deposits, and general and special investment deposits. Savings and demand accounts are normally based on Wadiah (safe custody or safe keeping with guarantee) or Qardul Hassan (benevolent loan) contracts, while general and specific investment accounts are based on Mudarabah (IADI, 2006).

Wadiah Deposit and Qardul Hassan - Under Wadiah Yad Dhamanah, where the nominal value is guaranteed, Islamic banks act as custodian or guarantor of the funds deposited by customers, e.g., demand deposits. Customers may withdraw their balances at any time (IADI, 2006). By using this product, depositors no longer supply funds to earn a fixed income. Instead, they place deposits for protection (Rosly & Zaini, 2008). Banks are not supposed to use these funds as a source of investment and financing or risk-bearing projects. However, in reality they do.

It is hard to quantify those banks that use Wadiah accounts, but we do know that some banks provide a token of appreciation known as hibah to depositors for banking with them. It should be noted that since the custodian service is given without a price, the Islamic bank holds no legal obligation to pay depositors a fixed return and may do so only on voluntary basis (Rosly & Zaini, 2008) . However, the banks are obliged to reimburse the funds at par value to their depositors in the event that a loss does occur (IADI, 2006).

The second type of widely used contract for Islamic deposit is Qardul Hassan. Under the Islamic Fiqh Academy ruling, shareholders are obliged to guarantee those deposits because they received returns from utilizing the deposits in investment projects (Othman, 2006).

PLS Deposits and the Risk of Eroding Sharia Principles - The profit and loss sharing (PLS) or Mudarabah forms the bulk of Islamic deposits. PLS was and still is a centre of debate on multiple levels. To begin with, The prohibition of interest in Islamic banking is replaced by PLS arrangement whereby the rate of return on financial assets held with banks is not known and not fixed prior to the undertaking of each deposit transaction, also known as ex-post rate (IADI, 2006). In this partnership structure, no guarantee is given for capital protection or a fixed income. This product structure is run under the principle of sharing equity. Unfortunately this makes it a risky product for depositors as the underlying contract is based on profit€“loss sharing system (Rosly & Zaini, 2008).

Under a Mudarabah contract, the depositors act as providers of funds who place a specified sum of money to the bank, while Islamic banks act as entrepreneur through investing the funds and sharing the investment profit according to the predetermined profit sharing ratio (IADI, 2006). Profits are acquired only when the investments are gaining ground, while capital may depreciate or even diminish if the investment does not turn a profit (Rosly & Zaini, 2008). Banks bear the entirety of the loss if there is negligence and mismanagement on the part of the bank.

While conventional banks guarantee the capital and rate of return, the Islamic banking system can not provide such to PLS depositors. Some practitioners in the industry would argue that insuring a deposit goes against the PLS principle (Baeshen, 2010). Hence, depositor will not incur any risk, which contradicts the basic concept of Mudarabah. Other researchers are beginning to debate if protecting Muslim depositor funds, by providing guarantee, can erode Sharia principles.

First Attempt to Guarantee PLS - Before Malaysia took the helm, the concept of designing a complete Islamic deposit insurance system started in the GCC as a relatively innocuous idea that was based on understanding the economic and Sharia justification of the necessity of protecting depositors by guaranteeing PLS. For example, depositors are the ones who provide funds for specific investment activities by the bank. Thus, shareholders should consider sharing their distributed profits fairly to the small depositors who are bearing the risk.

The second justification on why Islamic Banking scholars favoured a guarantee of investment deposits (PLS) was based on the fact that conditions of Mudarabah contracts were not applicable to investment deposits and therefore the bank should guarantee nominal value on the deposits. This opinion was based on the fact that Islamic banks were so diversified that if a loss did occurred in one investment, there would still be enough profits to cancel out any defaults to depositors. (Othman, 2006).

After establishing the logical argument, the concept of tabarru (donation) was introduced in 2003 for guaranteeing the principal amount of PLS deposits. It has been suggested that the mudarib can voluntarily agree to compensate for any loss of principal amount of capital in a mudarabah contract (Al-Tegani, 2003). Then, Dr. Mohamed A. Elgari, one of the most influential Sharia scholars today, issued a fatwa of its permissibility. In order to ensure the validity of such offer of guarantee as a pure gift, it should not be stated in the Mudarabah contract, neither explicitly or implicitly, nor should it be given except after the Mudarabah contract has already been concluded (Elgari, 2003).

