Bancassurance in Oman

Bancassurance is the arrangement between a bank and an insurance company for the sale of insurance products by the bank. This arrangement is widely used around the world and helps insurance companies maintain smaller sales teams by benefitting from the branch and sales network of their partner banks.

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Islamic Banking: Shari'a Governance

One of the first matters to be addressed as the Sultanate of Oman moves to implement Islamic banking is Shari`a governance within Islamic banking institutions (i.e., full-fledged domestic Islamic banks, Islamic windows of conventional domestic banks and Islamic banking branches of foreign banks, which are referred to as “Licensees”). Shari`a governance is a subset of the general obligations and corporate governance framework and includes a range of topics that are particular to Islamic banking activities.

This article addresses a subset of those Shari`a governance matters, specifically certain matters pertaining to Shari`a supervisory boards (each an “SSB”) and related Shari`a governance entities and mechanisms. These topics are addressed in Title 2 (“Title 2”) of the proposed Islamic Banking Regulatory Framework of the Central Bank of Oman (the “CBO”), Version 2.0, of March 2012 (the “IB Framework”).


As a notable general position, the IB Framework makes reference to, and encourages (but does not seem to mandate) adoption of and adherence to, various guidelines of the Islamic Financial Services Board (“IFSB”). The explicitly referenced IFSB guidelines include the Basic Professional Ethics and Conduct for Members of the Shari 'a Board pursuant to the Guiding Principles on Shari 'a Governance Systems for Institutions Offering Islamic Financial Services (December 2009), the Guiding Principles on Conduct of Business for Institutions Offering Islamic Financial Services (December 2009), and the Guiding Principles on Corporate Governance for Institutions Offering Islamic Financial Services (December 2006).


Under the IB Framework, the required Shari`a governance structure is implemented by mandating each Licensee to (a) provide, in its memorandum and articles of association, for the conduct of its business in accordance with Islamic Shari`a principles, (b) establish and maintain systems and controls to ensure Shari`a compliance of its operations and business activities (in addition to the normal compliance requirements), (c) appoint an SSB to oversee operations from a Shari`a compliance perspective and prepare and present an annual Shari`a compliance report to the Licensee’s Board of Directors, and (d) implement a system of Shari`a governance as specified in Title 2.

The Shari`a governance system is the “hallmark and the differentiating factor for Islamic Banks and Islamic Windows which sets them apart from their conventional counterparts”. Its critical elements are (i) the SSB, (ii) the Internal Shari`a Reviewer, (iii) the Shari`a compliance unit and the Shari`a audit unit. The ultimate responsibility for ensuring Shari`a compliance, and the implementation of the required governance systems, lies with the Licensee’s Board of Directors (“Board”), although both the SSB and management have related responsibilities.

Constitution of SSBs

In other words, the restriction on the employee’s right to compete should be no greater than what is necessary and lawful to protect the employer’s business interests.

Licensees must establish their own independent SSBs, although there is a limited outsourcing exception for small institutions as approved by the CBO. Foreign banks must demonstrate to the CBO that their SSB satisfies the requirements of Title 2.

Each SSB must be comprised of at least three Shari`a scholars, and each scholar must be specialized in fiqh al-mu’amalat (Islamic commercial jurisprudence). An SSB may also include one or more non-voting members who are not specialized in fiqh al-mu’amalat but have expertise in Islamic banking or related areas, such as finance, economics, law, accounting or the like and possess basic knowledge of fiqh al-mu’amalat.Licensees are encourage to the use of Omanis on SSBs and to encourage the development of relevant Shari`a expertise among Omanis. These provisions are supplemented by provisions that allow the SSB to consult with outside experts in appropriate circumstances on a case-by-case basis. As a general admonition, the IB Framework indicates that SSB members should come from diverse backgrounds in terms of areas of expertise, qualifications and experience in order to enhance the depth and breadth of Shari`a deliberations and, additionally, should be familiar with the domestic legal and regulatory environment and sensitivities of the Sultanate of Oman.

