LECTURE 2 Funding product of Islamic bank I

Islamic Banking Management

Wahyu JATMIKO, PhD

wahyujatmiko@ui.ac.id | w.jatmiko09@gmail.com

February 2023

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Objectives

• Debt based contract vs equity based contract
• Funding using wadiah (and Qard) contract: demand deposit and saving deposit
• Islamic bank depositor characteristics

Wahyu Jatmiko | Funding product of Islamic bank I

Reading Materials

ISM Ch.3

KUR Ch. 12 – 14

Asset-liability: Between Islamic Bank and Its Conventional Counterpart

Wahyu Jatmiko | Funding product of Islamic bank I

The normative theory of profit in Islamic finance

Wahyu Jatmiko | Funding product of Islamic bank I

Simplified Asset & Liability of Conventional Banks

Wahyu Jatmiko | Funding product of Islamic bank I

Assets

Liabilities

Shareholders’ Equity

1. Cash
2. Current Accounts
• BI
• Other banks
3. Investments in marketable securities
4. Loans
5. Investment
6. Debt-based Receivables
7. Bonds Purchased
8. Fixed Assets
9. Intangible Assets

1. Deposits from customers
• Demand deposits
• Saving deposits
• Time deposits
2. Deposits from other banks
• Demand
• Saving
• Time
• Interbank call money
1. Derivatives

Simplified Asset & Liability of Islamic Banks

Wahyu Jatmiko | Funding product of Islamic bank I

Assets

Liabilities

Shareholders’ Equity

1. Cash
2. Current Accounts
• BI
• Other banks
3. Investments in marketable securities
4. Receivables
• Murabaha
• Istishna
• Ijara
5. Financing
• Mudharaba
• Musharaka

Temporary Syirkah Funds

1. Deposits from customers
• Wadiah demand deposits
• Wadiah saving deposits
2. Other liabilities

1. Deposits from customers
• Mudhaaraba saving deposits
• Mudharaba time deposits

Debt based contract vs equity based contract

Wahyu Jatmiko | Funding product of Islamic bank I

Debt Based Contract in Conventional Bank

Recall conventional bank balance sheet.

• In the liability side, bank collects public fund through debt based contract.
• Interest-bearing loan
• Fixed obligations
• Delink between performance of the project (or assets) and payoffs of the debt/loan.
• In the asset side, bank channel its financing employing debt-based contract as well.
• Here again, the entrepreneur has to pay a fix amount of money (or sometimes refer to the interest rate) regardless of its underlying business performance.
• Therefore, delink between asset and liability side of the bank.
• Bank has the burden of all kind of risk faced by the asset side:
• Risks: (i) market; (ii) liquidity; (iii) credit; (iv) operational; (v) idiosyncratic.

Wahyu Jatmiko | Funding product of Islamic bank I

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Debt Based Contract in Conventional Bank

In the extreme case:

• The majority of loan are not collected 🡪 High Non-Performing Loan (NPL)
• Public needs more liquidity 🡪 probability of bank cannot fulfil the liquidity (recall fractional reserve) 🡪 lack of trust towards banking industry.
• Higher probability of default.
• Public needs insurance: Indonesia Deposit Insurance Corporation (or LPS) was thus established to ensure public safety.
• Bail out for the too big to fail or too many to fail banks. Ex: BLBI, Bank Century.

Wahyu Jatmiko | Funding product of Islamic bank I

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Debt Based Contract in Conventional Bank

Risk-Shifting

Wahyu Jatmiko | Funding product of Islamic bank I

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The equity goes underwater when the value of the asset (Vt) is lower than the debt obligation (Qt), as observed in the interval (t1, t2). This leads the borrower to default by transferring the downside risk of the asset to the financier. Source: Jatmiko et al. (2021).