It is unclear as to how many GCC banks established, at that time, in-house Islamic deposit insurance based on the concept of tabarru. As far as how the concept works, we know that banks retain a fraction of the yearly shareholders income in a special account of shareholders which would be used to compensate the depositors for any loss of their principal amount that may occur when taking risks with their money (Khan, 2003). For instance, a Saudi bank sustained large losses around the same time and its Board of Directors decided to have the bank's owners bear this loss on behalf of the owners of the investment accounts (Elgari, 2003). Maintaining such an account from contributions from shareholders income will be similar to paying an insurance premium to a third party to guarantee the depositors principal amount (Khan, 2003).

Prior to its establishment in 2005, Malaysia Deposit Insurance Corporation (MDIC), Malaysian banking officials were monitoring these non-institutionalized efforts in the GCC to design in-house deposit insurance schemes. Indeed, it was reported that MDIC studied several other frameworks including donation (Tabarru'), agency (Wakalah), and an approach based on government regulations (siasah syar'iyyah) (Baeshen, 2010). The Sharia Advisory Council (SAC) of Bank Negara Malaysia decided to adopt the Kafalah bil Ujr structure (explained below) as the most viable option. Keep in mind that the tabarru' concept was internally implemented by some GCC banks even though there were no third-party guarantee in place.

For a country striving to lead the way in developing standard international best practices relating to Islamic deposit insurance, the concept of tabarru' was not the answer. In its argument, MDIC stressed that tabarru' might not be a sufficient alternative to convince central banks that Islamic institutions could provide a guarantee as voluntary rather than a obligatory act (Baeshen, 2010). It added if Islamic banks were allowed to provide guarantee as a tabarru' act, they might abuse it and provide guarantee for Mudarabah investment deposits, and then allege that it was not an explicit guarantee, but only tabarru'.

Second Stage: Laying the Foundation of an Islamic Deposit System

In this section I will attempt to highlight some of the hurdles that may stand in the way of developing a sound Islamic deposit insurance (IDI) system. In order to understand how to overcome such obstacles, the Malaysia Deposit Insurance Corporation (MDIC) will be at the centre of this case study.

Dual Banking System - The vast majority of Islamic and Western countries have a dual banking system, which makes it difficult to design a deposit insurance model that is compatible with the principles of Islamic finance. The Malaysian deposit insurance system was introduced in September 2005 and was the first deposit insurance system to provide separate protection for conventional and Islamic deposits under one organization. Without such an entity, there would be a complete lack of consumer protection in the Islamic banking system. This would undoubtedly create an unfair disadvantage in the evolution and stability of the Islamic banking system (Sabourin, 2009).

Eliminating Commingling of Funds - The Sharia Advisory Council of Bank Negara Malaysia, which has one of the most respected group of scholars in the Islamic banking industry, issued a fatwa prior to the establishment of the IDI system that emphasized the need to separate funds in the operation of deposit insurance schemes for Islamic banking to ensure that the funds of such a scheme are invested in Sharia-compliant instruments. For Malaysia, it was already in compliance with that, but for the other few countries that have incomplete IDI system, they were not.

While other regulators lacked the willingness to make an effort to eliminate commingling of Sharia and conventional deposits, others failed to separate Islamic deposit insurance funds with conventional funds after receiving the scheme's insurance premiums. According to Moha-Pisal Zainal, INCEIF Joint Director of Research, (personal communication, 6 February 2010), Indonesia has one pool where all the premiums and returns out of purchasing securities are mixed. Hence, the paid capital of the IDI fund has been contaminated with conventional funds.

Third Party Guarantee for PLS - As in the GCC, the PLS or Mudarabah investment accounts were the centre of debate in Malaysia as observers argued as to whether PLS depositors should be protected. MDIC laid down two rationale why these accounts should be protected. First, deposit insurance is a prudential measure to promote the stability of the financial system due to significant proportion of PLS vis--vis other types of deposit products in the Islamic banking industry. The public's interest should be taken into consideration as PLS accounts for more than 45% of total Islamic deposits and therefore accounts for the bulk of deposits mobilised in the Islamic banking system (Sabourin, 2009). Second, the protection will only take effect in the event of a bank's failure. In the normal course of banking operations the loss arising from investing PLS accounts will continue to be borne by the PLS holders. As such, the nature of the Mudharabah contract remains enforceable and the conditions are not voidable.

