CHAPTER 5 - Islamic Banking Sources and Uses of Funds

Slide ini khas untuk digunakan dalam kelas BWSB 5053 Contemporary Islamic Banking. Perbincangan bersama pelajar Master (MIBS & MIFB) di UUM. Juga bermanfaat untuk sesiapa yang ingin mendalami ilmu muamalat dan kewangan Islam.

1. CHAPTER 5: Islamic Banking Sources and Uses of Funds MAJOR DR. MOHD ADIB ABD MUIN, IFP, CQIF (WEALTH MANAGEMENT) Senior Lecturer Islamic Business school ( Ibs ), uum BWSB5053 Contemporary Islamic Banking - 2024

2. OUTLINE BWSB5053 Contemporary Islamic Banking 2 Sources of Islamic Banking Funding. Types of deposits. Practices in sourcing deposits. Determining profit margins and profit-sharing ratios from the perspective of funding. Financing and investment activities. Types of financing & investments

3. Sources of Islamic Banking Funding 3 BWSB5053 Contemporary Islamic Banking 1. Equity Capital (Shareholders' Equity): This is the capital provided by the shareholders of the Islamic bank. It forms a primary source of funding and acts as a buffer for absorbing potential losses. 2. Customer Deposits: a. Current Accounts ( Qard ): These are non- interest bearing accounts where customers deposit funds which the bank can use freely but must return on demand. b. Savings Accounts (Mudarabah): These accounts are based on a profit-sharing agreement where the bank invests the funds and profits are shared according to a pre-agreed ratio. c. Investment Accounts (Mudarabah/ Musharakah ): These accounts are similar to savings accounts but usually have a fixed term and higher potential returns, as they involve longer-term investments. 3. Investment Certificates (Sukuk): These are Islamic bonds issued by the bank or other entities, which comply with Sharia principles. Sukuk provide a source of funding by raising capital from investors who receive a share of profits from the underlying assets.

4. CONT.. 4 BWSB5053 Contemporary Islamic Banking 4. Interbank Funding: a. Commodity Murabaha: An interbank financing tool where banks buy and sell commodities to each other at a profit margin, ensuring compliance with Islamic principles. b. Wakala : A contract where one bank acts as an agent (wakil) for another bank to invest funds in Sharia-compliant activities. 5. Islamic Development Bank and Other Islamic Financial Institutions: Funding and support can be obtained from multilateral Islamic financial institutions which aim to promote economic development in member countries. 6. Retained Earnings: Profits retained by the bank from previous periods, which are reinvested into the business. 7. Restricted and Unrestricted Investment Accounts (RIA/UIA): These accounts involve investors providing funds to the bank to be invested according to specific or general guidelines, with profits shared based on pre-agreed ratios.

5. Types of deposits. 1. Current Accounts (Al- Wadiah / Qard ): Al- Wadiah : This is a safe-keeping contract where the bank guarantees the return of the deposited amount. The depositor can withdraw funds at any time, and the bank may provide a hibah (gift) at its discretion. Qard ( Qard Hasan): These are benevolent loans where the bank can use the funds but must return the full amount to the depositor upon request. No interest is paid, but the bank might offer a discretionary hibah . 2. Savings Accounts (Mudarabah): Mudarabah Savings Accounts: These are profit-sharing accounts where the depositor acts as a capital provider ( rab al-mal), and the bank acts as the entrepreneur ( mudarib ). Profits generated from the investment of these funds are shared based on a pre-agreed ratio, while losses are borne by the depositor. 5 BWSB5053 Contemporary Islamic Banking

6. CONT.. 3. Investment Accounts: Mudarabah Investment Accounts: Similar to Mudarabah savings accounts but usually involve a fixed term and potentially higher returns due to longer-term investments. Profits and losses are shared as per the pre-agreed ratio. Musharakah Investment Accounts: These accounts involve a partnership between the depositor and the bank, where both contribute capital and share profits and losses according to their capital contribution ra 6 BWSB5053 Contemporary Islamic Banking