Debt Based Contract in Conventional Bank

Underinvestment

Wahyu Jatmiko | Funding product of Islamic bank I

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Underinvestment occurs in Period 3 when the borrower's Net Operating Income (NOIt) is lower than its Debt Obligations (DO). Here, the borrower rejects profitable (i.e., the positive net present value - NPV) projects as the additional wealth mainly accrues the financier. Source: Jatmiko et al. (2021)

Debt Based Contract in Conventional Bank

Financial fragility leads to financial crisis.

• Debt-based banking system is by structure prone to crisis.
• Recall 1997-1998 Asian Crisis and 2008 Global Financial Crisis

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Wahyu Jatmiko | Funding product of Islamic bank I

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Equity Based Contract in Islamic Bank

Two-tier Mudharaba of Uzair

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Wahyu Jatmiko | Funding product of Islamic bank I

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Shinsuke (2012)

Equity Based Contract in Islamic Bank

• Islamic banking is not a mere interest free bank.
• Its concept is based on the equity based contract.
• In the right hand side of the balance sheet, Islamic bank collects deposit from public through profit-and-loss sharing (Mudharaba or musharaka).
• Hence, the depositor acts as an investor investing through Islamic bank.

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Wahyu Jatmiko | Funding product of Islamic bank I

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Equity Based Contract in Islamic Bank

• In the left hand side of the BS, Islamic bank finances public through profit-and-loss sharing contract as well. Therefore, the debtor of IB is actually a partner of the bank.
• This two-tier equity based contract by definition prevents interest.
• Profit sharing is priced based upon the performance of underlying transaction (ex post), not the predetermined rate (ex-ante) like interest benchmark.
• No single benchmark of interest rate 🡪 every sector has different performance 🡪 different return 🡪 different payoffs 🡪 more just.

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Wahyu Jatmiko | Funding product of Islamic bank I

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Equity Based Contract in Islamic Bank

Features in equity based contracts of IB

• Risk sharing
• Link between bank asset and liability, hence more stability
• Bank is an intermediary institution who also acts as an entrepreneur
• Finance-real coupling
• Two sides monitoring function: depositor to bank and bank to debtor.

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Wahyu Jatmiko | Funding product of Islamic bank I

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Equity Based Contract in Islamic Bank

Hence, theoretically speaking Islamic bank:

• Far more stable than conventional counterparts.
• Far more just than conventional banking
• More efficient intermediaries function

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However, this will only hold if:

• Allowed by supportive institutional framework

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Wahyu Jatmiko | Funding product of Islamic bank I

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Equity Based Contract in Islamic Bank

Challenges

• Low literacy 🡪 resistance to accept higher risk
• Support from regulation
• Lack of Research and Development
• Lack of High Quality Human Capital
• Entrepreneurial skills.

Wahyu Jatmiko | Funding product of Islamic bank I

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Adjustment of Business Model of Islamic Banks

1st best model: Two-tier mudarabah

Wahyu Jatmiko | Funding product of Islamic bank I

Source: HMD pp. 74

Adjustment of Business Model of Islamic Banks

2^nd best model: One-tier Mudarabah with Multiple Investment Tools (murabahah syndrome)

Wahyu Jatmiko | Funding product of Islamic bank I

Source: HMD pp. 75

Adjustment of Business Model of Islamic Banks

3^rd best model: Fixed-income liability with multiple investment tools model

Wahyu Jatmiko | Funding product of Islamic bank I

Source: HMD pp. 76

Group Works

1. Pick one of Indonesian Islamic banks.
2. Evaluate (through nice graphs) their proportion of contracts (funding and financing).