Under the Mudharabah contract, the entrepreneur is not allowed to guarantee the principal amount of PLS accounts. However, in 2003, Elgari issued a fatwa for the permissibility of such guarantees as long as it came from an unrelated third party. After that, the Shariah Advisory Council resolved that a third party guarantee is allowed to protect Mudharabah investment accounts (Sabourin, 2009). If an Islamic bank fails, MDIC would reimburse the PLS account holder up to the limit of deposit insurance coverage based on the value of their deposit at the date of payment and subject to priority of claims.

Public Interest Justifies Setting up Islamic Insurer

One of the justifications for setting up an IDI is for the public's interest (Maslahah) and the banking industry as a whole. According to MDIC, their Islamic deposit insurance system contains the element of maslahah in the several areas:

  • First, the main objective of establishing a deposit insurance system is to protect the public's money and prevent the public from facing financial difficulty in the event of a bank failure. Such hardship would affect people's lives and cause even greater hardship to those who have limited financial resources.

  • Second, IDI instils public confidence in the safety of depositors' funds in banks. The act of instilling confidence amongst members of the public in the safety of their deposits contributes and promotes to financial stability.

  • It also promotes the competitiveness of the Islamic deposits and the banking system. Without the protection, Islamic deposits may lose their competitiveness against the conventional deposits which enjoy such protection. As a result, there is a possibility depositors would withdraw their funds in Islamic banks and place them in conventional banks. This would create liquidity issues to Islamic banks and dampen the development of the Islamic banking industry. (Sabourin, 2009).

Examining the Malaysian IDI System

After reviewing many concepts, the Sharia Council of Bank Negara endorsed its IDI system as long as its implementation is based on the arrangement of kafalah bil ujr, or guarantee with fee. This is a contractual guarantee given by a guarantor (MDIC) to take on the responsibilities and obligations of the depositors in the case that claims arise (Baeshen, 2010). The guaranteed party pays the guarantor a fee (Ujr) as consideration for the guarantee. In the event of a member's failure, MDIC will reimburse the insured depositors and banks be automatically subrogated to the rights and interests of the depositor's claim to the extent of the payment mode (Sabourin, 2009).

Funding and Premium Assessment - The Malaysian IDI system adopted an ex-ante funding where the premiums are paid annually. The operations of the IDI are funded by premiums received from members. This is compatible for both Islamic banks and those offering Islamic windows. Premiums are calculated by the MDIC through two different models: 1) a flat rate (2005-2007), and 2) a differential premium system (DPS).

A flat rate premium system is relatively simple to design, implement and administer (Baeshen, 2010). However, it is open to criticism as it does not take into account the level of risk that Islamic member institutions pose to the deposit insurance system. A flat rate premium system is also viewed as being less equitable since member institutions with lower risk profiles would effectively be subsidizing those with higher risk profiles (Baeshen, 2010). In 2008, MDIC switched to the DPS system, which is not intended to be an actuarially based measure of the risks posed to the deposit insurer by individual member institutions. Rather it is intended to send an early warning signal - with financial consequences - to the management and directors of member banks (Baeshen, 2010). The DPS aims to provide incentives for members to adopt sound risk management practices, differentiates members according to their risk profiles, introduce fairness into the premium assessment process and promotes the stability of the financial system (Sabourin, 2009). The DPS in a sense becomes a tool for MDIC to exercise financial discipline on behalf of depositors by charging higher premiums from banks that are more risky and prescribing early corrective actions for troubled banks. These annual premiums are assessed on the amount of total insured Islamic deposits held by each bank as of 31 December of the preceding year (Sabourin, 2009).

Coverage - In term of coverage, MDIC provides separate protection for Islamic deposits and these include savings, demand and investment deposits accepted under various contracts such as Wadiah, Qardul Hassan and Mudarabah (PLS). However, this system excludes accounts such as deposits payable outside Malaysia, negotiable instruments of deposit, other bearer deposits and repurchase agreements (as is the case for conventional deposits). MDIC has the legal authority to also assess and determine the insurability of new Islamic deposits as and when the deposits are offered by members (Sabourin, 2009).

Each country can set its own deposit insurance limit under such IDI systems, although there are still some questions on how such limits will be applied. Furthermore, if a country has already an established conventional deposit insurance system, is the insurance coverage limit per depositors under Islamic deposit insurance comparable or equal to the limit of the conventional deposit insurance system? (IADI, 2006)?

