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Operational Techniques of Islamic Bank
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SOURCES OF FUNDS
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The financial
resources of the Islamic banks consist of ordinary capital resources comprising
paid-up capital and reserves, and funds rose through borrowings from the central
bank and other banks (inter-bank borrowing), and issue of Islamic financial
instruments. The major part of their operational funds is, however, derived from
the different categories of deposits accepted on the Islamic principles of
Al-Wadiah (safe custodianship) and Mudaraba (trust financing). For
the sake of ease of understanding we call these two sources as ‘Primary’ and
‘Secondary’. These are discussed as under.
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PRIMARY SOURCES
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Paid-Up
Capital
Islamic banks
are public limited companies incorporated under the companies Act, which are
listed on the Stock Exchange. Individuals and institutions, local and foreign,
have subscribed their capital. For example, the First Islamic bank of Bangladesh
- Islami Bank Bangladesh Limited (IBBL)- is a joint venture of Bangladesh and
overseas capital in the ratio of 38:62. Its local capital is owned by the
Government of Bangladesh and private individuals and institutions. The overseas
capital (62%) of the bank is owned by the institutions and individuals as
follows.
i)
Islamic
Development Bank, Jeddah, Saudi
Arabia
ii)
Kuwait Finance
House, Kuwait
iii)
Bahrain Islamic
Bank, Bahrain
iv)
Jordan Islamic
Bank, Jordan
v)
Al-Rajhi Company
for Currency Exchange and Commerce, Saudi
Arabia
vi)
Dubai Islami
Bank, UAE
vii)
Islamid
Investment and Exchange Corporation, Qatar
viii) Ministry of
Awqaf and Islamic Affairs, Kuwait
ix)
The Public
Authority for Minor Affairs, Ministry of Justice,
Kuwait
x)
Public
Institution for Social Security,
Kuwait
xi)
Ahmed
Salah
Jamjoom, Saudi
Arabia
xii)
Fouad Abdul
Hameed
Al-Khateeb, Saudi
Arabia
xiii) Islamic Banking
System International holding S. A. Luxembarg
Similarly,
joint-venture Islamic banks have been established in quite a few other Islamic
countries like Egypt, Sudan, Senegal
and Turkey. The Islamic Development Bank has also participated in the share
capital (and represented in the Management Board) of a number of Islamic Banks
set up in the OIC member countries in order to promote Islamic financial
institutions.
The capital
resources of the Islamic banks are mobilized through the issue of shares for
which negotiable share certificate are used. With prior permission from the
Government, shares are issued from time to time. Laws governing the shares
correspond to the Musharaka laws of Shariah. The
holders of shares have management (voting) right and participate in the
profit/loss of the bank. The shares are transferable. In the case of the IBBL,
its entire capital is denominated in the local currency - i.e. Taka, though the
foreign shareholders had to pay for their shares in US Dollars.
The central bank
requires the Islamic banks to have and maintain capital funds, unimpaired by
losses or otherwise, in such proportion to such assets of their branches and
offices as may be prescribed from time to time by the central bank by notice in
writing. Capital funds mean paid-up capital and reserves and any other sources
of capital as may be defined and computed in such manner as may be prescribed by
notice in writing from time to time by the central bank. Banking rules of
Bangladesh require that the paid-up capital and reserves together must not be
less than 8-00 percent of the Islamic banks' risk weighted asset (total deposit
liabilities).
Reserves
The central bank
also requires that every Islamic bank shall maintain a reserve fund. Before any
dividend is declared, an Islamic bank shall transfer to the reserve fund out of
the net profits of each year, after due provision has been made for Zakat
and taxation, a certain percentage of the net profits in order to build up
adequate reserves. If the central bank is satisfied that the aggregate reserve
fund of an Islamic bank is adequate for its business, it may by order in writing
exempt the bank from this requirement for a period of one year. In Bangladesh,
the IBBL besides maintaining the statutory reserve, has built up an
Investment Loss Offsetting Reserve (ILOR) by appropriating 10 (ten)
percent of the bank's annual investment profits.
Liquid Assets
Every Islamic
bank is further required to keep at all times minimum amount of liquid assets
against its deposit liabilities expressed as certain percentage of the deposits,
as may be prescribed from time to time by notice in writing by the central bank.
For this purpose, liquid assets mean (i) cash in bank, (ii) balances with the
central bank/other designated banks, (iii) Government Investment Certificates,
and (iv) such other assets as may be approved by the central bank. Failure to
keep the minimum liquid assets invokes penalty for each day of deficiency.
Borrowing From
Central Bank
To tide over
temporary liquidity shortages Islamic banks, as member banks, are entitled to
borrow from the central bank, as the lender of last resort. In such cases, IBBL
does not pay interest like the conventional banks. Such borrowing from the
central bank is treated as a PLS deposit with the Islamic banks and profit is
paid at the rate payable on corresponding PLS deposit of the bank.
Inter-Bank
Borrowing
The Islamic
banks have established interest-free fund arrangements with local and foreign
banks on the basis of reciprocity. Normally, under prior arrangement, the
Islamic banks keep surplus funds with selected banks. When needed, these banks
also place interest-free compensating balance with the Islamic bank. If balances
are not equal, then periods for which funds placed are
adjusted.
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SECONDARY SOURCES
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( MOBILIZATION OF DEPOSITS )
Like
interest-based conventional banks, the main function of Islamic banks is to
mobilize savings and provide financial support to the entrepreneurs. Yet there
are differences in techniques applied in the process of savings mobilization and
financing investment by the two banking systems. Depositors receive interest in
a predetermined rate for their deposits made with an interest-based bank.
