Sources & Use of Funds of Islamic Banks

The corporate objective of Islamic banks is to provide banking facilities and services following Islamic principles, rules, and practices. The Islamic principles, rules, and practices belong to the body of Islamic principles on commercial transactions (Ahkam Al-Muamalah Al-Lslamia) related to banking and finance.

Consequently, the modes of operation of Islamic banks have evolved in conformity with these principles, rules, and practices as approved by the Ulamas (Islamic scholars) in various Islamic countries.

Conventional and Islamic banks are trading most funds from sources other than themselves. But they differ in both raising funds and using the same for profit.

Sources of Funds of Islamic Banks

The Islamic banks’ financial resources consist of ordinary capital resources comprising paid-up capital and reserves and funds raised through borrowings from the Central Bank and other Banks (inter-hank borrowing), an issue of Islamic financial instruments.

However, the major pan of their operational funds is derived from the different categories of deposits accepted on the Islamic principles of Al-Wadiah (safe custodianship) and Al-Mudarabah (trust financing).

Islamic bank raises their initial equity (or paid-up capital) straightforwardly through the Islamic equity-financing contract of AI-Musharakah among its initial shareholders. Only one class of shares-ordinary shares – are initially issued, usually quoted in the share market.

Islamic Banks may further issue shares, such as:

Special Share (or Golden Share) to be subscribed by the Government.
New ordinary shares in the form of the Employee Share Option Scheme (ESOS).
New ordinary shares in exchange for Syarikat Takaful share with its minority shareholders.
New ordinary shares in the rights issue.
New ordinary shares in public issue.

Customers’ Deposits in Current Accounts (Contract: Al-Wadiah Yad Dhamanah/Guaranteed Custody)

Islamic bank mobilizes its customers’ deposits in Current Accounts on the contract of Al-Wadiah Yad Dhamanah. This is neither equity financing nor strictly debt financing.

Rather, it is based on the combination of two other categories of Islamic Commercial Contracts, namely Al-Wadiih (Custody) and Al-Dhamanah (Guarantee). The details are as follows:

The Bank accepts deposits from its customers looking for the safe custody of their funds and absolute convenience in their use in the form of Current Accounts on the principle of Al-Wadiah Yad Dhamanah.
The Bank requests permission from such customers to use their funds so long as they remain with the Bank.
The customers may withdraw a part of the whole of their balances at any time if they desire, and the Bank guarantees the refund of such balances.
All the profits generated by the Bank from the use of such funds belong to the Bank.
The Bank provides its customers with checkbooks and other usual services connected with Current Accounts.

Customers’ Deposits in Savings Accounts (Contract: Al-Wadiah Yad Dhamanah/Guaranteed Custody)

The Bank takes customers’ deposits in Savings Accounts on the same contract with modification on the payment of profit at the absolute discretion of the Bank. The details are as follows:

The Bank accepts deposits from its customers looking for the safe custody of their funds, a degree of convenience in their use, and the possibility of some profits in the form of Savings Accounts on the principle of Al-Wadiah Yad Dhamanah.
The Bank requests permission from such customers to use their funds so long as they remain with the Bank.
The customers may withdraw a part of the whole of their balances at any time if they desire, and the Bank guarantees the refund of such balances.
All the profits generated by the bank from the use of such funds belong to the Bank. However, in contrast with Current Accounts, the Bank may, at its absolute discretion, reward the customers by returning a portion of the profits generated from the use of their funds from time to time.
The Bank provides its customers with Savings Passbook and other usual services connected with Savings Accounts. The Bank may also provide Automated Teller Machine (ATM) services for these accounts.

Islamic banks can mobilize their deposits in General Investment Accounts from their customers on the equity-financing contract of Al-Mudharabah. The details are as follows:

The Bank may accept deposits from its customers looking for investment opportunities for their funds in the form of General Investment Accounts on the principle of Al-Mudharabah.
The deposits will have to be for a specified period. The Bank may also accept deposits for the following periods:
- 1 month 18 months
- 3 months 24 months
- 6 months 36 months
- 9 months 48 months
- 12 months 60 months, and over 15 months
In the basic Shariah relationship, in this case, the Bank acts as the ‘entrepreneur’ and the customers as the ‘provider of capital.’ Both will agree, among others, on how to distribute the profits generated by the Bank from the funds’ investment. The Bank may offer the distribution in the ratio of 70 percent to the customers and 30 percent to the Bank. This offer of the ratio of the distribution of profits may vary from time to time.
In the event of a loss in the investment, the customer bears all the loss.
The customer does not participate in managing the investment of the funds.

In addition to the above facilities for accepting deposits from its ordinary customers, the Islamic bank may also selectively accept deposits from its government or corporate customers in the form of Special Investment Accounts.

These accounts are also operated on the principle of al-Mudharabah. Still, the modes of investment of the funds and the ratios of profit distribution may usually be individually negotiated.

Effectively, this is one of the Bank’s money market operations on the liability side. The Bank’s Treasury Department may usually manage the operations. Some other money market operations may also be added by keeping the spirit of Shariah.

