Practical experience under different changing paradigms has led the Basel Committee on Banking Supervision to draft the second revision of the Basel Accord i.e. Basel III. This latest version of the Basel Accord has been evolved as a more stringent regulation to come into force phasing over the years from 2013 to 2019. This stringency has disqualified many a hybrid or derivative instrument for treatment as regulatory capital. As a result, although they were eligible under Basel I and Basel II, those derivative elements are now scheduled to be excluded from the purview of capital according to Basel III. At the same time, non-joint-stock company shares with comparable features are included in the same status of ordinary shares of a joint-stock company. Both these exclusion and inclusion are prescribed on the basis of the extent of capital-likeness of the concerned instrument.
But we observe that regarding capital and its adequacy, a significant component yet remains ignored or overlooked in the sight of the Basel Committee. Incidentally this component also relates to Islamic banking. In principle, Islamic banking possesses some exceptional traits which are quite different from those of its conventional peers. Those features logically deserve significance in respect of capital, its composition and adequacy as well.
As of today, be it considered nationally or globally, the banking industry cannot ignore the emerging discipline of Islamic banking. Therefore, calculation of capital, as long as its purpose to justify strength of a bank is concerned, must not ignore the reality of Islamic banking. At home, around 15 per cent to 20 per cent of both assets and liabilities sides of the consolidated affairs or Balance Sheet of the banking industry are covered under the umbrella of Islamic banking. Growth of Islamic banking and finance all over the world is tremendous, particularly for the last decade.
But the Basel Accord is yet to recognise the distinct characteristics of different aspects of Islamic banking. We feel that the reality must not be ignored. So is the specialty of Islamic banking. Mudaraba deposit, the substantial (±80 per cent) component of total deposit of any Islamic bank is, by nature, quite different from the deposit of a conventional bank.
Mudaraba principle of deposit implies that the bank receives deposits as Mudarib or manager of fund. The bank is authorised to invest such fund 'at the risk of the depositor'. Income/profit resulting from deployment of such deposits is shared between the bank and the depositor at a pre-agreed ratio. Loss, if any, not resulting from the negligence of the bank or any of its representatives, is exclusively borne by the Mudaraba depositors themselves.
Mudaraba deposits are neither like usual deposit liability of a conventional bank, nor are they shareholders' fund. But yet they possess many important features of capital. This is why Mudaraba deposit is rather called quasi-capital. Such a quasi-capital may easily be eligible for a secondary component of capital as a parameter of the strength of a bank. In terms of quality (of capital), Mudaraba deposit is far better than many items, which are still recognised as the components of capital in its different tiers even under most stringent Basel III.
Traditional scholars may not go deep into the matter above; but the concerned professionals including the banking regulators, auditors and rating agencies cannot but do so. In fact Mudaraba fund is by nature an equity. It has got loss-absorbing capacity, a vital characteristic of capital. This very character differentiates capital from debt. A Mudaraba deposit is neither secured nor guaranteed by the (Islamic) bank. These two features are very strong criteria of a capital instrument.
As a rationale to the proposition for recognising Mudaraba deposit, in the calculation of banks capital, reference may again be invited to some of the new provisions of Basel III as already stated above. This revision indicates that focal point in assessing the quality of an instrument (to be treated as capital) is nothing but the features or terms and conditions of deployment of money there against it. The inherent provisions of Mudaraba deposit naturally qualify the same as one of the components of equity or capital.
The very terminology of 'Mudaraba' itself denotes capital. In fact Mudaraba depositors make deployment of their fund in the business of the bank. No doubt, they invest in expectation of share of profit to be earned by the bank. But at the same time they agree to bear the entire of the genuine loss, if any. This provision of taking the risk of loss by the depositor is a sine qua non of any Mudaraba agreement. Such a provision is rather a divine mandatory stipulation of any Mudaraba deal.
Under Mudaraba principle, provider of fund and the manager of fund are mutually exclusive. One is absolute provider of fund and the other is absolutely the manager of fund. In Islamic banking, the status of Mudaraba depositors is the provider of fund; whereas bank is the exclusive manager of fund. As far as the Mudaraba principle is concerned, incurring a loss of money means loss of the money provider (depositors); but sharing of profit between the depositor and the fund manager (bank), is to be based on a pre-agreed income sharing ratio (ISR). This is why in some countries a Mudaraba deposit account is called profit-sharing investment account or PSIA. It is remarkable that they call Mudaraba deposit as investment account to differentiate the same from all other non-Mudaraba deposit accounts.
By definition the Mudaraba depositors bear their own commercial risk. In that case, for commercial risk, no separate room therefore is required in the capital structure of an Islamic bank. But such rooms are required rather for the following two other banking risks, beyond routine commercial risk of Mudaraba deposits:
Fiduciary or management delinquency risk: it is the risk to incur non-genuine loss i.e. loss resulting from the events like negligence, misconduct or breach of contract on the part of the bank. Mudaraba depositors by themselves are to bear commercial risk; but not the fiduciary risk. Therefore, in case of a loss, arising from fiduciary risk, the bank is to compensate the depositors. A bank is to do so because, after all, every bank is the symbol of the custodian or trustee of its depositors' fund. This symbol at least socially as well as ethically entails operational risk on the part of the banks. As such, Mudaraba deposit creates a silent fiduciary risk, which is virtually to be borne by the bank i.e. its shareholders.
Displaced commercial risk: it refers to an extra risk of a bank beyond the usual commercial risk. Business or commercial risk is borne by Mudaraba depositors but displaced commercial risk is not. Any loss arising from the displaced commercial risk, may virtually need to be shifted to the bank's own capital. Mudaraba depositors are entitled to the pre-agreed ratio of income (not any fixed amount or rate pre-fixed on the deposit itself) of the bank, be it more or less. Under Mudaraba contract, profit on deposit is dependent on the bank's income with a positive correlation between the two.
As such, usually higher income of the bank would fetch the depositors a higher profit and vice versa. It is true that by definition they are also to bear genuine loss (i.e. the commercial risk), if any. But practically, for reasons whatsoever, if actual rate of profit on the Mudaraba deposits becomes abnormally low (even on genuine ground), not to talk of loss, it may trigger chain withdrawals of Mudaraba funds.
Such a chain withdrawal may give rise to reputational risk for that specific bank and even systemic risk for the banking sector as a whole. To prevent any such untoward event, it might again be a silent compulsion, on the part of the bank, to pay the depositors higher than the actual (low) rate earned. Thus an endeavour may be inevitable to keep the profit rate on Mudaraba deposit around at par to the market. Such an implicit or implied obligation to balance or adjust the said shortfall is originated from displaced commercial risk. This shortfall amount necessary to make good or compensate, virtually tags this risk to banks capital. This hidden or silent compulsion virtually shifts the incidence of commercial risk of the Mudaraba depositors to the bank itself, in the guise of displaced commercial risk.
Besides these two specialised risks as stated above, there remain some other reasons for which routine capital requirement beyond Mudaraba deposit itself cannot be fully avoided. Those factors constrain Mudaraba deposit from its being best quality capital like ordinary shares. When it is compared to share capital, Mudaraba deposit lacks in some features, like perpetuity and subordination. This is why one cannot claim that Mudaraba deposit itself is as good as common stock or ordinary shares in all respect. So, for obvious reason, Mudaraba deposit must not be proposed to be included in the predominant core share capital. Rather such a deposit qualifies for supplementary or additional capital.
The writer is steering Islamic banking of Bank Asia Ltd. Opinions are his own and not of the or ganisation he is serving. email@example.com
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