Two-Tier Mudarabah

This model is called two-tier because the mudarabah contract is utilized on each side of the balance sheet of the bank. The first model, relying on the concept of profit sharing, integrates the assets and liabilities sides. This model envisages depositors entering into a contract with a bank to share the profits accruing to the bank's business. The basic concept of this model is that both fund mobilization and fund utilization are based on the same profit sharing among the investor (depositor), the bank, and the entrepreneur or users of the funds. The first tier of the mudarabah contract is between the investor and the bank, analogous to a depositor and the bank, where investors act as suppliers of funds to be invested by the bank as mudarib on their behalf. Investors share in the profits and losses earned by the bank's business related to the investors' investments. Funds are placed with the bank in an investment account.

The liabilities and equity side of the bank's balance sheet thus shows the deposits accepted on a mudarabah basis. Such profit-sharing investment deposits are not liabilities (the capital is not guaranteed, and investors incur losses if the bank does) but are a form of limited-term, nonvoting equity. In this model, in addition to investment deposits, banks accept demand deposits that yield no returns and are repayable on demand at par and are treated as liabilities. This model, though requiring that current deposits must be paid at the demand of the depositors, has no specific reserve requirement.

The second tier represents the mudarabah contract between the bank as supplier of funds and the entrepreneurs who need funds and agree to share profits with the bank according to a certain percentage stipulated in the contract. The bank's earnings from all its activities are pooled and are then shared with its depositors and shareholders according to the terms of their contract. Thus the profit earned by depositors is a percentage of total banking profits. A distinguishing feature of the two-tier model is that, by design, the assets and liabilities sides of a bank's balance sheet are fully integrated, which minimizes the need for active asset-liability management, which, in turn, provides stability against economic shocks. The model does not feature any specific reserve requirements on either the investments or the demand deposits.

Two-Windows Model

The two-windows model also features demand and investment accounts but takes a different view from the two-tier model on reserve requirements. The two-windows model divides the liabilities side of the bank balance sheet into two windows, one for demand deposits (transactions balances) and the other for investment balances. The choice of the window is left to depositors. This model requires a 100% reserve for demand deposits but stipulates no reserve requirement for the second window. This is based on the assumption that the money deposited as demand deposits is placed as amanah (safekeeping) and must be backed by 100% reserves, because these balances belong to depositors. The bank does not have a right to use these deposits as the basis for money creation through fractional reserves. Depositors know that money they deposit in investment accounts will be invested in risk-bearing projects, and therefore no guarantee is justified. Also in this model, depositors may be charged a service fee for the safekeeping services rendered by the bank. In this model, the provisions of interest-free loans to those who may need them are limited to depositors who believe that the bank may be better equipped to channel such loans. No portion of the deposits in current accounts or investment accounts has to be used for this purpose.

Wikala Model

A third but less known model for an Islamic bank has also been suggested. This model is based on the contract of wikala, where an Islamic bank acts purely as a wakil (agent/representative) for investors and manages funds on their behalf for a fixed fee. The terms and conditions of the wikala contract are to be determined by mutual agreement between the bank and its clients. An Islamic bank is typically a hybrid between a conventional commercial bank and an investment bank, and thus resembles a universal bank. Table 8.1 constructs a conceptual balance sheet of an Islamic bank based on different functions and services to give us an overview of its structure, operations, and capabilities of intermediation.

Liabilities

On its liabilities side, an Islamic bank offers current, savings, investment, and special-investment accounts to depositors. Unlike conventional commercial banks, which accept deposits with the promise to return the principal amount in full with a fixed and predetermined return, an Islamic bank would not be able to offer such explicit guarantees of principal and fixed return. Rather it would assure depositors that it would select the best opportunities that minimize risk of loss for depositors but still provide attractive market-competitive returns. Using the techniques of portfolio management and diversification, an optimal portfolio of trade-related and asset-linked securities can be financed using depositors' funds. By deploying funds in this fashion, the intermediary will be able not only to offer short-term time deposits with minimized financial risk and sufficient liquidity but also to facilitate a system-wide payment system backed by real assets.

Current accounts are demand accounts kept with the bank on custodial arrangements and are repayable in full on demand. Current accounts are based on the principle of wadia or amanah, creating an agency contract for the purpose of protecting and safekeeping depositors' assets. The major portion of the bank's financial liabilities would consist of investment accounts that are, strictly speaking, not liabilities but a form of equity investment, generally based on the principle of mudarabah. Investment accounts are offered in different forms, often linked to a preagreed period of maturity, which may be from one month on and can be withdrawn if advance notice is given to the bank. Profits and returns are distributed between depositors and the bank according to a predetermined ratio (typically 80:20, but this may vary considerably from bank to bank).

