ISR-Based Framework: A Leap for Islamic Banking in Bangladesh

Islamic banking has seen impressive growth over the last four decades, becoming a well-established component of the banking industry in Bangladesh. Currently, Islamic financial services in the country are provided by 10 full-fledged Islamic banks, 23 Islamic banking branches of 11 conventional commercial banks, and 550 Islamic banking windows of 13 conventional commercial banks. Islamic banks hold more than 27 percent of the total banking sector’s deposits and 28 percent of its investments. The number of depositors at Islamic banks in Bangladesh has surged from 1.17 crore in 2014 to 2.85 crore in 2022. By the end of March 2023, total deposits in the Islamic banking system had reached BDT 4116.31 billion.

Islamic banks in Bangladesh accept deposits under two shari’ah principles: Al-Wadeeah and Mudaraba. Current accounts operate based on the Al-Wadeeah principle, while savings accounts are based on the Mudarabah principle. In Islamic banking, depositors, known as Sahib Al-Maal, provide the capital, while banks, known as Mudarib, use the capital. Banks conduct business independently while maintaining shari’ah compliance. Profits, if any, are divided between the Sahib Al-Maal and the Mudarib at a predetermined ratio, while any losses are borne by the Sahib Al-Maal.

Two frameworks are used in Islamic banks in Bangladesh for the distribution of profit to Mudaraba depositors: the weightage-based framework and the income-sharing ratio (ISR) )—based framework. The former was introduced in Bangladesh as early as 1983, and the latter was introduced in 2008. M. Azizul Huq (1935-2020), widely regarded as one of the founders of Islamic banking in Bangladesh, argued in his 2012 booklet entitled “Profits Payout to Mudaraba Depositors” that the ISR-based framework is superior to the weightage-based framework. Let’s now review the two options and see why we need to promote an ISR-based framework for a fair and equitable distribution of profits to Mudaraba depositors.

In the weightage-based framework, the bank’s management fee is recovered from the funded income with complete certainty, and the residues are distributed among different groups of Mudaraba depositors according to assigned weightage. As the bank (Mudarib) is kept outside this weightage schedule, any change in the weightage schedule or deposit mix does not affect the bank’s management fee. In this framework, the head office officials handle profit calculation exclusively, and Mudaraba depositors are informed only about the amount of profit paid into their accounts. As the profit determination is done at yearly intervals, the bank depends on provisional rates throughout the entire accounting year. This creates an uncomfortable situation for the Mudaraba depositors. Thus, the weightage-based framework is not a dependable mechanism as it enables an unscrupulous bank to unjustifiably promote its interest at the cost of the depositors.

The ISR-based framework is fair to the depositors because if the bank decides to offer a special benefit to any group, it has to do it at the bank’s cost, not at the cost of other clients of the bank. The ISR-based framework offers a very simple process of one-tier calculation. The calculation can be done every month, and the rates can easily be updated throughout the year. Since the actual rate is available year-round, no provisional rate is used.

The Mudarabah depositors are better protected in the ISR-based framework because of transparency and full disclosure. At the end of any accounting period, every individual depositor is informed about the amount of income generated by his fund, the amount retained by the bank from this income as its management fee, and the amount of income apportioned to him by applying the pre-agreed sharing ratio. The framework is transparent not only in terms of the underlying legal contract between the bank and the customer but also in regularly and timely disclosing relevant profit and performance measures to make transactions fair and equitable.

Despite the clear improvement of the ISR-based framework of return over the weightage-based framework, very few banks have adopted the ISR-based framework of return since 2008. It indicates that the present Islamic banking community either lacks awareness of the ISR-based framework or is reluctant to adopt the framework as they do not want to reduce the profits of banks and share them with the depositors. In this situation, Bangladesh Bank (BB), being the regulator, needs to come forward to smooth the transition to the ISR-based system.

Currently, the BB Guidelines for Islamic banking published in 2009 recognize the weightage-based framework as the only option for distributing profits to Mudaraba depositors. BB should revise the guidelines with the ISR-based framework of return and retain the weightage-based framework until the total Islamic banking adopts the ISR-based framework. Islamic banks also need to be cordial and sincere in understanding the benefits of introducing the ISR-based framework. For this, inter-bank and intra-bank discussions on the ISR-based framework need to be promoted. Furthermore, to discourage the weightage-based framework, the BB may introduce regulations such as keeping the band of weightage as short as possible and introducing a cap on the bank management fee. For example, any financial institution that limits its management fee to 10% and distributes 90% of its funded income to depositors may be given a tax incentive. It is hoped that through these initiatives, we will be able to introduce a standardized and uniform profit distribution system for all the Islamic banks in the country.