Similarly, the investors are to pay a predetermined rate of interest to the
bank. The technique, thus, involves each and every partner in the transaction
process (i.e. the depositor, the investor and the bank) with the element of
interest. Islamic bank, on the other hand, neither pays nor receives interest
from any of its transactions thereby saving everybody from the curse of
interest.
Islam
disapproves hoarding of savings and encourages its productive investment (Chapra
1985). It puts emphasis on savings and the productive use of savings. Thus, the
bank assembles the small deposits and savings of individuals into a common pool
and makes these deposits available for large investment opportunities, ensuring
the productive use of society’s savings.
Islamic banking
is a response to such exigencies. It mobilizes savings of the common people in
line with Islamic Shariah. Techniques employed by Islamic banks for
saving mobilization are as follows.
Al-Wadiah
Account
Islamic banks
receive deposits in their Al-Wadiah account. This account is similar to
the demand deposit account of interest-based banks. Conventional interest-based
banks do not pay interest on this type of deposit account. In addition,
depositors may withdraw all or a part of the funds deposited in this account
without restriction. The term Al-Wadiah means deposit of money allowing
somebody to claim the funds in the account. The bank as trustee preserves and
safe keeps the funds deposited. Thus, depositors feel safe keeping their money
with the bank because the bank provides assurance of returning their money on
demand.
When an
individual opens an Al-Wadiah account, he agrees to allow the bank to
lend these funds to entrepreneurs seeking financing for their products or
activities. In addition, the depositor understands that the bank may earn a
profit from its lending activity. However, any losses incurred from this
investment activity are totally borne by the bank. The depositor is not liable
for any losses incurred from this lending activity.
As the
depositors do not take the risk of losses with Al-Wadiah accounts, they
are not entitled to any profit from the use of their deposits by investors. On
the other hand, the bank is entitled to all of the profits, if any, as the bank
bears all of the risk.
Depositors are
provided with a checkbook. They can withdraw any amount up to the balance at any
time. The bank may charge a fee on the account to cover transaction
costs. Al-Wadiah Deposits are short-term funds. Due to the
liquidity to the depositor, they are not a reliable source of deposits to the
banks. Thus, banks have to be very careful as to what type of projects is
financed.
General
Mudaraba Account
Interest-based
banks receive deposits from clients in return for being paid a fixed interest
rate. These deposits are considered to be a loan from the depositors and, thus
banks must pay a predetermined rate of interest based upon the daily average
balance. So, under the interest-based banking system, the relationship between
the bank and its depositors is essentially that of a debtor and creditor. In the
case of checking deposits, depositors are provided with a checkbook. In most
cases, a depositor may withdraw all or part of the funds on deposit at any
time. In some instances, depending on the type of account, notice may need
to be provided to the bank for a withdrawal of money exceeding a specified
amount.
The
Mudaraba account of Islamic banks is different from the checking account
of an interest-based bank. Mudaraba is a form of business contract where
one party supplies money and the other manages the business by investing labor
and time. Profits generated from the venture are shared by both in a proportion
agreed upon at the time of contract. However, in this arrangement, the financier
is solely responsible for any loss that may be incurred. The financier of the
business is known as Sahib al Mal, Rabbul Mal or owner of the capital and
the manager of the business is called Mudarib or entrepreneur.
Banks receive
deposits in a Mudaraba account on the basis of a Mudaraba
contract. Generally the Mudaraba account is not for any specific
duration. Funds deposited in the Mudaraba account may only be invested in
Shariah approved ventures through the application of a legitimate Islamic
method of financing. This is why these deposit accounts are given the title
Mudaraba deposits. Specifically, in this transaction, the depositor is
the sahib al mal and the bank is the Mudarib. As mentioned above,
profit sharing percentages are determined at the inception of the
contract. It is not uncommon for the profits generated by the investment
to be distributed such that the Sahib al Mal would receive 50 to 75
percent of the profit and the bank would receive the difference. Islamic banks
cannot reduce the ratio of the sahib al mal, but it can reduce its own
share and increase the share of the sahib al mal, if it wishes. Here the
relationship between the bank and the depositor is shareholder and not a
debtor-creditor relationship as before.
Islamic banks
receive deposits in Mudaraba accounts that are invested into business
ventures by the bank directly or through some other third party. Any profit
earned from these investments is distributed among the Mudaraba
depositors at a predetermined percentage and the bank retains the residual
amount as its profit. In the event no profits are earned, the depositors receive
nothing for their deposit. In addition, should a loss be incurred, the
Mudaraba depositors are liable to share in the losses in the
proportionate share of their deposits. However, if the loss incurred is due to
the fault, negligence or non-adherence of bank rules on behalf of the bank or
bank personnel, liability of loss is the banks sole responsibility.
Thus, unlike the
deposits in the interest based system where the interest rate return is known
with certainty, the returns in a Mudaraba account are uncertain.
The only thing that is known with certainty is that the depositor will share
proportionately in the profits and losses of the lending or investing activities
of the bank. In the end, the depositor can withdraw the balance in the
account plus or minus any profits or losses incurred from the loans.
It may further
be mentioned for the sake of clarity that Mudaraba depositors, in spite
of being partners in the profits and losses, are not partners in the total
profits and losses as in the case of bank shareholders. Rather, they are
entitled to share in the profits or losses from the bank’s lending activity in
the proportion they actually have on deposit in the Mudaraba account.
Some experts have recommended establishing a loss-offsetting fund in order to
ensure that the money deposited by Mudaraba depositors is not reduced or
exhausted by investments or loans that do not perform well (Ibid, p.44). This
would be accomplished by depositing a percent of profits (5% or 10%) from
favorable business transactions into a loss offsetting reserve account.
The loss offsetting reserve account would then be used to reimburse
Mudaraba depositors for any losses due to unfavorable business
deals.
