Tuesday, 9 August 2016

The Profit Distribition Process

Islamic financial Institutions (IFIs) act as financial intermediaries between sources of funds (deposits) and applications of funds (financing and investment). Profit generated from the application of funds will be shared with the funds’ providers. A significant portion of IFIs’ sources of funds come from General Investment Account (GIA) that has been structured based on mudharabah (profit sharing) contract.
The contractual relationship between IFIs and depositors under the Islamic mudharabah gives rise to the need of a mechanism to distribute IFIs’ Income to their GIA depositors.

I was first exposed to the methodology of profit distribution in year 2000 when I attended a training in Brunei that was conducted by Bank Islam Research Institute (BIRT). I learnt that the process involved two main steps:

  1. Calculating of the amount of income to be distributed to depositors (termed as distributable income)
  2. Calculating the rates of returns by proportionating the distributable income into various types of deposits that an IFI offers to its customers
Few years later, when I was implementing an IT system in one of the banks in Malaysia, during requirement study process, I got hold of Bank Negara Malaysia(BNM) Framework Rate of Return that was issued on Oct 16, 2001, and to be implemented by Oct 1, 2004. BNM issued the framework as part of an “effort to standardise the method on the calculation of rate of return for the Islamic banking industry (IBI)”.
The framework has been further revised with the latest update issued on March 13, 2013.

Consistent with the steps stated above, the framework comprises two main tables and the guidelines, with formula and examples, on how to derive the tables. The two tables and the objectives are as follow:
  1. Calculation Table (CT) — To guide the IBIs in deriving the net distributable income to the depositors and the bank by incorporating the income generated from the assets, the relevant shared expenses and allowances between the bank and the depositors, and income attributable to the various types of depositors.
  3. Distribution Table (DT) — To guide the bank on the proper distribution of the net distributable income posted from the CT, IFIs are required to maintain separate CTs and DTs if they manage multiple funds.
CT is quite straight forward to work on as the information required is normally readily available from the finance department. However, it requires finalisation of income and expenses for the month before distributable income amount can be fixed. In order to avoid too significant fluctuation of distributable income from month to month and to maintain competitiveness with conventional banks.

IFIs practice income smoothing using Profit Equalisation Reserve (PER) following BNM Guidelines on PER. PER is a provision of income where during profitable periods some income is put aside to be reserved for not so profitable periods.
DT requires more effort

Every month, IFIs are required to keep track of the average daily amount of their deposits segregated by types of deposits. Different types of deposits will have to be defined for mudharabah and non-mudharabah products. For mudharabah, the types of deposits will be further segregated based on various profit sharing ratios (PSRs) offered to depositors.
Based on general practice by Malaysian local IFIs, new rates will be declared every 16th of the month and will be effective until 15th of the following month. The process to arrive at the rates will start on the 1st of previous month.

For example, for the rates to be declared on Feb 16, 2014, the process to accumulate deposit average daily amount would start from Jan 1, 2014 until Jan 31, 2014. From Feb 1 to 15, 2014, IFIs will be finalising their income and expenses so that they could also work on their CTs to determine the net distributable income (NDI).

The NDI is then fed into DTs to run simulation of rates calculations. Normally IFIs would run few simulations before IFIs can finalise the rates of returns for the month.

Based on my observations, Malaysian local IFIs normally already have an idea on what rates are to be declared. They will work backwards using PER to adjust their Distributable Income in order to arrive at their desirable rates.
My column appeared in THE MALAYSIAN RESERVE, 10 March 2014

1 comment:

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