7. CONT.. 4. Special Investment Accounts (SIA): Restricted Investment Accounts (RIA): Depositors specify the type of investment they want their funds to be used for. The bank acts as an investment manager, adhering to the guidelines set by the depositor. Unrestricted Investment Accounts (UIA): Depositors allow the bank to invest their funds in any Sharia-compliant ventures at the bank’s discretion. Profits are shared according to a pre-agreed ratio. 5. Fixed Deposit Accounts (Islamic Term Deposits): Murabaha Deposits: The bank uses depositors' funds to purchase goods and sell them at a markup. The profit from the sale is shared with the depositor. Wakalah Deposits: Depositors appoint the bank as an agent (wakil) to invest their funds in Sharia-compliant projects, with the promise of a specified profit rate. 7 BWSB5053 Contemporary Islamic Banking

8. Practices in sourcing deposits In Malaysia, Islamic banks employ various practices in sourcing deposits to ensure compliance with Sharia principles and to attract a broad base of depositors: 1. Product Differentiation and Innovation: Sharia-Compliant Products: Offering a range of deposit products that comply with Sharia law, such as Wadiah (safekeeping), Mudarabah (profit-sharing), and Musharakah (partnership) accounts. Product Customization: Tailoring products to meet the specific needs of different customer segments, including individuals, SMEs, and corporate clients. 8 BWSB5053 Contemporary Islamic Banking

9. CONT.. 2. Marketing and Branding: Ethical Branding: Emphasizing the ethical and socially responsible nature of Islamic banking to attract depositors who prioritize these values. Awareness Campaigns: Conducting educational and marketing campaigns to raise awareness about the benefits and principles of Islamic banking. 3. Competitive Returns: Profit Rates: Offering competitive profit-sharing ratios on Mudarabah accounts to attract depositors looking for better returns on their investments. Hibah (Gifts): Providing discretionary gifts or bonuses on Wadiah accounts as an incentive for customers to maintain their deposits. 9 BWSB5053 Contemporary Islamic Banking

10. CONT.. 4. Customer Relationship Management: Personalized Services: Providing personalized and high-quality customer service to build long-term relationships with depositors. Digital Banking: Offering convenient digital banking services, including mobile and online banking, to enhance customer experience and accessibility. 5. Community Engagement: Corporate Social Responsibility (CSR): Engaging in CSR activities and community development projects to build trust and goodwill among the community. Partnerships with Religious Institutions: Collaborating with mosques and Islamic organizations to reach potential depositors who are inclined towards Sharia-compliant financial services. 10 BWSB5053 Contemporary Islamic Banking

11. CONT.. 6. Financial Inclusion: Microfinance Initiatives: Implementing microfinance programs to include underserved segments of the population, such as low-income individuals and small businesses. Affordable Banking Services: Offering low-cost banking services to attract a broader base of depositors. 7. Regulatory Compliance and Governance: Sharia Governance Framework: Ensuring robust Sharia governance by involving Sharia scholars in the development and approval of deposit products. Transparency and Accountability: Maintaining transparency in operations and ensuring that depositors are well-informed about the terms and conditions of their deposits. 11 BWSB5053 Contemporary Islamic Banking

12. CONT.. 8. Innovative Deposit Mobilization Strategies: Islamic Investment Accounts: Promoting specialized investment accounts that align with depositor preferences for ethical and high-return investments. Green and Sustainable Finance Products: Introducing deposit products that fund environmentally sustainable projects, appealing to depositors who prioritize green initiatives. 12 BWSB5053 Contemporary Islamic Banking

13. Determining profit margins and profit-sharing ratios from the perspective of funding Profit Margins 1. Profit Margins in Financing Transactions: Murabaha (Cost-Plus Financing): In Murabaha contracts, the bank purchases an asset and sells it to the customer at a marked-up price. The profit margin is the difference between the purchase price and the selling price. This margin is agreed upon by both parties at the outset of the contract. Ijara (Leasing): In Ijara , the bank buys and leases an asset to the customer. The profit margin comes from the rental payments received over the lease term, which include the cost of the asset plus a profit component. Istisna (Construction Financing): In Istisna contracts, the bank finances the construction of an asset and sells it upon completion. The profit margin is pre-agreed and included in the final sale price. 13 BWSB5053 Contemporary Islamic Banking

