Islamic banks are finding the going tough in deposit mobilisation after the State Bank’s linking of minimum deposit rate of conventional banks to its own repo rate.

Islamic banks are free to determine their own deposit rates and don’t have to comply with the State Bank’s instructions on the minimum deposit rate (MDR). But after a 100-basis point increase in conventional banks’ MDR since September, Islamic banks are burning the midnight oil to mitigate the risks related to their rates of return.

Islamic bankers say the statistical evidence of any impact of the linking of banks’ MDR with the SBP’s repo rate on their deposit rates would emerge after some time. The average rates of return of Islamic banks, as a group, are also not reported routinely.

Islamic banks internally compute such average rates, but in a more complex way than conventional banks. Going by the ‘expected rates of return’ being offered by individual Islamic banks on different products, it seems that these banks try to catch up with their conventional peers, particularly in case of Shariah-compliant fixed deposits.

“One thing that should now be of greater concern for Islamic banks is that their already low financing-to-deposit ratio (FDR) may deteriorate further if they fail to retain return-cautious depositors,” warns the senior executive of a local conventional bank. Their FDR has gradually fallen to just 34 per cent in June this year, from as high as 54.3 per cent at the end of 2009.

“We have a complex system for determining rates of return. We can’t ensure higher returns for depositors at a given point without exposing ourselves to some other risks,” the chief financial officer of a local Islamic bank told this scribe.

Islamic banks are required by the SBP to establish a gross income pool for distributing profits among deposit holders. When direct expenses, write-offs and losses in investment are deducted out of this pool, a net income pool, or NIP, emerges. Out of the NIP, Islamic banks get their profits under a pre-agreed formula, leaving a lump sum amount of money as ‘distributable profits’.

Then, out of the distributable profits, depositors get their share after leaving the share of the Islamic banks again, this time for their services as Mudarib or custodian/operator of the NIP.

One can imagine how difficult it is for Islamic banks to catch up, if deposit rates of ordinary banks go up after monetary tightening, particularly with such frequency as in every two months.

After policy rate hikes on September 16 and November 18, banks’ MDR rose from six to 6.5 per cent and then to seven per cent. This has created competitive pressure for Islamic banks and exposed them to risks ranging from adverse impact on net income and income margins to feared withdrawal of deposits.

While the possible ways to mitigate rate-of-return risks are many, each one has its own costs and benefits. Islamic bankers say they are successfully employing some of them, like keeping their cost of deposit mobilisation low and optimising income from Modaraba depositors and investors.

Some bankers say creating a reserve for ‘income smoothening’ has been a tested tool of mitigating rate-of-return risk, and add that the use of this tool would become more frequent now after the linking of conventional banks’ MDR with the SBP’s repo rate.

Commodity Murabahah is also being used by Islamic banks to raise fixed term deposits without violating Shariah injunctions. This is a sort of the Islamic version of fixed-term deposit products that offer fixed rates of return through buying and selling of commodities as underlying transactions.

Islamic bankers say the use of this product is expected to increase in the near future to provide cushion to short-term remunerative deposits.

Many of them, however, fear that non-remunerative current deposits of Islamic banks would particularly be hit due to the pressure on their rates of return emanating from improving returns of conventional banks.

Risk management in Islamic banking is trickier than that in conventional banking, because Islamic banking has to manage some additional risks. The most prominent among them include the risk of non-compliance with Shariah, and the commercial pressure emanating from depositors not well-versed with the principles of Islamic banking.

Besides, Islamic banks have to manage equity investment risks and rate-of-return risks more minutely than conventional banks. Finally, common banking risks, including credit risk, market risk, liquidity risk and operational risk, also have to be managed under tighter conditions than those that are applicable for conventional banks.

Islamic bankers say managing the risk of non-compliance with Shariah has not been a big problem in our context.

The reason is, most Islamic banks and Islamic banking networks of conventional banks have first-class Shariah advisors, and the State Bank’s role has been very supportive.

But they add that the risks related to rates of return and associated risks of deposit withdrawals by depositors who are too focused on MDR are testing their nerves. Managing the risks associated with equity investment is equally challenging.

“Even before the linking of conventional banks’ MDR with the SBP’s repo rate, Islamic banks, by the very nature of their business, were exposed to what we call GAP risk,” says an executive of Meezan Bank. “GAP risk arises more frequently, and with more intensity, in case of Islamic banking where funding is variable but financing and investment is often of longer tenure.”

Prudent bankers manage this risk by obtaining versatile funding composed of both short-term and mid-term or long-term deposits, and by venturing into such financing arrangements where the borrowers’ track record is proven and the sectors to which they belong to are either growing rapidly or have potential.

That explains why Islamic banks have lately been lending generously to food, chemicals and trading sectors, and why their financing to cement and construction sectors remains limited.

Likewise, Islamic banks also remain choosy about individual customers when it comes to financing under Modaraba and Musharaka contracts.

“That’s because when we enter into a partnership for undertaking or participating in a specific project financing or in ordinary business activity, particularly under Modaraba and Musharaka contracts, we expose ourselves to equity investment risk,” explains the head of Islamic banking of a local commercial bank.

“Managing this risk indirectly enables us to manage other risks as well, but it requires both big money and specialised human resources, which don’t come handy and cheap.”

Islamic bankers say that under the current banking environment, managing generic banking risks is also becoming more demanding. They particularly mention market risks arising out of the change in benchmark interest rates and exchange rates.

“The long spell of the rupee depreciation since the beginning of the last fiscal year has really tested our nerves,” admits a senior Islamic banker.

“There is a system wherein we can square our daily local currency positions through interbank dealings within the confines of Shariah guidelines.

“But when it comes to forex dealings, we need to develop,” says a conventional bank’s executive who looks after treasury affairs of the Islamic banking network of his bank.

“This affects our ability to provide trading finance to exporters and importers because unlike conventional banks, setting forward prices of foreign currencies isn’t that simple.”