The IB Framework contains a number of required qualifications (“fit and proper” standards) for SSB members. Most are stated as general requirements, without specific standards. All members must be of respectable character and be of good conduct, particularly in terms of honesty, integrity and reputation in their professional business and financial dealings. SSB members must be Muslim. It is unclear whether this applies to only Shari`a scholar members or also non-scholar members. The rationale for allowing non-scholar expertise with respect to professional matters to be brought into the SSB on a non-voting basis (as noted below, and subject to the conditions noted below) supports an interpretation that such expertise should be sought at the highest and most refined levels, without regard to affiliation restrictions. This matter will be left to future clarification.

SSB members with a Shari`a background must be holders of academic qualifications in the field of Shari`a (a minimum of a bachelor’s degree) that includes the study of usul al-fiqh and fiqh al-mu’amalat from “a recognized institution” (an undefined phrase). Those members must also demonstrate “an adequate understanding of finance / banking in general and Islamic finance / banking in particular” as well as an understanding of the legal and regulatory frameworks applicable to the functions of the Licensee. Shari`a scholars must have accumulated overall experience of ten years or more (in teaching, research, issuance of fatawa and similar matters). And they must demonstrate a strong proficiency in Arabic. It is also recommended that they have reasonable understanding of English.

SSB members other than Shari`a scholars must be individuals generally recognized for their expertise in their respective field (e.g., banking, finance, economics, law, accounting, etc.). They must hold at least a master’s degree. Non-scholar members must have accumulated relevant experience of 15 years or more in the relevant field. These non-scholar members should demonstrate reasonable proficiency in English, and it is recommended that they have some understanding of Arabic.

The IB Framework provides for disqualification of an individual from SSB participation for a range of “for cause” events, including (a) cessation of good character and reputation or a position of respect among one’s peers, (b) failure to attend a substantial number of meetings without reasonable excuse (currently, 75%), (c) association with any unethical or illegal activity, including contravention of any of the requirements and standards of the financial, banking or corporate regulatory system, (d) conviction of any criminal offense, including financial impropriety or moral turpitude (except misdemeanors), (e) dismissal as an employee or director from any entity on the grounds of fraud, misrepresentation or breach of trust, (f) use of confidential and privileged information about the Licensee or its clients obtained as a result of his position in a manner that is detriment to the competitive interests of the Licensee in the market place (but, apparently, not if otherwise in contravention of confidentiality requirements), or (g) assumption of membership in the SSBs of two or more competing financial institutions in Oman.

With regard to clause (g) of the next preceding paragraph, and as noted above, no SSB member can be on the SSBs of more than one competing institution in Oman. However, an SSB member can be on the SSBs of more than one non-competing institutions. The example provided in the IB Framework is that an Islamic bank SSB member can also sit on the SSB of a takaful company or an Islamic fund management company. However, no SSB member can be on the SSBs of more than four institutions in Oman.

The SSB is appointed by the Licensee’s shareholders upon the recommendation of its Board. The IB Framework does not address situations in which a foreign bank might have a different method of SSB appointment. An SSB member may be appointed for a maximum initial term of three years, and can serve one consecutive renewal term of three years on that SSB.

Roles and Responsibilities of SSBs

The SSB is entrusted with the duty of directing, reviewing and supervising the Licensee’s activities in order to ensure Shari`a compliance. The SSB is obliged to issue fatawa in respect of matters considered by it, which fatawa shall be determined by majority vote of the SSB’s Shari`a scholars and are binding on the Licensee.

The SSB’s scope of work is prepared by the Licensee and approved by its Board and is set forth in a charter. The charter must address a range of matters, including, at a minimum, (a) its purpose, (b) the membership and composition of the SSB, (c) the SSB’s chairperson and secretary, (d) grounds for removal and replacement of SSB members, (e) responsibilities and authority of the SSB, (f) meetings, agenda, quorum, voting, minutes and procedural requirements, and (g) amendment matters.

