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Jakarta Post

Sharia compliance in deposit insurance

Jakarta   /   Tue, August 2, 2016   /  07:35 am
Sharia compliance in deposit insurance A BCA Syariah staff member serves a customer after an opening ceremony at its headquarters on Jl. Jatinegara Timur in East Jakara on April 5, 2010. (The Jakarta Post/P.J. Leo)

Revolutionary changes are now taking place in the financial system. Deposit insurance is an integral part of the financial fractional — reserve banking system. Under fractional-reserve banking, banks are allowed to act as financial intermediaries between borrowers and savers, and to provide longer-term loans to borrowers while providing immediate liquidity to depositors. 

However, a bank can experience a bank run if depositors wish to withdraw more funds than the reserves held by the bank. To mitigate the risk of bank runs and systemic crises when problems are extreme and widespread, governments regulate and oversee commercial banks, provide deposit insurance and act as the lender of last resort to commercial banks. 

This structure was put into place twelve years ago through the enactment of the Indonesia Deposit Insurance Act 2004. The rationale of establishing this kind of system was clear: to prevent a recurrence of the catastrophic financial collapse that occurred between 1997 and 1998. 

The new system was intended, among other things, to restrain competition, not only among financial industry groups but also within the banking industry itself. It is responsible, in considerable part, for the structure of depository institutions that has evolved and the nature of the supervision and regulation of depository institutions. 

Islamic deposit insurance has become more relevant of late due to the development of Islamic finance, which has grown rapidly not only in the Muslim world but also across the Western world. 

Today, the Islamic financial landscape has been dramatically transformed into a vibrant, dynamic and competitive global intermediation mechanism. The industry is supported by more than 300 Islamic financial institutions in over 75 countries and its assets are projected to grow to US$4 trillion globally by 2020. There are two levels of sharia compliance issues in the implementation of the deposit insurance system. First, sharia compliance issues within the fractional banking reserve system framework. Second, sharia compliance issues within conventional deposit insurance schemes. 

Fractional-reserve banking ordinarily functions smoothly. Relatively few depositors demand payments at any given time, and banks maintain a buffer of reserves to cover depositors’ cash withdrawals and other demands for funds. However, during a bank run or a generalized financial crisis, demand for withdrawals can exceed the bank’s funding buffer, and the bank is forced to raise additional reserves to avoid defaulting on its obligations. 

Related to the implementation of the fractional banking reserve system in Islamic banking institutions (IBIs), there are issues to do with the reserve structure that is incompatible with sharia principles. Islamic deposits are accepted by IBIs based on sharia principles. 

They are offered under various sharia contracts such as safe-keeping (wadiah)and profit-sharing (mudharabah). Deposits are accepted under a safe-keeping contract (wadiah). 

Under this mechanism, the deposits are held in trust and utilized by the bank at its own risk. The depositor does not share in the risk or return in any form. Any profit or loss resulting from the investment of these funds accrues entirely to the bank. Another feature of such deposits is the absence of any condition with regard to deposits and withdrawals. 

Demand deposits under a safe-keeping contract should be backed by 100 percent reserves. The deposits accepted under a profit-sharing contract (known as a profit-sharing investment account or PSIA) are mudharabahplacements made by an investor (PSIA holder) with an IBI, which acts as entrepreneur. The IBI invests the fund in sharia-compliant business activities, such as the provision of financing and investment in sukuk. 

Any profit from such activities is shared between the PSIA holder and the IBI according to an agreed profit-sharing ratio. Any losses are borne by the PSIA holder, except in the case of the IBI’s mismanagement or negligence, where losses are borne by the IBI. Since losses are borne by the PSIA holders, some have argued that PSIA holders should not enjoy protection or zero percent reserve.

The Chicago economists were the first to propose 100 percent reserve banking. The economist Irving Fisher proposed a system of 100 percent reserve banking as a means of reversing the deflation of the Great Depression. He wrote: “100 per cent banking would give the Federal Reserve absolute control over the money supply.” 

Recall that under the present fractional-reserve system of depository institutions, the money supply is determined in the short run by such non-policy variables as the currency/deposit ratio of the public and the excess reserve ratio of depository institutions.

Islamic and conventional deposits in Indonesia are protected under a conventional deposit insurance system, which is administered by the Indonesia Deposit Insurance Corporation (IDIC). Deposit insurance is relatively new to the Islamic financial world and has attracted a lot of interest as regards understanding its permissibility from a sharia perspective, and the differences between Islamic or sharia-compliant and conventional deposit insurance systems. 

The basic principle of all Islamic financial transactions is that they must be free from elements that Islam strictly prohibits, i.e. interest (riba), uncertainty(gharar) and gambling (maisir). In any financial transaction, interest or usury exists when there is an unequal exchange of two interest-based or usurious commodities or an exchange of money for money with different quantities, different values and at different times.

Under the deposit insurance system, a bank pays a premium to the deposit insurer and, if the bank is wound up, the deposit insurer reimburses the insured depositors. The acts of the deposit insurer in collecting the premium from the bank and reimbursing the insured depositors of the bank is deemed to be an interest-based transaction. 

Based on the above, deposit insurance does involve the exchange of money for money and the exchange occurs with different values and at different times. 

Hence, some sharia scholars would argue that it is an interest-based transaction and therefore non-permissible. The interest element could also exist in deposit insurance when the deposit insurer is involved in interest-based transactions or activities. 

This can happen when the deposit insurer protects deposits, invests the deposit insurance funds, lends to troubled banks or obtains external funds (when in deficit), as all these activities are based on interest. In addition to interest, uncertainty and gambling, Sharia also does not allow certain other elements to exist in a deposit insurance system. For instance, deposit insurance funds must not be used for the purchase of liquor and pork, or any activities prohibited under sharia.



The writer is a sharia banking practitioner.

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Disclaimer: The opinions expressed in this article are those of the author and do not reflect the official stance of The Jakarta Post.