Islamic banking: Strengthening regulatory surveillance and diversifying business model

In March of this year, the Islamic banking sector in Bangladesh marked 35 years of its existence. Despite all sorts of scepticism, the sector continues to grow at a faster rate than its conventional counterpart. Eight full-fledged Islamic banks, along with 17 conventional banks with Islamic banking branches or windows, are currently offering Islamic banking services. The performance indicators of the Islamic banks are also better than those of the conventional banks.

Despite this impressive progress, Bangladesh is yet to make an Islamic Banking Act. As there is no proper regulatory framework, compliance with the Central Shariah Board for Islamic Banks (CSBIB) remains voluntary. Due to the absence of a Shariah governance system, Islamic banks continue to face criticisms. Most people do not find them as any different from the conventional banks. Though the criticisms are at times due to lack of understanding of Islamic banking concepts, these are not always baseless.

About 80 per cent of Islamic bank deposits in Bangladesh are collected on mudarabah principle. But one of the common criticisms faced by the Islamic banks is the absence of profit-or-loss sharing practice, though

Mudarabah is a partnership principle where the depositors act as the capital provider (rabb al-mal) and the Islamic bank acts as the manager of that capital (mudarib). The mudarabah principle entails that any profit generated from investment of the deposited money will be shared between the depositors and the Islamic bank at a pre-agreed profit sharing ratio, whereas any loss will be fully borne by the depositors.

Critics argue that in reality the mudarabah-based depositors do not bear any loss. Rather they commonly receive a steady profit. The profit rate often is similar to the rate indicated by the Islamic bank at the time of opening the account. This rate is also very similar to the rate that other banks (Islamic or not) offer on deposits to their accountholders. While there is truth to this, it should be observed from a proper perspective.

A tentative profit is ensured to avoid displaced commercial risks. The Islamic banks operate in a dual banking environment, and the direct competition with the conventional banks puts commercial pressure on them to give out profit that is competitive. A lower rate than the market or a real potential of capital loss (i.e. loss of deposited money) are not going to attract many depositors. Moreover, directly participating in the profit-or-loss of an investment will incur additional monitoring costs for the depositors as well as increasing chances of disputes between the depositor and the Islamic bank.

Around 95 per cent of investments in Islamic banks of Bangladesh are based on sale or rental-based Islamic finance concepts. Shariah allows a fixed rate of return in such arrangements. This ensures a steady profit for depositors.

The Islamic banks also apply different techniques to keep the profit rates stable. If the investment does not generate the expected level of profit, then the Islamic bank can voluntarily forgo its share of the profit. If the investment makes a loss, then the Islamic bank can use shareholders' capital to make good of the amount lost earlier. The Islamic bank can also use a profit equalisation reserve, which is created by retaining part of the mudarabah profit during the good times, so that this can be used during times of crisis. Even though everyone does not appreciate these techniques, these are not outside the parameters of Shariah.

The core reason behind depositing money in a bank is to ensure that the fund is safe and, depending on the deposit type, earns a return from it. Anyone seeking equity exposure, that is investment risks and rewards, can easily invest in the equity market instead of depositing money in a bank. 

While moving forward, the Islamic banks in Bangladesh can explore experiences of other countries such as Malaysia. The Islamic Financial Services Act (IFSA) 2013 of Malaysia separated a 'deposit account' from an 'investment account'. A deposit account guarantees repayment of the deposited money in full with or without a profit as agreed between the Islamic bank and the depositor at the time of account opening. An investment account does not provide any such guarantee. The investment accountholders fully bear the risks and get rewards associated with the investments of their money. In a similar manner, the Islamic banks in Bangladesh can offer investment accounts along with regular 'deposit accounts'. This will thus cater to the demands of all types of customers.

The Islamic banks can also consider launching investment account platforms and crowd funding platforms. These platforms will facilitate matching of investors with specifically identified ventures or projects that need financing. The investors will bear the actual risks and get returns. As the operational model of this platform is different from regular banking activities, these can become subsidiary entities of existing Islamic banks in the country.

Mezbah Uddin Ahmed is a Researcher at International Shari'ah Research Academy for Islamic Finance (ISRA), Malaysia and Fellow of ACCA.

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