It should be
noted that Mudaraba depositors do not share in the other sources of
income to the bank such as profits from Al-Wadiah accounts, service
charges, commissions, and other forms of income etc. Likewise, they are not
liable for any losses or expenses incurred by these other banking activities
either.
It is important
to note that the bank is not entitled to wages, allowances or any other kind of
remuneration for their time and labor spent in managing the funds deposited
under Mudaraba accounts. However, they are entitled to reimbursement for
normal and essential expenses associated with the managing of Mudaraba
deposits.
Islamic banks
distribute profit among the Mudaraba depositors on the basis of the
average amount of money available in each depositor's account for a specific
period of time such as one month, three months, six months or one year,
depending on the contract.
General
Mudaraba depositors are provided with passbooks and checkbooks. However,
since the bank distributes profits to the deposit account holders, it has some
regulatory control over the liquidity of the account. For example, the bank may
limit the number of withdrawals allowed. The bank may require prior advance
notice before withdrawing money from the account, and the bank may have a
minimum required balance restriction on the account. Non-adherence to these
conditions may result in the forfeiture of any profits. In addition, the bank
may appropriate miscellaneous expenses to the accounts of those depositors who
do not follow the account restrictions. Of course, this can only happen if the
agreement includes clauses containing such restrictions. As per
Shariah rules, Mudaraba depositors cannot interfere in the
activities of the bank and they do not have the right to take part in the
management of the bank.
Term
Mudaraba Account
Interest-based
banks receive different kinds of Term Deposits from the depositors. The deposits
are generally for 3 months, 6 months, 9 months, one year, 2 years, or 3 years,
and the bank pays a stated interest rate on each of these deposits, which varies
depending on the term. In general, the bank pays a higher rate of
interest the longer the term of the deposit and lower rates for shorter time
periods. In addition, a higher rate of interest is generally paid on term
deposits than on saving deposits. Depositors are not generally allowed to
withdraw money from a term deposit until the term matures. Premature withdrawal
may result in penalties in excess of the interest earned, resulting in a
negative return. Once a time deposit matures, the depositor may wish to reinvest
for a new term. Term deposit arrangements under conventional banks result in a
debtor-creditor relation as in the case of saving deposits. The bank receives
deposits in exchange for a fixed rate of interest for a specific period of time.
The depositors are not provided with checkbooks on term deposit accounts, but
they are given term deposit certificates and as mentioned above, are paid a
higher interest rate.
Islamic banks
also receive term deposit from their clients. The term deposit is, of course,
altogether different from that of the interest-based banks. Fixed term deposits
received by Islamic banks are called "Term Mudaraba Deposits".
Generally an Islamic bank receives these types of deposits for a minimum period
of 3 months to 3 years at the maximum. The bank invests the money, and shares
any profits with the depositor based upon a percentage agreed upon at the time
of contract. In the event a loss in incurred, depositors share the loss in
proportion to the deposit in their account. At the end of the term the contract
terminates and the depositors withdraw their money, plus or minus any gains or
losses. The depositors, if they like, can again deposit their money for a new
term under a new contract. No checkbook is issued against a Term Mudaraba
Deposit, however, Term Mudaraba Certificate is provided to the
depositor.
Since the term
Mudaraba deposit has restrictions on the withdrawals, the bank can invest
the money in projects that match the term without concerns of
liquidity. In exchange for this benefit, the bank offers higher rate of
profit to a Term Mudaraba Deposit than that offered on a General
Mudaraba Deposit. In fact, the longer the term deposit, the higher the
profit sharing percentage and vice versa.
Therefore, the
basic difference between a term Mudaraba account and a general
Mudaraba account is the specified term of the deposit. In other words,
there is no specific duration or term for a general Mudaraba account,
whereas the term Mudaraba deposit does have specific stated duration or
term.
Special
Mudaraba Account
When an Islamic
bank receives a Mudaraba deposit for investment in some specific
business, sector, or project, the deposit is called a "Special Mudaraba
Deposit". In this case, an Islamic bank, while receiving deposits, comes to an
agreement with the depositors that the money to be received will be invested in
some specific business such as the fertilizer or salt business; or in some
specific sector like the industrial sector, textile sector, export-import
sector; or in some specific investment sector of the bank such as real estate,
shipping or a special project. Profits earned from these types of specific
projects are distributed between the bank and the Special Mudaraba
depositors based a previously agreed to percentage. As before, in the event of a
loss, the depositors share the loss in an amount proportional to their deposits
in the account.
Special
Mudaraba depositors will share only in the profit and loss of those
particular businesses, sectors or projects for which they have deposited their
money. They are not impacted by profits or losses from the other operations or
projects in the general Mudaraba accounts.
In summary,
there are three types of Mudaraba accounts. First, is the General
Mudaraba account, which does not have a specified term and is not
restricted to being invested in specific project. In addition, deposits may be
taken out of the General Mudaraba account on relatively short notice. A
second type of account is the Term Mudaraba account. Just as the name
suggests, this account is a time like deposits with a specified maturity, but is
similar to the General account in that it is not restricted to specific
projects. Third, is the Special Mudaraba account. These accounts can
either be readily liquid like the General accounts or fixed for a specific term
like the Term accounts. In addition, these accounts are invested into specific
projects or industry, which is stipulated in the contract.
REFERENCES
1.
Chapra, M.U.
(1985): Towards a Just Monetary System, published by Islamic Foundation,
London,
UK.
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PROJECT SELECTION CRITERIA
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1.
WHAT IS A PROJECT?