A bank may also offer special-investment accounts customized for various types of investors: ordinary householders, high-net-worth individuals, or institutional clients. These accounts also operate on the principle of mudarabah, but the modes of investment of the funds and distribution of the profits are customized to suit client needs. In general, these accounts are linked to special investment opportunities identified by the bank. These opportunities have a specific size and maturity and result from the bank's participation in a pool of investment, private equity, a joint venture, or a fund. To some extent these accounts resemble specialized funds to finance different asset classes. The maturity and the distribution of profits for special-investment accounts are negotiated separately for each account, with the yield directly related to the success of the particular investment project. Funds for special-investment accounts can be designed and developed with specific risk–return profiles to offer customers and clients opportunities to manage portfolios and to perform risk management. In addition to deposits, an Islamic bank offers basic banking services, such as fund transfers, letters of credit, foreign-exchange transactions, and investment management and advice, for a fee, to retail and institutional clients.

The last item on the liabilities side is typically equity capital and reserves accumulated over the time. It should be noted that given the prohibition of debt, Islamic banks do not carry any debt capital, which is a significant source of capital for conventional banks. Rather, Islamic banks are capitalized through equity. It has been argued that since the mode of intermediation is based on a pass-through profit-sharing/loss-sharing agreement, Islamic banks do not need to keep significant equity capital. This notion may be theoretically correct but as we will see later, Islamic banks are still required to maintain a certain minimum level of capital. They can also set aside a portion of the profits each year as reserves to be used during times of economic slowdown.

Assets

While the liabilities side of the bank has limited ways to raise funds, the assets side can carry a more diversified portfolio of heterogeneous asset classes, representing a wider spectrum of the risk and maturity profile. For short-maturity, limited-risk investments, there is a choice of investing in short-term trade financing. Such assets originate from trade-related activities, such as murabahah, bay' al-muajjil, or bay' salám, and are arranged by the bank, which uses its skills, market knowledge, and customer base to finance the trading activity. In addition, the bank can provide short-term funds to its clients to meet their working capital needs. The short-term maturity of these instruments and the fact that they are backed by real assets minimize their level of risk. The bank considers these securities highly attractive and gives them preference over other investment vehicles.

For medium-term maturity investments, the bank has several choices. The funds can be invested in assets based on ijarah (leasing) and istisna (construction/manufacturing contract). A benefit of these contracts is not only that they are backed by an asset but that they can also have either a fixed- or a floating-rate feature that can facilitate portfolio management. The common features of Islamic and conventional leasing provide additional investment opportunities for the bank since investing in conventional leases with appropriate modifications can be made consistent with Shariah principles. However, leasing has its own overheads, which a bank may not like to accept. For example, leasing requires a bank to deviate from its primary role as a financial intermediary, in that it involves purchasing an asset and retaining ownership of it until the asset is disposed of, with the responsibility of maintenance and associated costs over the life of the contract. Disposing of the asset requires not only bearing all risks resulting from price fluctuations but also having some marketing expertise. All this will require the bank to engage in activities beyond financial intermediation.

In addition, an Islamic bank can set up special-purpose (customized) portfolios to invest in a particular asset class and sector and can finance these portfolios by issuing special-purpose mudarabah investment accounts. In some way, this segment of the assets side represents a fund of funds, where each fund is financed by matching mudarabah contracts on the liabilities side through special-investment accounts. For longer-term maturity investments, an Islamic bank can engage in venture-capital or private-equity activities in the form of musharakah.

An Islamic bank can attract depositors/investors either by inviting them to share profits and losses on a general pool of assets maintained by the financial intermediary itself or by acting as a dealer/broker for third-party products. The general pool could be in the form of various funds specializing in specific sectors or geographical regions. In this case, investors/depositors will be placing funds with the bank in a fund of funds, a collection of diversified portfolios of financial assets. The relationship between the bank and the depositors/investors could be on the basis of a mudarabah, where the bank manages assets for a fee, or a musharakah, where the bank shares profits and losses with the depositors/investors. In either case, there is risk sharing between the financial intermediary and depositors/investors. Or the Islamic bank can act simply as a dealer/broker and help the investor to select and place funds in portfolios of independent fund managers who specialize in specific asset classes, investment styles, sectors, and maturity terms. In this case, the bank facilitates the purchase/sale of third-party products and has no liability regarding the outcome or the performance of those products. However, the bank may perform due diligence on the funds and their managers before making any recommendations to customers. Typically, the assets are divided into banking and trading books. The banking book consists of old-fashioned investments and financing of real-sector activities, whereas the trading book contains financial securities such as bonds.