14. CONT.. Profit-Sharing Ratios 2. Profit-Sharing Ratios in Investment Accounts: Mudarabah (Profit-Sharing): In Mudarabah contracts, the bank ( mudarib ) and the depositor ( rab al-mal) agree on a profit-sharing ratio at the outset. The bank manages the investment, and profits are distributed according to this pre-agreed ratio. Losses, if any, are borne solely by the depositor unless caused by negligence or misconduct by the bank. Musharakah (Partnership): In Musharakah , both the bank and the depositor contribute capital to a joint investment and share profits and losses in proportion to their respective capital contributions. Profit-sharing ratios are agreed upon at the beginning of the contract. 14 BWSB5053 Contemporary Islamic Banking

15. CONT.. Determining Profit Margins and Ratios 3. Factors Influencing Profit Margins and Ratios: Market Conditions: Profit margins and ratios are influenced by prevailing market conditions, including demand for financing, competitive rates offered by other banks, and overall economic stability. Risk Assessment: The bank assesses the risk associated with the investment or financing activity. Higher-risk projects might command higher profit margins or different profit-sharing ratios to compensate for the increased risk. Investment Tenure: The duration of the investment or financing can impact the profit margins and ratios. Longer-term investments may offer higher returns due to the extended period of capital engagement. Bank's Profitability Goals: The bank sets its profitability targets based on its financial goals and regulatory requirements. These targets influence the profit margins applied to financing contracts and the profit-sharing ratios offered to depositors 15 BWSB5053 Contemporary Islamic Banking

16. CONT.. 4. Setting and Negotiating Profit Margins and Ratios: Negotiation with Customers: For contracts like Murabaha and Ijara , the profit margin is often negotiated directly with the customer based on the cost of the asset and the bank’s desired return. Pre-Agreed Ratios: In Mudarabah and Musharakah , the profit-sharing ratios are pre-agreed with the depositors. These ratios are based on factors such as the expected profitability of the investment and the depositor's risk appetite. Regulatory Compliance: Islamic banks must ensure that their profit margins and sharing ratios comply with Sharia principles and any relevant regulatory guidelines set by authorities like Bank Negara Malaysia (the central bank). 16 BWSB5053 Contemporary Islamic Banking

17. EXAMPLE OF CALCULATION Example 1: Murabaha Profit Margin: Purchase Price: RM 100,000 Mark-Up: 10% Selling Price: RM 110,000 Profit Margin: RM 10,000 Example 2: Mudarabah Profit-Sharing: Investment Capital: RM 200,000 (Depositor) Profit Generated: RM 40,000 Agreed Profit-Sharing Ratio: 70% (Depositor) / 30% (Bank) Depositor's Share: RM 28,000 Bank's Share: RM 12,000 17 BWSB5053 Contemporary Islamic Banking

18. Financing and investment activities Financing activities involve transactions that affect a company's capital structure. These activities typically include: Issuance of Equity : Raising funds by issuing shares to investors. This can include common stock, preferred stock, or other forms of equity. Debt Issuance : Borrowing funds through loans, bonds, or other forms of debt. This includes both short-term and long-term borrowing. Repayment of Debt : Paying back borrowed funds, including principal and interest payments. Dividends Payments : Distributing a portion of the company’s earnings to shareholders as dividends. Repurchase of Own Shares : Buying back the company’s own shares from the stock market. 18 BWSB5053 Contemporary Islamic Banking

19. CONT… Investment activities pertain to the purchase and sale of long-term assets and other investments not related to the company’s core operations. These include: Capital Expenditures ( CapEx ) : Spending on property, plant, and equipment (PP&E) such as buildings, machinery, and technology. These investments are critical for a company's long-term growth and efficiency. Acquisitions : Buying other businesses or investments in joint ventures and partnerships. Sale of Assets : Disposing of long-term assets, which could include selling equipment, property, or parts of the business. Investments in Securities : Purchasing stocks, bonds, or other financial instruments that are intended to generate returns. 19 BWSB5053 Contemporary Islamic Banking