An industrial project is a proposal
for investing resources to develop facilities for the production of goods and
services in a systematic manner. A project, whether a new venture or an
expansion of the existing facility, is undertaken by entrepreneurs for the
purpose of earning profit. The project proposal is prepared by the entrepreneur
and submitted to the bank for financial assistance and support. As the bank's
interest is linked with the earnings capability of the enterprise, it has to
judge the worthiness or suitability of the project by applying suitable
appraisal criteria. Any failure on the part of the bank to assess the soundness
of the project would seriously affect the profitability of the enterprise. A
project can be considered viable if it satisfies the various aspects of the
appraisal criteria. The important criteria are discussed in Section 3
below.
2.
CHARACTERISTICS OF A SOUND PROJECT
A sound
industrial project apart from being technically and economically sound should be
capable of producing early profits for both investors and the economy. They
should also fit in with the long-term economic objectives of the country. The
following are the general characteristics of a sound project:
a)
Readiness of a
market
b)
Advantage in
production costs compared to foreign or domestic competitors
c)
Long-term value
to the economy.
Generally, a
technically and economically viable project with a ready market and inherent
cost advantage will have a prospect of high commercial profitability to attract
investors. Such a project is difficult to find but can be identified if value of
the project is judged by adopting scientific criteria. The major criteria for
judging the value of a project are factor intensity, the plant size and
complexity, foreign exchange benefits commercial profitability and natural
economic criteria. Though these criteria are valuable tools for selecting a
project, other non-measurable factors like politics, institutions, attitudes,
social customs and the belief climate are also important.
Project
appraisal provides a rational basis for determining if a project is viable.
Appraisal involves detailed investigation into the various aspects of the
project. The purpose is to find out whether the project is technically,
economically, financially, commercially and managerially sound. The tasks of
project appraisal involves determining whether technical investigation, analysis
design have been adequate, whether economic study, commercial and financial
study have been well done, whether financial structure is sound and whether
entrepreneurial and managerial capability of the sponsors are adequate. It also
involves evaluating the value of the project to the national economy. There are
no standard criteria for project appraisal. Each agency has its own standards.
Its objective is to determine whether those standards are met by the project.
Islamic banks may develop their own standard project appraisal criteria keeping
in view the Islamic principles. The viability of the project should be judged by
examining the project in the following aspects.
3. CRITERIA FOR
SELECTING A PROJECT
3.1 Technical
Criteria
The purpose of
technical criteria is to examine whether the project is viable with regard to
every engineering and technological aspect of the project’s specification and
process. The technical feasibility study of a project covers a wide range of
activities including a study of the availability cost, quality and accessibility
of all the goods and services needed to make the project a success. It includes
ensuring that the raw materials, supplies of fuel, power, water, land, labor,
and heavy equipment are available in abundance. Further technical study
would examine the purpose and design of the project, technology used in the
process of production, suitability of the machinery and equipment, availability
of technical services and methods of quality control, schedule of
implementations and sequence of balanced development of all related technical
factors. A well-qualified engineer capable to assess the technical soundness of
the project has to be appointed by the bank to review the plans to undertake the
job. The technical report on the project should clearly show the appropriateness
of the technology used in the production process and operation and its fitness
in the coming several years. Any technological advances taking place in
the industry that might affect the technical and commercial soundness of the
project should be indicated in the technical report of the project. As far as
machinery and equipment are concerned the appraiser should particularly examine
their detail specification like the year of manufacturing, materials used in
it’s manufacture, life of the machine, availability of spare parts, and
prospects of replacement, to ensure the quality of the machinery and equipment
is up to standard.
3.2 Economic
Criteria
Economic study
of a project begins with a thorough analysis of the market for the product to be
made or sold. Obviously no project can be a success unless there is market for
its product. In a market study, it is necessary to find out the answers of three
questions: (a) How big is the market? (b) To what extent it is
likely to grow? and (c) How much of it can the project capture? To
get the answers of these questions, the researcher must examine import
statistics, which include domestic production of the item and the potential for
growth in demand for the product. The critical factor in demand and market
analysis is an estimate of the demand for specific product during the life of
the proposed project. The size of demand, at any given point, is a function of
several variable factors such as the composition of the market, the competition
from the other sources of supply of the same product, the possibility of
substitute products, income and price elasticity of demand, market responses to
socio-economic patterns, distributive channels and consumption growth levels.
Thus, while preparing the market report the analyst must carefully analyze these
variables. Any mistake in the projection of demand may result in either excess
production capacity or poor capacity utilization. In addition to these, the
techniques used for market penetration as well as sales promotion methods should
be examined carefully, so that actual sales do not fall short of the target.
3.3 Commercial
Criteria
The importance
of assessing commercial viability of a project cannot be over emphasized,
regardless of whether the project is a new one or an expansion of an existing
business. The commercial viability is measured by determining the profitability
of the project. Profitability indicates public acceptance of the product and
shows that the enterprise can produce competitively. Profits provide the money
for repaying the debt incurred to finance the project and are the source for
internal financing of expansion.
The commercial
viability of the project can be determined by estimating sales revenue,
operating cost and profit margin at a given level of production and under a
given set of operating conditions. In addition, the analyst should do a
pro-forma analysis of the cost of production and profitability taking into
consideration capacity of the entire plant, product mix, selling price, unit
cost of production as well. The elements of costs covered in this computation
are the direct costs including raw materials, chemicals, components, power, and
labor. Repairs and maintenance, plant overhead, administrative expenses,
packaging cost, sales expenses, financial expenses, and depreciation costs are
also important elements of the cost of production. The analyst is to examine
each element of the cost of production as well as the soundness of the sales
forecast and selling price in determining the profitability of the enterprise.
3.4 Financial
Criteria
The
acceptability of the project to the bank is also dependent on the financial
viability of the project. The financial study involves the analysis of capital
structure, working capital financing plan, cash flow potential and
profitability. Detailed analysis of proposed financial statements (Balance
Sheet, Profit & Loss A/C) provide a useful indication for assessing the
financial viability. In addition, calculating the usual financial ratios,
debt-service coverage, fixed assets coverage, break-even analysis, return of
investment, internal rate of return (IRR) should be examined carefully. The
return on investment should be satisfactory compared to the opportunity cost of
capital. The internal rate of return should be acceptable to the bank.