Management of Islamic Deposit Insurance fund - MDIC then established a separate fund, the Islamic Deposit Insurance Fund (IDIF). For this purpose, MDIC maintains distinct and separate accounting records and financial statements for both conventional and Islamic deposits. In managing both funds, MDIC ensures that there is no commingling or cross-subsidisation between the conventional and Islamic IDIs. All premiums received from the Islamic banks and Islamic windows are channelled into the Islamic fund, which is then invested in Sharia compliant instruments (Sabourin, 2009).

Payments in the event of the failure of member institutions are similarly separated and no transfer of funds between the IDI and conventional IDI are permitted. Instead, MDIC is statutorily permitted to increase funding from the government should there be a need (Othman, 2006). Moreover, MDIC ensures all expenditures charged to the Islamic IDI fund are incurred through permissible activities. If an expense cannot be specifically attributed to either the Islamic or conventional funds, the expense is apportioned to the respective fund based on the amount of premiums collected in the preceding year (Sabourin, 2009). Any non-permissible expenses will also be borne by the conventional fund.

Payment and Priority of Payment - To maintain confidence in the financial system when a member institution fails, MDIC is required to reimburse depositors quickly, and by law no more than three months from the date of the issuance of a winding-up order. All reimbursements for Islamic deposits must be made from the IDI fund. In the event of a shortfall in the Islamic fund, MDIC would use the credit line from the government or funding from the market, which would be structured in a sharia-complaint fashion (Sabourin, 2009).

The priority of claims accorded to depositors would affect the amount that may be recovered by the deposit insurer or resolution costs incurred. Depositor's would automatically subrogate to MDIC their rights and interests to their funds, but only to the extent of the payment made by MDIC (Sabourin, 2009). In respect to the priority of Islamic deposits, the legislation sets out the priority of payments based on the underlying contracts of the deposits where, given the nature of Wadiah deposits, they are given the highest priority over all other Islamic deposits.

Components of a Financial Safety Net

After elaborating on the micro-factors that support the initial infrastructure of a sound IDI system, it is time to add a macro-economic perspective. Deposit insurance has become an increasingly used tool by governments in an effort to ensure the stability of banking systems and protect depositors from incurring large losses due to bank failures. Almost all countries have financial safety nets in place which include explicit and implicit deposit insurance, bank regulation and supervision, a central bank lender-of-last-resort facilities, and bank insolvency resolution procedures (Othman, 2006).

The Islamic financial industry recognizes the important role of ethical banking in contributing to economic growth. This includes the intermediation function between providers and users of capital, but also a country's payment and settlement system are particularly important (Sabourin, 2009). The preservation of the stability of the financial system is essential to a country's economic growth. For observers of financial safety net systems, the recent crisis has showed even sophisticated economies are susceptible to financial upheavals. According to the IMF the cost of cleaning up the financial crisis is estimated at US$12 trillion, which is equivalent to one fifth of the world's annual economic output.

Safety net arrangements are intended to maintain the stability of the financial system. If there is a lack of confidence in the stability of the financial system, any news of problems faced by one or more financial institutions may lead to bank runs. Bank runs can be one of the primary causes of a liquidity crisis; as there simply is not enough cash on had to meet every depositor's needs at once. More importantly this type of event has the ability to pollute the entire banking system and cause a systemic crisis (Sabourin, 2009).

To ensure a strong and robust banking system, policy makers have at their disposal a toolkit of safety net components. These encompass ways to manage the full spectrum of activities throughout the life cycle of a financial institution, from birth to death of the institution (Sabourin, 2009). In a speech by Jean Pierre Sabourin, CEO of MDIC, he highlights the components of a robust financial safety net. This covers the chartering or licensing function, prudential regulation and continuous supervision, lender-of-last-resort facilities, intervention and resolution mechanisms including liquidation and depositor reimbursements (Sabourin, 2009).

Chartering Function - Character and capital requirements are at the front end of any financial safety structure. Typically, this gate-keeping function is performed either by the ministry of finance, central bank, or supervisory authority but certain deposit insurers also play a role, such as the Federal Deposit Insurance Corporation in the United States. The first safety net component is the chartering or licensing function. The chartering function imposes minimum set-up capital and character requirements on the underlying financial sector (Sabourin, 2009). Minimum set-up capital requirements typically ensure that the new entries to the financial system have sufficient capital to conduct a sound business and financial operations.

Prudential Regulation and Supervision - The second component of the financial safety net is the prudential regulation and supervision function which, amongst others, include disclosure and capital adequacy requirements as well as restrictions on selected business activities. The aim of prudential regulation is to reduce unwarranted or unmitigated risk taking while supervision is to monitor banks to ensure that they are complying with regulations in order to maintain the safety and soundness of the banking system (Sabourin, 2009).