Uses of Funds of Islamic Banks

Now we move to the main items of use of the Islami banks’ funds:

Statutory Reserve (Contract: Al-Wadiah Yad Dhamanah/Guaranteed custody)

This is the statutory requirement that Islamic banks, like traditional banks, are also required to maintain reserves with the country’s central bank. The reserve must be maintained with all types of customer deposits but not of the shareholders’ funds.

The country’s central bank determines the reserve ratio to deposits to be maintained from time to time. The probable contract is Al-Wadiah Yad Dhamanah.

In such a case, the central bank does not pay any profit on the reserve maintained by the Islamic banks.

From a regulatory and institutional point of view, the statutory reserve may serve as a safety valve for the Islamic bank’s solvency. It faces serious difficulty and is a monetary instrument for the central bank to conduct its monetary policy.

Liquidity Requirements (Contract: Al-Qardh ALHasan/BenevoIent Loan)

There may be a statutory requirement that the bank should maintain certain ratios of defined liquid assets to its various types of deposits at all times. The central bank stipulates the ratios from time to time.

An important asset that the bank can hold for this purpose is the Government Investment Certificates or Govt Bonds Conceptually. Government Bonds are certificates showing the borrowing by the Government from the country’s financial institutions, etc.

Effectively it is the loan taken by the Government from its own citizens. The Government usually requires a loan to finance its recurrent expenditure or development expenditure for public projects.

These may be issued on the Islamic contract of Al-Qardh Al-Hasan. They are of various maturities: short-dated and long-dated. Each certificate carries a face value in multiples of any denomination and is issued at par. It is also redeemable at maturity or on-demand at par.

Al-Qardh Al-Hasan is a benevolent debt financing contract quite distinct from the strictly commercial deferred contracts of exchange. The benevolent nature of this contract is aptly suitable for lending by the country’s citizens to their Government for financing its operation and development of social projects.

Under Al-Qardh Al-Hasan, the borrower is not obliged but has the option to reward the lender for his benevolent deed. The Government thus has the absolute discretion whether to reward the holder of such instruments or not and, if so, by how much. It may also vary the rewards /or the short-dated and the long-dated bonds.

The absolute discretion that the Government has in respect of reward holds the potential of making such a suitable instrument of monetary policy under the Islamic banking and financial system.

Investment Financing

After meeting the statutory reserve requirement and holding the required level of liquid assets, the Islamic bank is free to apply the remainder of the customers’ deposits and the shareholders’ funds for banking operations.

The bank may undertake to finance the acceptable project under the principle of Al-Mudliarabah.
In this instance, the bank is the “provider of capital” and will provide 100 percent financing for the relevant project. In this instance, the bank is the “provider of capital” and will provide 100 percent financing for the relevant project.
“The initiator of the project is the entrepreneur” who will manage the project. The bank cannot interfere in the management of the project but has the right to undertake the follow-up and supervision task. ‘The project’s initiator is the entrepreneur’ who will manage the project. The bank cannot interfere in the management of the project but has the right to undertake the follow-up and supervision task.
Both parties agree through negotiation on the ratio of the distribution of the profits generated from the project.
In the event of a loss in the project, the bank bears all the losses.

The bank may undertake to finance the acceptable project under the principle of Al-Musharakah.
In this instance, the bank and the initiator or initiators of the relevant project will provide the whole financing for the project in agreed proportions.
All parties, including the bank, have the right to participate in project management; but all parties can waive such right.
All parties agree through negotiation on the ratio of the distribution of the profits generated from the project, if any. Such a ratio need not coincide with the ratio of participation in the project’s financing.
In the event of a loss in the project, all parties bear the loss in proportion to their shares in financing.

Financing Acquisition of Assets (Contract: Al-Bai Bithaman Ajil/Deferred Instalment Sale)

The bank may finance customers who wish to acquire a given asset but want to defer the payment for the asset for a specific period or wish to pay by installments under the principle of al-Bai Bithaman Ajil.
The bank first determines the requirements of the customer regarding his period and manner of repayment.
The bank purchases the asset concerned.
The bank subsequently sells the relevant asset to the customer at an agreed price which comprises:
- The actual cost of the asset to the bank; and
- The bank’s margin or profit allows the customer to settle the payment in installments within the period and in the manner so agreed upon.

Financing the Use of Services of Assets (Contract: Al-Ijarah/Leasing)

The bank may finance its customers to acquire the right to use the services of a given asset under the principle of Al-Ijarah.
The bank first purchases the asset required by the customer.
Subsequently, the bank leases the asset to the customer for a fixed period, lease rentals, and other terms and conditions as both parties agree.

Syndication Services (Contract: Al-Ujr/Fee)

It might be briefly mentioned that the above facilities may be organized on a syndication basis for a fee if the financial requirements are beyond the capability of a single bank or if it is desirable to spread the risk. Similar Syndication services also apply to trade finance facilities which will be explained below.