The responsibilities of the SSB include, without limitation: (i) advising the Board and management on Shari`a matters in the Licensee’s day-to-day business; (ii) review and approve all policies, procedures, products, processes, systems and contracts as to their Shari`a compliance, each to be subsequently ratified by the Board; (iii) review and approve products and related documentation, including structures, contracts, marketing and implementing materials; (iv) performance of follow-up to ensure compliant implementation of products; (v) review and approve Shari`a compliance and Shari`a audit functions; (vi) provision of guidance regarding Shari`a compliance to legal counsel, external auditors and other related parties; (vii) provision of written fatawa on relevant matters brought to it through the Internal Shari`a Reviewer or taken up by the SSB itself; (viii) submission to the Licensee’s Board of an annual Shari`a compliance report that addresses the rather detailed matters, and satisfies the standards (including the detailed opinion standards and requirements), set forth in the IB Framework, and (ix) development and implementation of annual training programs for SSB members regarding deficiencies in knowledge regarding banking, finance, economics or other related disciplines for SSB members with Shari`a background and Shari`a-related knowledge for SSB members who are experts in their respective fields but do not have adequate knowledge of Shari`a.

The report’s opinion paragraph included in its annual report (clause (viii) above) must address a variety of matters as specified in the IB Framework. These include whether the SSB has examined, “to a reasonable extent on a test-case basis, each class of transaction, the relevant documentation and procedures”. As one might expect, the opinion must also state, whether, in the SSB’s opinion, the affairs of the Licensee have been carried out in accordance with the rules and principles of Shari'a, the CBO's regulations and guidelines regarding Shari`a compliance and other rules as well as with specific fatawa and rulings issued by the SSB from time to time. The opinion must also address whether, in the SSB’s opinion, the allocation of funds, weightages, profit sharing ratios, profits and charging of losses (if any) relating to investment accounts conform to the basis given by the SSB in accordance with Shari`a rules and principles and whether there has been income from prohibited sources. Obviously, flesh will be put on these bones in the future.

The SSB is required to define the key elements to be evaluated while reviewing and approving a new product. These key elements establish the basis for developing the relevant product prior to its final presentation to the SSB for approval. Key elements pertain to, at a minimum, essential features of the product, processes, structure, documentation (including legal contracts), risk and compliance considerations, marketing, collateral and other necessary details. New product development must include an opportunity for the expression of views by, among others, internal and external auditors, lawyers and others involved in the process. The SSB will determine a product’s Shari`a compliance in the context of relevant fiqh literature, evidence and reasoning.

The IB Framework requires the SSB to report to the Board, non-compliant activities that it has “reason to believe” [are being] carried out in a systematic manner by the Licensee. If those activities shall continue, the SSB is required to inform the CBO and report such violations in its annual Shari`a compliance report. It is likely that the “reason to believe” and “systematic manner” qualifications will give rise to the need for further clarification in the future.

The SSB is required to issue fatawa and guidelines relating to products and bank functions. These are required to be maintained as central reference tools, be disseminated to Licensee employees, and be published in the annual Shari`a compliance report.

The IB Framework outlines a system for the protection of confidential, privileged and sensitive information made available to the SSB. This information may pertain to, among other matters, new product development and transactions, SSB and management decisions, matters presented to the SSB, discussions and deliberations of the SSB, Licensee client information under the banking laws, and matters so designated by management.

Fiduciary Duty and Conflict of Interest Provisions

A welcome development in the IB Framework, although one likely to give rise to some spirited discussion, relates to the considerable array of provisions that are designed to address fiduciary duties, conflicts of interest and related matters involving SSB members. These are defined as obligations to all of the Licensee and its stakeholders, the general public and the industry. Some of those have been previously discussed and relate to prohibitions on SSB members acting on the Shari`a boards of more than one competing institution or more than four institutions in Oman. Others require fairness, objectivity and independent functioning by the SSB members, in both substance and appearance, free from conflicts of interest, and the members are required to continually assess that status.

