Cost hike for Islamic banks

by **Cals** Mon 07 Apr 2014, 01:32

Published: Saturday April 5, 2014 MYT 12:00:00 AM
Updated: Saturday April 5, 2014 MYT 10:29:58 AM
[size=40]Cost hike for Islamic banks
BY DALJIT DHESI[/size]
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Islamic banks are said to be already taking steps to convert their existing mudarabah deposits into either commodity murabahah or wadiah deposits in compliance with the IFSA.
ISLAMIC banks could experience a potential spike in operating costs and see further pressure on net interest margins (NIM) once they comply with Bank Negara’s move to reclassify Islamic deposits as either principal guaranteed or investment accounts.
Islamic banks or conventional banks with Islamic banking subsidiaries are given until June 30 next year to comply with this requirement under the Islamic Financial Services Act (IFSA) 2013.
This means that products with mudarabah (profit sharing) or wakalah (agency) features are considered investment accounts and are not-principal guaranteed and hence not protected by the Malaysia Deposit Insurance Corp (PIDM)
The classification aims to provide greater legal clarity on the types of syariah financial contracts. Customers will have a choice and will be able to differentiate between products that are principal guaranteed and those which are not that provide potentially higher risk returns like mudarabah.

Mudarabah is a contract between a depositor and an entrepreneur (bank), whereby the latter can mobilise funds for its business activity. Any profits made between the two will be shared according to an agreed ratio while losses are borne solely by the depositor unless the bank is negligent.
Islamic deposits, on the other hand, like wadi’ah (custodian), qard (loan) and tawarruq (sale) are principal guaranteed. Currently, all Islamic deposits are protected by the Malaysia Deposit Insurance Corp (PIDM).
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About 50% of Islamic deposits in the banking system falls under the investment account category. Based on PIDM’s latest statistics for the assessment year in 2012, total insured deposits for the Islamic banking business totalled RM50.2bil, compared with RM40bil the previous year.
Although discussions on the reclassification are still ongoing with the central bank, banking analysts and players feels the likely one would be the conversion of investment-based mudarabah (profit sharing) accounts to commodity murabahah (cost plus). This will potentially lead to higher operating cost and further compress NIM for Islamic banks, according to analysts.
Under the commodity murabahah principle, the customer purchases an asset (commodity) from the vendor on a “cost-plus” mark-up basis where profit margin has to be agreed upfront.
In Malaysia under this principle, the banks use the funds received from depositors to buy commodities either from the London Metal Exchange (LME) or from Bursa Malaysia.
At this stage, banking analysts contacted by StarBizWeek agree that commodity murabahah is the most viable option. A banking analyst from MIDF Research says Islamic banks in his view are already taking steps to convert their existing mudarabah deposits into either commodity murabahah or wadiah (custodian /safekeeping) deposits in compliance with the IFSA.
The conversion, the analyst says, from mudarabah into commodity murabahah would attract transaction cost, adding that competition for the latter was expected to be more intense moving forward.
CIMB Research analyst Winson Ng says the reclassification will be detrimental to banks’ margins as banks earn smaller spreads from investment accounts than Islamic deposits. At this juncture, he says the research house is not able to quantify the impact as the percentage of Islamic deposits that will be reclassified as investment accounts is unclear, since it will be determined by depositors.
This, he notes, will add pressure to Islamic banks’ cost of funding and impact their NIM. Maybank IB Research in a recent note says that in view of the parallel banking system in the country, the conversion will mean that Islamic banks would have to compete even more aggressively with conventional banks for funds.
As for wadiah accounts, the restrictions on promotional activity and rate advertising may place Islamic banks at a disadvantage to conventional banks especially in terms of their current accounts-savings accounts gathering efforts.
Maybank Islamic, in responding to queries, says it will continue to offer mudharabah deposits alongside wadiah and commodity murabahah until June 2015. In line with IFSA, by June 2015, the bank says it will be introducing an investment account based on mudharabah structure that targets to give a more competitive rate to customers.
Meanwhile, Maybank IB research analyst Desmond Ch’ng says the most viable alternative at this stage after having spoken to several industry players was the conversion of mudarabah accounts to commodity murabahah.
Ch’ng in his recent report said the downside to commodity murabahah was that it was a slightly more expensive alternative to mudarabah as it involves a transaction fee of RM15 that would be levied on every RM1mil transaction on both the buy and sell side.
This, he says, would increase the operating costs to a bank that decides to pursue this route, noting that this transaction fee would be treated as an operating expense.
Additional operating costs could include issuing investment prospectuses and preparing regular updates on the performance of the assets if mudarabah accounts are converted to investment accounts.
At the same time, IT systems may have to be upgraded to ensure the proper tagging of assets to liabilities, and additional personnel may have to be employed to cope with the increase in transactional activity, Ch’ng says.
Industry observers concur that there will be opportunity costs if depositors decide to opt for conventional banks.
He says the financial impact would vary from bank to bank depending on the strategy adopted and frequency of deposit churned. Based on general parameters, he says he expects the additional transaction costs would average just about 5% of pre-tax profit for Islamic banks. Since these banks account for less than 16% of their respective financial groups earnings, the impact at group level is even more marginal, at below 1%.
However, he says the impact to BIMB Holdings would be larger since bank Islam accounts for 81% of group pre-tax profit.
Even so, Ch’ng feels the impact would still be manageable at just minus 4%.
Many analysts, however, feel that besides seeing NIM compression and hike in operating costs due to the reclassifaction and conversion, also agree that it could see a reduction in the size of bank balance sheet.
Commenting on this point, Ch’ng says if mudarabah/wakalah accounts are taken off-balance sheet, banks’ asset size will contract as these accounts makes up about 43% of total assets of Islamic banks.
However, he feels the impact is likely to be marginal if only restricted investment accounts (RIA) are taken off-balance sheet, for these make up a much smaller proportion of deposits.
He says whether an investment account has to be taken off-balance sheet or not has not been clearly spelt out yet by the central bank, adding that it could eventually depend on whether the account is a “restricted investment account (RIA)” or “unrestricted investment account (URIA)”.
RIA refers to a type of investment account where the investment account holder provides a specific investment mandate to the bank with regard to the purpose, asset class, economic sector and period of investment.
Whereas, URIA refers to a type of investment account where the investment account holder allows the bank to make the ultimate investment decision without specifying any particular restriction or condition.