Lender of Last Resort - The lender of last resort is another safety net component. Typically performed by the central bank, the lender-of-last-resort function is available to provide liquidity to a solvent but illiquid bank, should a run against an institution occur (Sabourin, 2009). Should contagion occur, the lender of last resort can also provide liquidity to the entire banking system, as we famously saw in 2008 and 2009.

Intervention and Resolution Mechanisms - The fourth component of any safety net is the framework of intervention and resolution mechanisms. A timely and effective strategy for handling problem or failed banks help to substantially mitigate costs and avoid adverse effects on the public, the banking industry, and the economy. One author (Sabourin 2009) points out that it is important to have a public policy in place to remove troubled banks from the system quickly. This should be done in an orderly manner to mitigate contagion, promote discipline, mitigate moral hazard and ensure that depositors are promptly reimbursed their insured deposits. The monetary authority (central bank) also has to play a vital role in the safety net and this fact should be known by all those involved.

Deposit Insurance - The role of Islamic deposit insurance is to provide explicit protection in the form of a promise to pay depositors of member banks in the event of a bank failure. This promotes and contributes to confidence in the financial system, thereby reducing potential contamination of healthy banks (Sabourin, 2009). Globally, deposit protection has become an integral part of the financial safety net. Over the past two years 47 countries raised deposit insurance coverage or adopted depositor guarantees (Parker, 2009). These included temporary measures in 26 countries that will be scaled back in the foreseeable future.

Dual deposit insurance is not intended to be structured to singlehandedly deal with an entire meltdown of the financial system. In such situations, it is the role of all safety net providers to play their respective part under proper coordination (Sabourin, 2009). There is also a wide spectrum of deposit insurers with varied mandates, powers, roles and responsibilities. These range from supervised funds with limited mandates that only reimburse depositors after a bank fails, but also risk minimisers that have a mandate to take pre-emptive action necessary to minimize the loss of bank failures on the financial system (Sabourin, 2009).

Before any Islamic deposit insurance scheme is set in place, stakeholders should strive to educate small depositors and allow them to be fully informed about the benefits and limitations in order to help mitigate bank runs during bad times as they are unlikely to trust an agency that they have never heard of. Unfortunately it has been noted that having depositors with no knowledge of deposit insurance, is as good as having no deposit insurance (Sabourin, 2009). What depositors do not know does not benefit them.

A country's national deposit insurer should require banks to disclose to depositors which products are insured and those that are not protected prior to making financial decisions (Sabourin, 2009). On the other hand, Islamic banks are also exposed to bank-run risks when the financial system loses public confidence. Islamic deposit insurance systems, whether they are explicit or implicit, can play an important role in easing bank-runs and thereby promotes financial stability (IADI, 2006).

Regional status of Islamic Deposit Insurance

The concept of Islamic deposit insurance has come a long way over the last ten years. It grew from a simple idea of guaranteeing PLS deposits to the creation of actual comprehensive Islamic deposit insurance systems in Malaysia and to less extent in Turkey, Sudan and Indonesia. Jordan and Bahrain are the closest countries in the Middle East to adopting an Islamic deposit insurance scheme for their banks. The rest of the GCC has implicitly adopted the deposit insurance scheme, and thus there is no formal regulation that explains the scheme. Instead the individual country is relied upon to observe the situation informally (Othman, 2006).

During the recent credit crisis, many GCC countries used public statements for deposit guarantees rather than introducing legal protection. These were primarily countries that made political rather than legal commitments to protect depositors. Current plans for easing temporary or special protection (for depositors) should be deconstructed within the next few years, with the majority split between 2010 and 2011 (Parker, 2009). One can only wonder what will happen to Islamic deposits when these temporary deposit insurance measures expire. The Islamic finance industry in the GCC needs a sustainable and comprehensive Islamic deposit insurance system in order to have a level playing field with conventional banking.

The Way Forward

Over the past decade differing views on Sharia interpretations between Malaysia and the GCC have contributed to some extent in the creation of a secular deposit insurance systems in the relative jurisdictions. However, this research concludes that when it comes to deposit insurance, there is a common Sharia ground between Malaysia and the GCC. Hence, there is a need for the political will if such system is to ever be implemented in the GCC.

Your feedback and comments are very important to us, please feel free to contact the author via email.

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