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Saturday, February 27, 2010

Explain the process of deposit creation in an Islamic bank.

There is no difference between the deposit creation between conventional and Islamic banks because both banks mobilise deposits as their primary source of funds[1]. However, the process of financing services and credit facilities provided by the Islamic banks make it difference from its conventional counterpart. Islamic banks eliminate any interest (usury) elements when providing the financing services. The process of deposit creation can be viewed at 2 different level; micro and macro level.

At micro level, Islamic bank acted as the financial intermediaries between the surplus units and the deficit units in the economy. Islamic banks receive deposits from customers and mobilises the deposits by providing financing services to the borrowers. When the borrowers received the financial assistance, in turn, he will credit into his account as deposits. Thus, by providing financing assistance to the deficit units, deposits are expanded and credit is created. The borrower can spend the credits in his name for payments through his current account by issuing cheques. The people who receive the cheques can cash them, thereby increasing currency in circulation or deposit the cheques in their current accounts. If the cheques are cashed, then deposits are drained from the banking system. However, if the cheques are deposited either in the same bank or other banks, the amount of deposits in the banking system are not affected. The financial instruments used in financing activities can be in the form of mudarabah (profit and loss sharing) and musyarakah (joint venture), murabahah (cost plus) and bai bithaman ajil (cost plus specified mark-up), ijarah (leasing), salam (deferred delivery) etc.

At the macro level, deposits are expanded when an Islamic bank places its excess funds in another Islamic bank (deficit units) that is facing tight liquidity. Even at this point, Islamic bank must adhere to the interest-free financing. As demonstrated by Abdullah Saeed (1999), the funds will be placed by the Islamic bank (surplus unit) in nostro[2] accounts with correspondent banks (deficit unit). The Islamic banks (surplus unit) and the correspondent banks (deficit unit) can recover the cost of the interest-free deposit with each other in two ways: (i) reciprocal exchange of funds and by mutually agreeing not to charge interest on either the vostro or nostro account, even if the accounts go into the red, and (ii) the banking services provided ‘free’ by the correspondent bank for the Islamic bank vice versa. There is no explicit charging or paying of interest, but the benefits from keeping funds have been achieved in ‘kind’ (as long as there is compensation for their funds, banks would be willing to place ‘interest-free’ deposit). This inter-bank financing creates credit and this credit is recorded as deposits and placements of Islamic bank.

[1] The profit generated by an Islamic bank is largely the result of the utilization of depositors’ fund. In many Islamic banks, the equity to deposits ratio is less than ten percent, and in some cases significantly less than that.
[2] A Nostro or Vostro (from Latin: nostra and vostra, ours and yours) Account is a deposit account that a bank holds at a foreign or correspondent bank for the purpose of holding foreign currency and making/receiving international payments. A single deposit account is a Nostro account from the perspective of one bank and a Vostro account from the perspective of another.

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