20. Importance of Financing and Investment Activities Liquidity Management : Ensures that the company has enough cash to meet its short-term obligations. Growth and Expansion : Facilitates the expansion of operations, entry into new markets, and increases in production capacity. Value Maximization : Helps in maximizing shareholder value by investing in profitable projects and maintaining an optimal capital structure. Risk Management : Allows the company to manage risks associated with financing and investment decisions. 20 BWSB5053 Contemporary Islamic Banking

21. Types of financing and investment Types of Financing: Financing can broadly be classified into two categories: Debt Financing and Equity Financing . Here are the types: 1. Debt Financing Bank Loans : Loans provided by banks, which can be short-term or long-term. These typically require regular interest payments and repayment of principal. Bonds : Long-term debt securities issued by companies to raise capital. Bondholders receive regular interest payments and the return of principal at maturity. Lines of Credit : A flexible borrowing option where a company can draw funds up to a pre-approved limit. Commercial Paper : Short-term unsecured promissory notes issued by companies, usually for financing working capital needs. Leasing : Financing through leasing arrangements for equipment or property, avoiding the need for large capital expenditure. 21 BWSB5053 Contemporary Islamic Banking

22. Types of financing 2. Equity Financing Common Stock : Issuing shares of common stock to investors, giving them ownership in the company and voting rights. Preferred Stock : Issuing shares that have preferential rights to dividends and assets upon liquidation but typically lack voting rights. Venture Capital : Funds provided by venture capitalists in exchange for equity, often used by startups and early-stage companies. Angel Investors : High-net-worth individuals who provide capital to startups in exchange for equity or convertible debt. Crowdfunding : Raising small amounts of money from a large number of people, typically via online platforms, in exchange for equity or rewards. 22 BWSB5053 Contemporary Islamic Banking

23. Types of investment Investments can be classified into various categories based on the asset class or the purpose of the investment. Here are the common types: 1. Capital Expenditures ( CapEx ) Property : Investing in land, buildings, and other real estate properties. Plant and Equipment : Investing in machinery, factories, and other physical assets used in production. 23 BWSB5053 Contemporary Islamic Banking

24. Types of investment 2. Financial Investments Stocks : Buying shares of publicly traded companies, aiming for capital appreciation and dividends. Bonds : Investing in debt securities issued by governments or corporations, seeking regular interest income. Mutual Funds : Pooling funds with other investors to buy a diversified portfolio of stocks, bonds, or other securities managed by a professional. Exchange-Traded Funds (ETFs) : Similar to mutual funds but traded on stock exchanges, providing diversification and liquidity. 24 BWSB5053 Contemporary Islamic Banking

25. Types of investment 3. Alternative Investments Real Estate : Investing in residential, commercial, or industrial properties for rental income and appreciation. Private Equity : Investing in private companies or buyouts, usually through private equity firms or funds. Hedge Funds : Pooled investment funds that employ various strategies to earn active returns for their investors. Commodities : Investing in physical goods such as gold, oil, or agricultural products. 4. Intangible Investments Research and Development (R&D) : Investing in the development of new products, services, or technologies to drive future growth. Intellectual Property (IP) : Investing in patents, trademarks, copyrights, and other forms of intellectual property that can generate royalties or licensing income. 25 BWSB5053 Contemporary Islamic Banking

26. CONCLUSION BWSB5053 Contemporary Islamic Banking 26 Islamic banking sources of funds are derived from equity capital, deposits, Sukuk, Mudaraba , and Wakala agreements. These funds are then utilized in various Sharia-compliant financing activities such as Murabaha, Ijara , Mudaraba , Musharaka , Istisna , and Salam contracts. The sources of funds for Islamic banks in Malaysia are robust and varied, leveraging both traditional and innovative financial instruments. The ethical principles of Islamic finance, combined with Malaysia's strong regulatory framework and supportive government policies, have created a conducive environment for the growth of Islamic banking. This has attracted a broad base of depositors and investors, both locally and internationally, ensuring a steady and sustainable inflow of funds. The continued development of diverse funding sources, such as Sukuk and investment accounts, positions Malaysian Islamic banks well for future growth and stability in the global Islamic finance industry.

27. Dr. mohd adib abd muin [email protected] | [phone]