In a move toward the development of more stringent professional responsibility standards than are seen in most jurisdictions, the IB Framework addresses situations involving even the appearance of impropriety. For example, SSB members shall not have (a) any relationship with the Licensee that “could possibly be seen to interfere or reasonably be perceived to interfere” with the exercise of a member’s independent judgment when delivering fatawa and rulings or (b) any relationship that “could possibly be seen to interfere or reasonably be perceived to interfere” with the exercise of independent profession judgment. These are strong standards, and constitute a strong move toward a code of professional conduct and professional responsibility for SSB members. It will be interesting to see how these requirements are given definition. Some definition is provided by the IB Framework’s restrictions on employment, board positions, relationships (including those with family members of, and stakeholders of, the Licensee) and managerial and operation responsibilities that are expressly specified. More detail will undoubtedly be forthcoming as the framework is implemented.

The Board is required to undertake annual checks on the independence and conflicts of interest of SSB members as well as their annual performance and report the results to the Central Bank of Oman. The SSB members are made solely and personally responsible for their own work as members of the SSB. Notably, the SSB members are admonished to “appreciate the diversity of opinions among various mainstream schools of thought and differences in expertise among the fellow members” of the SSB.

In the event of an actual or potential issue of independence impairment, SSB members are obligated to document the issue, review and address the issue with the SSB, and, if the issue is unresolved, resign from the SSB and take the issue to the Licensee’s General Assembly. This is yet another step toward a strong professional conduct and responsibility framework. How it will be implemented is yet to be determined.

Management Responsibilities to SSBs

SSB members are required to enable and assist the Licensee’s management by providing advice and guidance regarding Shari`a compliance. Management, on the other hand, is responsible for observing and implementing SSB fatawa, rulings and decisions, and making them available to those who have implementation responsibilities and to other stakeholders. It is obligated, on a timely basis, to disclose information and provide necessary informational access to the SSB through the Internal Shari`a Reviewer (or risk Board penalties). Management is obligated to allocate adequate resources (including people, systems and processes) to support the Shari`a governance framework.

In instances of non-compliance with the Shari`a requirements, the management is obligated to take remedial action, including notification of the Internal Shari`a Reviewer and the SSB, cessation of new business relating to the non-compliance, and acting on the remedial and preventative advice of the Internal Shari`a Reviewer and/or the SSB. These are commendable steps toward strong professional conduct and a professional responsibility system, but these steps leave a broad range of unaddressed questions.

Conclusion

The Shari`a governance system that is to be implemented in the IB Framework is already the subject of considerable, and spirited discussion in the Islamic finance, banking and investment industry. It will certainly evolve as it is given greater form and substance. All are urged to participate in the on-going discussions as this is a fundamental, and forward looking, centerpiece of the Islamic banking governance package that the CBO desires to implement.

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Islamic Banking: A Brief Introduction

The Sultanate of Oman is in the process of establishing the legal and regulatory framework that will be applicable to Islamic banks and to the Islamic “windows” of conventional banks that are licensed to operate in Oman.  Various Islamic banks and windows are being structured and are preparing their initial product offerings.  Over the coming months, the Client Alert will be publishing a series of articles introducing basic Islamic banking concepts, and we will continue to address a range of Islamic finance topics of interest to Omani businesses.

This month, we begin with an introduction to general principles and structures applicable to Islamic banking around the globe.  This introduction is not intended to indicate or imply that any Islamic bank or window licensed in Oman will adopt and apply any specific structure or product discussed in the Client Alert.  Each Islamic bank and window will have a palette of products that is tailored to that bank or window and its clientele.  The particulars of these matters will evolve as the banks and windows are formed and develop, and we will follow these formations and developments for you as they materialize.

