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Saturday, February 27, 2010

Compare and contrast salient features of the cost of deposits in a mudarabah deposit and an interest-bearing fixed deposit.

Under conventional banking, the cost of deposits in an interest-bearing fixed deposit is fixed and guaranteed regardless of the actual outcome of investments done by the banks. In summary, whatever the rate for cost of deposit is indicated, the realised cost of deposit would be the same at the end of maturity period for fixed deposit. 

The costs of deposits for any deposits in conventional banks are the combination of elements of;

(i)                 time value of money or the interest rate, and
(ii)               (ii) deposits maintenance costs or overhead cost. The rate of return determined for the depositors is determined ex-ante.

“Cost of deposit (Fixed deposit) = Time value of money (TVM) + Overhead cost.”

TVM in conventional banking sense is the opportunity costs available for the depositors either by holding or consume the money themselves according to their preferences or the opportunity costs available by them to invest it to any other investment products available in the market. In summary, TVM in this context is only the justification for the conventional banks to charge interest.

Under Islamic banking, the return or profit for depositors in mudarabah (profit and loss sharing) account is subject to the actual investment outcomes. The profit on investments is shared based on the agreed profit-sharing ratio, for example 80:20 for depositors and banks respectively. There will be no indicative cost of deposit in mudarabah account. However, one can determine the contracted cost of deposit based on the previous average costs paid to the depositors. However, the realised cost of deposit is not guaranteed to be the same with the contracted rate. The costs of deposits in mudarabah account are the combination of elements of;

(i)                 performance of the investment of the mudarabah account, and
(ii)               (ii) deposits maintenance costs or overhead cost.

“Cost of deposit (Mudarabah) = performance of mudarabah account + Overhead cost.”

In Islamic banking context, the performance of mudarabah account not only relates to the actual return on deposits, but also the opportunity costs available for the depositors according to their liquidity preferences. Unlike the return for conventional bank, the return for mudarabah account is not fixed (for example, ex-ante returns from by the fixed deposit accounts). In Islamic banking perspectives, the return will only be known ex-post.

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