3.5
Entrepreneurial Capability Criteria
Assessing
entrepreneurial capability of the sponsor is crucially important to the
financial institution as the success of the enterprise lies on his capability.
The essential entrepreneurial qualities for starting and running an enterprise
consist of self-confidence, ability to sense new ideas and translate them into
realities, innovative and creative risk taking ability resourcefulness,
profit-oriented, future oriented, hard working individuals with initiative,
drive and compassion. He should also be capable of planning and managing the
enterprise successfully. It is very difficult to assess the enterprising
qualities of the sponsor, as there is no standard criteria to assess the
enterprising quality.
The evaluation
of the entrepreneur should not be limited to assessing the above entrepreneurial
qualities, but also to identify that the entrepreneur has a continuous strive
for perfection in the industrial activities undertaken by him. Proper evaluation
of entrepreneurs may help ensure a self-sustaining enterprise. In a developing
country where financial assistance is easily available to setting up new
enterprises, there is an inherent risk that unless enough precautions are taken
such concessions might encourage dependence on promotional agencies. While
evaluating potential entrepreneurs, care should be taken to select those
promoters who would not be satisfied with just setting up their own industries,
but will collaborate in developing a self-sustained system which will help to
further industrial growth of the economy. Managerial ability of the entrepreneur
should also be carefully evaluated, as the key factor for successful business
operation is the managerial efficiency.
Currently
there is no formal analysis put into the evaluation of the entrepreneur at most
financial institutions. In order to evaluate the entrepreneurial capability of
the sponsor, a bank must develop expertise in this area. One must be equipped
with the required knowledge and techniques of evaluating entrepreneurs. The
capacity to access entrepreneurial capability can be gained through years of
experience of interviewing candidates. One must also have a clear understanding
of the methods to be adopted, the characteristic traits and dimensions to be
evaluated and the limitations of the techniques. A checklist may also be used to
assess the essential qualities of potential entrepreneurs. In addition, modern
methods of identifying the managerial qualities and risk taking ability of the
entrepreneur should also be used.
3.6 Managerial
Criteria
Assessment of
managerial capability of the sponsor is crucially important for any financial
institutions before agreeing to finance a project. Many enterprises fail
due to the lack of managerial skills. Therefore, it is very important to assess
the managerial capability of the entrepreneur. If the entrepreneur does
not posses managerial competence to run the enterprise, he may employ
professional managers. Like entrepreneurial skills, there is no standard
criteria to assess managerial ability of the borrower. The managerial capability
of the entrepreneur/managers can be assessed by studying the past experience,
educational background, specialized training, planning ability, decision making
strength, and leadership quality. Managerial competence can also be measured
through interview techniques, and understanding his capability with regard to
planning orientation and management techniques. In order to assess the planning
orientations, a series of questions with regard to his choice of the business,
process and production technology may be asked. The objective is to ensure that
the candidate has the required knowledge and skills to manage the enterprise.
3.7 Security
Criteria
Every financial
institution places emphasis on this aspect of the project appraisal process. The
security coverage may be given by mortgaging fixed assets and freehold property,
hypothetical pledge of machinery and equipment, personal guarantee of the
sponsors and comprehensive insurance coverage on the project’s assets and goods.
It is essential to examine the title of the property and authenticity of the
assets very carefully. While emphasis is placed here, it has been observed that
the security coverage on a project is not an effective tool for recovering the
investment. In addition, security requirements prevents a good number of
emerging entrepreneurs from seeking assistance from the bank. Strict collateral
requirements are not compatible with the goal of promoting entrepreneurship by
the bank. The time has come for banks to find a compromise with regard to the
collateral issue. Perhaps the introduction of a credit guarantee, or personal
guarantee may be a solution step to the problem arising out of collateral issue.
3.8 Benefit of
National Economy Criteria
The suitability
of the project can be judged by ascertaining its contribution to employment
generation, value added to the economy, import substitution and the promotion of
backward and forward linkage industries. The starting point for measuring
national economic profitability is the calculation of commercial profitability.
To estimate the economic profitability, a series of adjustments are made in the
commercial cost and revenue estimates. The adjustments can be classified into
three groups:
(a) Adjustments to
estimated operating cost items in which the real cost of the economy are either
greater or less than the cost to the enterprise.
(b) Adjustments to
estimated operating income items in which the real benefit to the economy is
either greater or less than to the enterprise.
(c) Adjustments to
estimated net operating income of the project to reflect measurable economic
costs or benefits to the economy and from those that would affect the project as
a commercial enterprise.
A project with
high material economic profitability and low commercial profitability may be
considered for financial assistance if such project warrants subsidy and special
incentives from the government.
The overall
decision on financing a project is the combined result of several sub-decisions
made at various stages of project appraisal. The appraisal report on various
aspects of the project provides a guideline for management who must ultimately
decide the enterprise for financial assistance. If the bank has not yet
developed a team of expertise to appraise the project, assistance from external
competent experts may be sought to undertake this job.
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DISCOUNTING TECHNIQUES
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1. MEANING OF
DISCOUNTING TECHNIQUE
Discounting
techniques are one of the most important and meaningful tools for financial
decision-making. They are of utmost importance in making a time-adjusted
ascertainment of the cash flows that are expected to be generated over a period
of time. These techniques have far reaching implications for present day
investors in their efforts to make sound financial decisions. Islamic banking
being one of the important constituents in the total financial setup of our
country must take into consideration the applicability of discounting techniques
to its various modes of financing. Discounting techniques are important
parameters in evaluating the feasibility of a project and no meaningful capital
valuation or financial analysis can be done without them.