The bank lias led-managed and participated in some syndications regarding facility investment financing above.

Securitization and Debt Trading (Contract: Bai Al-Dayn/Debt-Trading)

Facilities (c) al-Bai Bithaman Ajil and (d) Al-Ijarah, as we have seen, are debt-financing modes. They give rise to debt or Al-Dayn.

The Islamic debt market will be enormously enhanced by the securitization of such debt and the creation of an institutional framework for trading in such debt instruments.

Trade Financing

The bank may provide specific facilities and financings, mostly short-term, to facilitate trade or working capital requirements for its customers.

These facilities may be granted in connection with the purchase/import and sale/export of goods and machinery and the acquisition and holding of stock and inventories, spares and replacements, raw materials, and semi-finished goods.

Letter of Credit (Contract: Al-Wakalah/ Agency)

The customer informs the bank about his Lettci of Credit requirements and requests the bank to provide the facility.
The bank may require the customer to place a deposit of the full amount of the price of the goods to be purchased/ imported, which the bank accepts under the principle of Al-Wadiah Yad Dhamanah.
The bank establishes the Letter of Credit, pays the proceeds to negotiate with the bank utilizing the customer’s deposit, and subsequently releases the documents.
The bank charges customer fees and commissions under the AI-Ujr(Fee) principle.

The customer informs the bank of his Letter of Credit requirements and negotiates the terms of Al-Musharakah financing for his requirements.
The customer places a deposit for his share of the cost of goods to be purchased/imported as per the Al-Musharakah agreement, which the bank accepts under the principle of Al-Wadiah Yad Dhamanah.
The bank establishes the Letter of Credit and pays the proceeds to negotiate bank utilizing the customer’s deposit and its own shares of financing. Subsequently, it releases the documents to the customers.
The customer takes possession of the goods and disposes of these manners agreed in the agreement.
The bank and the customer share in the profit from the venture as provided for in the agreement.

Letter of Credit (Contract: Al-Murabahah/ Deferred Lump-Sum Sale or Cost Plus)

The customer informs the bank of his Letter of Credit requirements and requests the bank to purchase/import the goals, thereby indicating that he would be willing to purchase the goods from the bank on their arrival on the principal of Al-Murabahah.
The bank establishes the Letter of Credit and pays the proceeds to the negotiating bank utilizing its own funds.
The bank sells the goods to the customer at a sale price comprising its cost and a profit margin under the principle of Al-Murabahah for settlement on a deferred term.

Letter of Guarantee (Contract: ALKafalah/ Guarantee)

The bank may provide the facility of a Letter of Guarantee to its customers for certain purposes under the principle of ALKafalah.
The Letter of Guarantee may be provided regarding the performance of a task or the settlement of a loan.
The bank may require the customer to place a certain amount of deposits for this facility which the bank accepts under the principle of Al-Wadiah Yad Dhamanah.
The bank charges the customer a fee for the services it provides.

Financing Working Capital (Contract: AJ Murabahah/Deferred Lump-Sum Sale or Cost Plus)

The customer may approach the bank to provide financing for his working capital requirements to purchase stocks and inventories, spares and replacements, or semi-finished goods and raw materials.

The bank first purchases or appoints the customer as its agent to purchase the required goods on its behalf and settles the purchase price from its own funds.
The bank subsequently sells the goods to the customer at an agreed price comprising its purchase price and a profit margin and allows the customer to settle this sale price on a deferred term of 30 days, 60 days, 90 days, or any other period the case may be.
The customer pays the bank the agreed sale price on the due date.

Securitization and Islamic Accepted Bill (IAB) (Contract: Bai aLDayn/Debt-Trading)

The previous working capital financing under Al-Murabahah, which gives rise to debt, or Al-Dayn may indeed be securitized.

In that instance, the bank draws a Bill of Exchange and is accepted by the customer. This Bill of Exchange will be drawn for the full amount of the bank’s selling price on the maturity date of the financing.

Use of Funds in Direct Investment

The bank may also utilize the customers’ deposits and the shareholders’ funds to undertake the following types of direct investment. In all cases where it involves other parties, the contractual form is Al-Musharakah/Joint-Venture Profit-Sharing:

Setting up wholly-owned subsidiaries.
Taking up equity as a shareholder in unquoted companies.
Purchase of shares in public companies quoted on the stock market for long-term investment.
Portfolio investment in shares of public companies quoted on the stock market.

Conclusion

Islamic banks mobilize and utilize their funds in ways that do not violate Islamic Shariah’s principles, rules, and practices. These banks remain cautious against the element of interest while collecting their resources and using their funds.

Seemingly, most of the items of sources & uses of funds of both traditional and Islamic banks are alike.

But major sources of funds like deposits and major use of funds like loans/investments make a remarkable distinction.

It is mentioned here that both types of banks must remain vigilant and may be vigilant about ethical issues and adherence to the laws of the land. Islamic banks, in addition, must perform only in conformity with the rules of Islamic Shariah.