Banks in the Islamic financial system can be reasonably expected to exploit economies of scale, as do their counterparts in the conventional system. Through their ability to take advantage of these imperfections, they alter the yield relationships between surplus and deficit financial units and thus provide financing at a lower cost to deficit units and a higher return to surplus units than would be possible with direct financing. Just as in the conventional financial system, the Islamic depository enables financial intermediaries to transform the liabilities of business into a variety of obligations to suit the preferences and circumstances of the surplus units. Their liabilities consist of investments/deposits, and their assets consist mainly of instruments of varying risk-return profiles. These banks are concerned with decisions relating to such issues as the nature of their objective functions; portfolio choice among risky assets; liability and capital management; reserve management; the interaction between asset and liability sides of their balance sheets; and the management of off-balance sheet items, such as revolving lines of credit, standby and commercial letters of credit, and bankers' acceptances.

Moreover, as asset transformers, these institutions become risk evaluators and serve as filters to evaluate signals in a financial environment with limited information. Their deposit liabilities serve as a medium of exchange, and they have the ability to minimize the cost of transactions that convert current income into an optimal consumption bundle. One major difference between the two systems is that, due to the prohibition against taking interest and the fact that they have to rely primarily on profit sharing, Islamic banks have to offer their asset portfolios of primary securities in the form of risky open-ended “mutual fund”–type packages for sale to investors/depositors. In contrast to the Islamic system, banks in the conventional system keep the title of the portfolios they originate. The banks fund these assets by issuing deposit contracts, a practice that results in solvency and liquidity risks, since asset portfolios and loans entail risky payoffs and/or costs of liquidation prior to maturity while deposit contracts are liabilities that often are payable instantly at par. In contrast, Islamic banks act as agents of investors/depositors and, therefore, create pass-through intermediation between savers and entrepreneurs. In short, Islamic financial intermediaries are envisioned to intervene with an embedded notion of risk sharing. Intermediation is performed on a pass-through basis such that the returns (positive or negative) on the assets are passed to investors/depositors. The intermediary applies financial engineering to design assets with a wide range of risk-return profiles to suit the demands of investors on the liabilities side.

Distinctive Features of the Islamic Mode of Intermediation and Banking

Financial intermediation and banking in the Islamic financial system differ from conventional banking in a number of important ways.

Stock Markets

With the prohibition on interest and the preference for partnerships to share profits and losses, equity markets hold a significant place in the Islamic financial system. Therefore, Islamic scholars have pointed out the necessity, desirability, and permissibility of a stock market in the Islamic financial system in which transactions in primary capital instruments such as corporate stocks can take place. The conditions of the operations of these markets, in accordance with the rules of Shariah, are much like those that must prevail in markets for goods and services. For example, in such markets the rules are intended to remove all factors inimical to justice in exchange and to yield prices that are considered fair and just. Prices are just or equitable not on any independent criterion of justice but because they are the result of bargaining between equal, informed, free, and responsible economic agents. To ensure justice in exchange, Shariah has provided a network of ethical and moral rules of behavior for all participants in the market and requires that these norms and rules be internalized and adhered to by all. Given that a proper securities underwriting function is performed by some institutions in the system (e.g. the banks), the firms could then directly raise the necessary funds for their investment projects from the stock market, which would provide them a second source of funding other than the banks.

If we assert that Islamic finance is all about risk sharing, then the first best instrument of risk sharing is a stock market, “which is arguably the most sophisticated market-based risk-sharing mechanism.”⁴ Developing an efficient stock market can effectively complement and supplement the existing and to-be-developed array of other Islamic finance instruments. It would provide the means for business and industry to raise long-term capital. A vibrant stock market would allow risk diversification necessary for management of aggregate and idiosyncratic risks. Such an active market would reduce the dominance of banks and debt financing where risks become concentrated and lead to system fragility.⁵

A stock market operating strictly in accordance with Islamic rules is envisioned to be one in which the disposal of investible funds is based on the profit prospects of enterprises, in which relative profit rates reflect the efficiencies between firms and in which profit rates (as signals coming from the goods market) are not distorted by market imperfections. Such a market might be expected to allocate investible funds strictly in accordance with expected investment yields (i.e., resources would be allocated in order to finance higher-return projects). Stock markets would also be capable of improving allocation of savings by accumulating and disseminating vital information in order to facilitate comparisons between all available opportunities, thus reflecting the general efficiency in resource allocation expected from a system that operates primarily on the basis of investment productivity.

Securitized—Asset-Linked Securities—Markets

In addition to the standard stock market, there is another capital market that provides a platform for structuring and trading asset-linked securities. The notion in Islamic finance of binding capital and financing closely and tightly to the real asset that is financed encourages the issuance of marketable securities against such portfolios of assets.