Discounting
techniques basically consider what is called in financial jargon "the time value
of money". It takes into account the impact time has on the real value of money
because of each cash flow is being generated/invested at different periods. This
analysis is achieved by discounting the expected future cash flows with the help
of a suitable rate, which is called the "discount rate or time preference rate".
The application of this rate provides an investor with a sound basis as to
whether to accept or reject a project. This is made possible by converting all
the expected future cash flows into a present value with the help of discounting
techniques, and comparing the expected outcome with the cost. Thus, if the
present value of the expected outcome were greater than or less than the cost,
the investor would decide to accept or reject the project respectively.
2. DISCOUNTING
TECHNIQUES
There are two
discounting methods that fully recognize the timing of cash flows. The methods
are: Net present value and internal rate of return. These are discussed as
under.
2.1 Net Present
Value (NPV) Technique
Under the NPV
technique the present value of both cash inflows and outflows of a
project/investment are calculated by discounting the expected cash flows using
an appropriate discount rate/time preference rate. The NPV of the project is
then determined by subtracting the present value of cash outflows from the
present value of cash inflows. Only project/investment proposals yielding a
positive NPV are accepted.
The equation for
NPV assuming that all investments (cash outflows) have been made in the initial
year would be:
NPV
= [D1/ (1+ r) + D2/(1 + r) 2 +
D3/(1 + r) 3 + ......... + Dn/ (1
+ r) n ] - A
Where, D1,
D2, D3, ......Dn = Expected Cash
Inflows
r = Cost of Capital/Discount Rate/Time Preference Rate
A = Cost of the proposed Investment/Cash Outflows
n = Expected life of the project/investment.
In the above
equation, the discount rate is assumed to be known in order that the NPV can be
calculated.
2.2 Internal Rate of
Return (IRR) Technique
The IRR is
another discounted cash flow technique that considers both the amount and timing
of cash flows. The IRR is defined as the rate that equates the present value of
cash inflows with the present value of cash outflows of a project/investment
proposal. In other words, it is that discount which yields a NPV of zero for a
project. It is called the internal rate as it depends solely on the outlay and
proceeds associated with the project and not on any rate determined outside the
project/investment. The IRR can be determined by solving the following equation
for ‘r’:
A = [D1/ (1+r) + D2/(1 + r) 2 +
D3/(1 + r) 3 + ......... +
Dn/ (1 + r) n ]
or
A - [D1/
(1+r) + D2/(1 + r) 2 + D3/(1
+ r) 3 + ........ + Dn/ (1 + r) n ] =
0
For capital
valuation models in an Islamic economy vis-a-vis Islamic banking, the
discounting rate is given below:
P = r +
aY
Where, P =
Discounting Rate
r
= The required rate of return identified as the marginal efficiency of
Investment
Y = The
percentage share of risk-bearing by the entrepreneurs
a =
Suitable percentage representing the relative cost of production or investment
for the
enterprise.
3. IMPORTANCE OF
DISCOUNTING TECHNIQUES IN ISLAMIC BANKING
Islam forbids
interest/Riba, but permits trade that inevitably assumes risk in the
future. On the other hand, Islamic economic activities contribute to bringing
about "Economic and non-economic" returns for the entrepreneur as well as to
society. Therefore, any investment under Islamic principals should seek present
welfare derived through employment, higher present earnings for the community
and a reasonable return to the entrepreneur himself. The point to be examined
here is what could be the relationship between risk and Islamic return (both
economic and non-economic). In an Islamic economy the bank and its client
jointly share the price of risk. The sharing of profits and losses are
undertaken by both the Islamic bank and the clients. Under the Islamic framework
a project with a low expected return may be accepted if the non-economic/social
components of the project are significant. The profit earned or the loss
incurred are shared by the partners on a mutually agreed upon proportion under
the different Islamic modes of Financing. Unlike the conventional means of
project financing, where the bank-creditor is assured of a predetermined return
in the form of interest payment, the Islamic banks share with their clients both
the return and the risk that a project entails. Therefore, when the risks and
returns are jointly shared by the partners, it is more important that the
project be evaluated as realistically as possible as the interest of both the
bank and its client are at stake. No realistic and sound financial evaluation of
a project would be possible without considering the time value of money. Thus,
Islamic banks employ the above discounting techniques in order to determine the
feasibility of the project by adjusting the expected return of the project for
the "time value difference". Without such adjustments, the project’s feasibility
studies would tend to completely overlook the difference in the real value of
money caused by the different times at which they are invested/generated.
Discount rates
are used to minimize risk for both the banker and the borrower by converting the
future cash flows (that are expected to be derived from a project) into
the present value and then comparing it to the cash outlays. The IRR discount
approach helps to enumerate a rate through a process of trial and error that
equalizes the cash inflows and outflows of a project. A project failing to
generate this rate of return cannot be considered to be economically profitable.
Therefore, the investors will reject such projects. However, one basic
difference that underlies the acceptability of such a project under the Islamic
system is that if the non-economic/social return of the project is significant,
then the Islamic bank and its partners (investors) would still accept the
project to ensure greater social well-being. Whatever may be the marginal
efficiency of capital in such projects, in an Islamic economy, the choice to the
investor is not between today’s and tomorrow's consumption but rather between
today's investment return and tomorrow's investment return. Therefore,
discounting techniques act as the stimulus to identify the real economic picture
of any project and make the entrepreneurs aware of the economic feasibility of
any investment. This aids in understanding the extent of risk assumed and ways
to minimize such risk.