Wahyu Jatmiko | Funding product of Islamic bank I

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Funding using wadiah (and qard) contract

Wahyu Jatmiko | Funding product of Islamic bank I

Source of Fund in IBs

Wahyu Jatmiko | Funding product of Islamic bank I

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mudharib

∑

Profit

Sharing

Profit Sharing

Rent

PLS-based

Ujroh-based

Sale-based

margin

Table

Profit

sharing

Agent: mdh muqayyadah

Services: wakalah,

kafalah, sharf

Wadiah yad dhamanah

Mudharabah mutlaqah

lainnya

Income from

mdh mutlaqah

Fee-based income

Pooling Dana

Financial statement

Funding

Financing

Revenue

Funding Mechanism

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Pool of Fund

Source of Fund Use of Fund

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Equity

Wadiah

Mudharabah

Mutlaqah

POOL of Fund

Primary Reserve : CASH

Secondary Reserve : Non Cash

Qard

Musyarokah

Mudharabah

Murabahah

Salam

Istishna

Ijarah

Fixed Assets

Mudharabah

Muqayadah

Special Project

Assets Allocations Approach

Source of Fund Use of Fund

Wahyu Jatmiko | Funding product of Islamic bank I

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Wadiah

Mudharabah

Mutlaqah

Modal

Mudharabah Muqayadah

Primary reserve : Cash

Secondary Reserve : Non Cash

Qard

Murabahah

Salam

Istishna

Ijarah (wa iqtina)

Mudharabah

Musyarakah

Fixed Asset

Special Project

IB Sources of Fund

Wahyu Jatmiko | Funding product of Islamic bank I

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Source of Fund

IB

Core Capital

Wadiah

Paid-in-capital

Reserve

Retained Earnings

Saving Deposit

Mudharabah

Time Deposit

Mudharabah

Saving / Demand

Deposit Wadiah

Mudharabah

Funding in Islamic Bank

Wahyu Jatmiko | Funding product of Islamic bank I

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Components of Deposit

UU Banking No. 10 Year 1998

• Components of Deposit
• Savings Deposit (Tabungan)
• Demand Deposit (Giro)
• Time Deposit (Deposito)

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Wahyu Jatmiko | Funding product of Islamic bank I

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Wadiah

Wadiah refers to safekeeping, custody, deposit and trust.

In Islamic banking, it refers to the deposit of funds or assets by a person. In this arrangement, the depositor deposits his funds or assets with the bank for safekeeping and in most of the agreements the bank charges a fee for the safe custody of the depositor’s funds.

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There are two basic types of wadiah:

• Wadiah yad amanah refers to property is deposited on the basis of trust (guarantee safe custody).
• Wadiah yad Dhamanah refers to savings with guarantee or safe-keeping.

Wahyu Jatmiko | Funding product of Islamic bank I

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Wadiah yad amanah

Fee

Wahyu Jatmiko | Funding product of Islamic bank I

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Deposit (asset)

Wadiah yad dhamanah

Wahyu Jatmiko | Funding product of Islamic bank I

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Islamic Saving/Current Acc.

Wadi`ah Yad Dhamanah

Al-Wadi’ah

Daman/Kafalah

2 Different Contracts

A Safe Custody Contract

A Guarantee Contract

Wadiah yad dhamanah

Bonus

Wahyu Jatmiko | Funding product of Islamic bank I

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Deposit (asset)

Financing

Profit �Shring

Issues with Wadiah Yad Dhamanah

• Limited financing opportunities
• Bonus is not fixed (not certain either)
• Cannot mingle this with capital

Wahyu Jatmiko | Funding product of Islamic bank I

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Islamic bank depositor characteristics

Wahyu Jatmiko | Funding product of Islamic bank I

Islamic Bank from the conventional consumers’ point of view

Wahyu Jatmiko | Funding product of Islamic bank I

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Islamic Bank from the Islamic banks’ consumers’ point of view

Wahyu Jatmiko | Funding product of Islamic bank I

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IB Depositor Characteristics (Ismal)

Wahyu Jatmiko | Funding product of Islamic bank I

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IB Depositor Characteristics (another)

Wahyu Jatmiko | Funding product of Islamic bank I

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Thank you

Wahyu JATMIKO, PhD

wahyujatmiko@ui.ac.id

w.jatmiko09@gmail.com