Securitization involves the collection of homogeneous assets with a known stream of cash flows into a pool, or portfolio, which is independent from the creditworthiness of the financier. This pool or portfolio of assets is used to issue securities, which can be marketed to different classes of investors. The securities are structured in such a way that all payoffs in terms of risks and returns are passed through to investors or holders of the securities. As a result, this is similar to a direct ownership by the investor in the underlying assets; he or she shares the returns from the assets and is exposed to all associated risks. The securities can be traded on organized exchanges or over the counter.

The main structural difference between the Islamic securitization process and that of conventional securitization is, however, the way in which returns and risks are shared with investors; in the conventional system, the buyer and the holder of the security is exposed to a number of risks that are passed on to him or her (including credit risk, market risk, and interest rate risk,) but he or she enjoys some protection given by the underlying assets that “back” the security (“asset-backed security”). This structure does not transfer any rights or control or ownership over these assets to investors. The function of the asset backing is credit enhancement: In the case of a default, the assets will be seized and the proceeds from foreclosure will be used to repay investors.

In contrast, the Islamic finance structure suggests the establishment of a link between the security ownership and payoffs and the underlying assets. This “asset-linked” structure leads to (1) an ownership interest by investors (i.e., Islamic bank) in the underlying asset and (2) uncertainties in the security's cash flows to investors. Investors' returns will depend on the performance of the underlying asset. The repayment of principal will not be necessarily guaranteed but would be limited to the market value of the asset at the time of repayment. Additionally, the holder of the security establishes an ownership claim against underlying assets (whereas in a conventional securitization structure, the holder of a security establishes a claim against a pool of assets).⁶

Figure 8.1 depicts a simplified model of securitization as used in a ijarah-based securitization, which is commonly known as sakk (certificate of ownership). The core legal entity in the securitization is a special-purpose mudarabah (SPM) or special-purpose vehicle (SPV), which is bankruptcy remote and has Shariah-compliant assets on the asset side against liabilities of sukuk or marketable securities. Although fund mobilization, pooling of assets, setting up of SPMs or SPVs, placement, and servicing are structured similar to those of conventional securitization, credit enhancement, which gives the certificates an investment grade rating, is complex to replicate. It is difficult to provide financial guarantees and credit enhancement because Islamic finance is risk sharing and passing through the return on assets to investors. This is particularly critical in the case where the underlying assets are exposed to high risk, similar to that of microfinance portfolios.

Table 8.2 shows the main differences between conventional and Shariah-compliant securitized assets. The comparison is with a conceptual view of Shariah-compliant securitization and may be different from the actual securitized product practiced in the market. In a conventional asset-backed or mortgage-backed security, the typical pricing model uses variables such as the probability of prepayment or refinancing, which depends on the expected interest rate levels in the future, the loan-to-debt ratio, the credit score of the borrower, and other considerations. Since the principal of the security is guaranteed through credit-enhancing mechanisms, the security is priced in the same way as a coupon-bearing debt security with an early prepayment option.

In the case of an Islamic security, however, the price will depend on variables determining the expected periodic cash flows in the future. In addition, it will have to take into consideration the expectation of future market values or the residual values of the underlying assets. In the absence of any guarantee of the principal, the redemption value of the security will depend on the expected market value of the asset at the time of maturity of the security. Another factor that influences the pricing of an Islamic security is the underlying risk-sharing agreement. In an asset-linked security, the price of the security will also incorporate the riskiness of the underlying assets, and investors will be sharing the risk through fluctuations in the price of the security. Investors will be exposed to the risks associated with the portfolio of assets and will share the losses. This will put greater emphasis on the need for prudent selection of the underlying assets and close monitoring of the assets' performance, and should motivate securitization specialists to structure good-quality securities that offer valuable and secure investment opportunities.

Principal–agent problems are treated in a different way in the Islamic system. In a conventional securitization, securitization can create considerable agency costs if agents (borrowers, originators, issuers, arrangers, investors, servicers, credit-rating agencies, and third-party guarantors) are tempted to pursue their own economic interests. For example, uncertainty about the future value of the securitized assets could lead to moral hazard by originators if default risk is completely passed on to the investors. The advantage of the originator with regard to information about the quality of borrowers and the historical performance of individual asset exposures could also give rise to adverse selection when security selection favors the originator rather than the investor. In a Shariah-compliant securitization, moral hazard should be minimized by Shariah-compliant contract structures. For example, the musharakah arrangement with predetermined profit-loss-sharing ratios aims to regulate incentive structures.⁷ Additionally, Shariah requirements to maintain high moral values and ethics by the stakeholder would discourage practices such as predatory lending or walking away.