There is no
direct relation between Riba and the discount rate. Discount techniques
are tools for ascertaining the profitability of a project and are used for
taking into account the time value of money and also the diminishing value of
cash flows over a period of time. While Riba/interest in Islam is a
forbidden means of profit generation, discounting techniques are acceptable as a
financial mechanism that is used for evaluating the acceptability of a project
from an investor's viewpoint.
4.
APPLICAIBILITY OF DISCOUNTING TECHNIQUES
In a pure
Islamic economy, there is no existence of inflation or devaluation of money over
time. On the other hand in a capitalist economy, inflation is an accepted-part
of the system. As the Islamic banks operate in such unfavorable monetary
arrangements, it must take into consideration the time value of money to develop
and practice pragmatic banking policies. The commonly accepted concepts of trade
discounts and cash discounts must be incorporated into the Islamic Banking
system to encourage early payment and to save the time value of money. As
Islamic banks share profits and losses with their clients in the business
ventures undertaken, they must give adequate emphasis to the time value of
money, which ultimately affects the profitability of the project. As such,
Islamic banks must employ discounting techniques to ascertain a more realistic
picture of the profitability of the proposed project.
The gamut of
financial activities falling within the purview of Islamic Banks encompasses a
broad horizon that includes equity, industry, commerce, agriculture, real
estate, housing, transport, and other service sectors. Islamic Banks support all
commercial activities based on the Islamic principles of Shariah. A close
look into the applicability of discounting techniques to the different modes of
financing under the Islamic System reveals its utility under such a system.
a)
Musharaka/Shirkat
Musharaka is a
partnership in which each equity contributor has a right to share in the profits
of the project. Here the Islamic bank and its client enter into a temporary
partnership for the purpose of investing in some project for a mutually agreed
period of time. Both parties contribute to the capital in the agreed upon
proportion and share profits or losses accordingly. The Bank usually does
not actively participate in the management, but does provide an overall
supervision of the business.
If such
partnerships are undertaken in the commercial sector, it can easily take
advantage of trade discounts, cash discounts, purchase discounts and other sales
discounts that may be available. Here, there is no need to use either the NPV or
IRR methods of discounting. However, if such partnerships are undertaken in the
industrial sectors, both NPV and IRR can be applied to forecast and identify the
cash flows that are expected to be generated over the projected life of the
project. Discounted Cash Flow Techniques can be of considerable help in
determining the feasibility and acceptability of the project by helping to
ascertain the present value of both cash inflows and outflows. Such
predetermined present values of cash flows provide a sound basis to judge the
profitability of project and helps the partners, the Islamic bank and its
client, to decide whether the proposed project would be financially beneficial
for both of them.
b)
Mudaraba
Under this
Islamic mode of financing, the bank provides all of the capital for the project
while the Mudarib (client) only puts contributes his efforts and skills.
Under this arrangement, the bank and the client share profits in a predetermined
ratio, but any loss is solely the responsibility of the bank unless the loss has
been caused by the negligence or willful act of the client. The discounting
techniques are applicable to Mudaraba in the same manner as that of
Musharaka.
c)
Murabaha
Murabaha is a system of
purchase and sales of goods by the bank. It is an ordinary contract of sales of
a commodity for a profit/markup above the original price at which the bank has
purchased the commodity. In such investments banks purchase and keep custody of
the goods until full payment has been made by the client. Under this system both
the bank and its customer (ultimate purchaser) should know the original purchase
price paid by the bank and also the profit made by the bank. No element of
interest may be included in the original purchase price. The Murabaha
sale is used to finance, both internal and external, trade operations of a
country. In the event that the client fails to make payment, the bank cancels
the contract and sells the goods purchased in the open market.
Murabaha is a purely
short-term commercial venture. The bank usually purchases the commodity by
making cash payment and it is seldom a credit transaction. Because of the nature
of payment, the bank may get a trade discount that reduces the purchase price.
As mentioned above, the goods are delivered to the client after full payment of
the purchase price has been made. Since payment may be made in installments, the
bank may offer cash discounts to the clients to encourage early payment. Apart
from this consideration, the question of time value of money is not really a
concern here as it is basically a short-term investment made by an Islamic
bank.
d)
Bai-Muajjal
Bai-Muajjal
means credit sale of goods by the bank to the customer. Such contracts provide
for a margin of profit or mark-up to the bank as mutually agreed upon by the
buyer (client) and the seller (bank). Goods are kept at the disposal of the
customer/buyer and the sale price can be paid either in lump sum or in
installments. It can also be used for both internal and external trade
operations. Like Murabaha, Bai-Muajjal is also a short-term
commercial investment and therefore, the concept of discounting technique is not
really applicable here.
e)
Bai-Salam
Bai-Salam means forward
purchase of the potential product. Under this arrangement, the bank enters into
a contract to purchase a certain quantity of the product or commodity that is to
be delivered to the bank at a future date. However, the payment for the
aforesaid goods is made in advance. The price of the goods must be reasonable
and the bank is free to sell the goods in the open market to earn a good profit.
Bai-Salam may be used on
both short-term and long-term transactions of the Islamic bank. Under such
arrangement of advance purchase, the bank may receive a trade discount, which
ultimately increases its profit margin. The NPV and IRR concept of discounting
techniques are not relevant in short-term Bai-Salam transactions but are
applicable to long-term transactions.
f) Ijara
(Leasing)
Ijarah is a rental
agreement between the bank and the customer. It is a relatively long term
financing arrangement. Under Ijarah, the lessor (the bank) retains the
ownership of the assets and the lessee (customer) has the possession and use of
the asset on payment of specified rental over a given period of time. The cost
of insurance of the asset leased will be borne by the lessor to make the method
conform to the principles of Shariah. After the maturity of the lease
contract, the bank (lessor) maintains possession of the asset for further
leasing.
Under the lease
contract, the bank purchases some real property and then, leases it to the
client. Therefore, both the IRR and NPV methods of discounting can be used to
convert the expected future inflows of rentals (over the period of the lease)
into present value to ascertain its profitability. Also the initial market price
of the property and the estimated market value after the expiration of the
contract can be converted to net present value to assess the cost of capital,
profit margin and cost incurred on the property.
g)
Hire Purchase
The hire
purchase method of financing enables a bank to finance the purchase of movable
and immovable assets. It is a joint ownership agreement subject to the provision
of security/surety provided by the client. In addition to the repayment of the
principal amount, the bank receives a share in the net rental value after
allowing for necessary deduction on account of depreciation of asset. This
payment is made after adjusting the bank’s outstanding share of the asset, which
reduces with each installment payment made by the client. The cost of insurance
of the asset is shared by the bank and the other party in proportion of their
capital contribution to the asset. After the full payment has been made, the
client becomes the owner of the asset. Until full payment has been made the
client is only entitled to the use of the asset.
Since this mode
of Financing involves inflow of cash over a considerable period of time, the
discounting techniques can be applied to evaluate the acceptability of the
project. Each and every expected installment payment should be converted to
present value by applying the appropriate discount rate. The next step would be
to sum up the present value of the streams of cash inflows and compare it with
the purchase price. A proposal yielding a positive net present value would be
accepted and otherwise rejected. The same concept applies while applying the IRR
method, whereby the minimum expected rate of return is calculated which would
equate the present value of cash inflows with the initial cash outflow. An
investment proposal failing to yield this minimum required rate of return should
be rejected.
h)
Others
There are other
investment techniques in Islamic banking such as Direct Investment by the bank,
Investment Auctioning, and Qard Hasan. Except for investment auctioning,
both discounting techniques cannot be applied to these types of financing, as
they are basically short-term financing. In investment auctioning, the
bank may determine profit to be a Margin received from the Auction. This profit
can be determined by using the NPV method of discounting.
5.
CONCLUSION
From the above
discussion, we may legitimately state that the application of the two
discounting techniques would make the various Islamic modes of financing more
scientific and realistic. The puritan and simplified version of an economy, as
envisioned under the broad Islamic philosophy is non-existent in the present day
world. Therefore, to establish an Islamic financial system and to make it thrive
over the years, we must take into account the complex inter-relations that exist
among the various variables in a modern day financial set-up. This realization
is essential to formulate and practice a pragmatic financial policy under the
Islamic economic framework. As an important step towards that end, we must
encourage the application of discounting techniques to the various modes of
finance under an Islamic economy to increase their acceptability as
time-adjusted mechanisms of finance that reflect the actual profitability of a
project.
REFERENCES
(1)
Ziauddin Ahmed,
Munwar Iqbal and M. Rahim Khan (Eds) (1992), Fiscal Policy and Resource
Allocation in Islam, Islamic Development Bank. K.S.A.
(2)
Akkas, S.M.
(1991). Relative Efficiency of Conventional and Islamic Banking System
in Financing Investment, Unpublished Ph.D. Thesis, Dhaka University,
Bangladesh.
(3)
Mannan,
M.A. Trade and Commerce in Islam.
(4)
Jarhi and
Ziauddin (1983). A Monetary and Financial Structure of an Interest-Free
Economy: Institutions, Mechanisms and Policy.
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ACCOUNTING SYSTEM AND MIS
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Is accounting a mere technical
matter or is there any question of ideology or value judgment? In other words,
is an accounting system followed by the conventional bank compatible to Islamic
Shariah or is it necessary for Islamic banks to design their own
accounting system? As we know Islam is a way of life where ends does not justify
means rather both ends and means should be justified. Islam has its own
objectives and the ways and means to achieve those objectives. Like all others
spheres of life in the banking sector Islamic scholars have developed their own
banking system that differs from conventional banking system both in terms of
philosophy and operational mechanism. Undoubtedly the accounting system is a
very technical matter but not without any principle or philosophy. So, the
principles and philosophy of the accounting system of an interest-free bank
should not be as that of a conventional bank.
1.
Objectives of Financial Accounting for Islamic Banks
There are two approaches in developing objectives and concepts of financial
accounting for Islamic banks:
a)
The first
approach is to deduce such objectives and concepts from the Shariah. In
this way we can establish the objectives of Islamic accounting based on the
principles of Islam and then consider these established objectives in relation
to contemporary accounting thought.
b)
The second
approach is to start with objectives established in contemporary accounting
thought, test them against Islamic Shariah, accept those that are
consistent with the Shariah and reject those objected by the
Shariah.
From among these two mutually
exclusive alternative approaches of establishing objectives for Accounting and
Auditing Organization for Islamic Financial Institutions have decided to adopt
the second approach.
Although there is a large degree of
similarity between the proposed objectives for financial accounting for Islamic
banks and those developed by Western accounting professional bodies, the former
require the provision of additional information regarding the compliance of
Islamic banks and financial institutions with the Shariah doctrines in
their business transactions. Furthermore, it is proposed that financial
accounting for Islamic banks should provide information to assist in separating
prohibited earnings which occur advertently or inadvertently, if any, and to
verify that such earnings have been utilized for charitable causes.
The objectives of financial
accounting for Islamic banks may be described as follows:
a)
To determine
the rights and obligations of all interested parties, including those rights and
obligations resulting from incomplete transactions and other events, in
accordance with the principles of the Islamic Shariah and its concepts of
fairness, charity and compliance with Islamic business values;
b)
To contribute
to the safeguarding of the Islamic bank's assets, its rights and the rights of
others in an adequate manner;
c)
To contribute
to the enhancement of the managerial and productive capabilities of the Islamic
bank, encourage compliance with its established goals and policies and, above
all, compliance with Islamic Shariah in all transactions and events;
and
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