Islamic foundations: the Shari`ah supervisory board

Each Islamic bank or window will have a unique Shari`ah supervisory board that will guide that bank or window in designing and implementing its products and conducting its banking activities.  While the relevant policies and regulations have not been finalized as yet, we understand it is proposed that each Islamic bank and window in Oman would be free to determine the composition of its Shari`ah board, subject to some minimal constraints.  Examples of such constraints could include a requirement as to the number of scholars on a Shari`ah board (not less than three is currently being discussed), limitations on the number of boards on which an individual scholar may sit (no more than two boards in the Sultanate), and a requirement that boards include Omani Shari`ah scholars as well as internationally recognized scholars.  At present, it does not appear that there would be a requirement for the scholars to be from specifically identified madhahib (schools of Islamic jurisprudence); the individual banks and windows would be accorded discretion to comprise their Shari`ah boards as they determine appropriate and prudent.  We also understand that there will be no central Shari`ah board at the governmental level (such as a Shari`ah board at the Central Bank of Oman).  The Sultanate will likely take the position that allowing the banks and windows relatively unfettered freedom and discretion in this regard generates greater creativity and responsiveness to market needs and desires.

The function of Islamic banks

Islamic banks and windows perform much the same intermediation functions in the banking system as conventional banks.  They provide (a) asset transformation activities, (b) administration of payments systems, (c) brokerage services, and (d) risk transformation services.  Asset transformation involves the matching the supply of, and the demand for, financial assets and liabilities (e.g., deposits, equity, credit, loans, insurance).  Transformative activities relate to modifications in the scale, maturity and location of instruments and assets.  Payments administration involves, primarily, check transfer activities, electronics funds transfers, settlement activities and clearing activities.  Brokerage activities relate to linking sellers and purchasers of instruments to each other.  Risk transformation pertains to facilitating the supply of, and demand for, intangible and contingent assets and liabilities, including guarantees, collateral, financial advice and custodial services.

The three Islamic banking models

As a theoretical matter, there are three Islamic banking models.  They are commonly referred to as (a) the two-tier mudaraba (service partnership) model, (b) the two windows model, and (c) the wakala (agency) model.  Any given Islamic bank or window may utilize elements of more than one of these models.

Before considering these three models, it is conceptually important to recognize that there are two different types of deposit accounts in the Islamic banking models.  These accounts are the sources of funds for Islamic banks and windows.  Money deposited with a bank by a depositor may go into a demand deposit account or it may go into an investment account.

Generally speaking, there are two types of demand deposits:  savings deposits and current deposits.  In a savings deposit, the depositor may deposit and withdraw money at will, and some banks require minimum deposits.  Structures used for savings deposits include qard hassan (non-interest-bearing loan), wadi`ayaddhamanah (guaranteed safekeeping), and, somewhat infrequently, mudaraba.  In a current deposit, money can be deposited and withdrawn at any time and the account is accompanied by a checking capability or a multifunctional card.  Structures used for current deposits include qard hassan, wadi`ayaddhamanah, and, somewhat infrequently, mudaraba.  Generally, demand deposit accounts do not earn returns (unless a mudaraba structure is used).

Funds that go into investment accounts are invested, with the investments being managed or directed by the bank.  The depositor may lose its deposit in the investment account and, as discussed below, the bank may not guarantee any return of the principal amount of the deposit or on the deposit.  Generally speaking, there are two types of investment accounts: term deposits; and investment deposits.  In a term deposit, money is deposited for a specified minimum period or term and may be withdrawn only at the end of the term.  The maturities used for these accounts are frequently one month to a few years.  The structures used for term accounts include mudaraba and wakala.  An investment deposit is usually a profit and loss sharing account.  Structures used for investment deposits include mudaraba and wakala.

The terms “deposit”, “deposit account”, “depositor” and similar terms are used in this Client Alert because of their familiarity in connection with conventional banking practices.  However, under Islamic banking principles these are not deposits as conventionally conceived.  In many instances they are more in the nature of capital contributions (in the case of monies placed in investment accounts) or loans or safekeeping deposits (in the case of demand deposits).  Returns of and on investment deposits and returns on demand deposits cannot be assured under relevant Shari`ah principles, including by way of deposit insurance as conventionally conceived in most bank regulatory systems.  We understand that the Central Bank of Oman will require Islamic banks and windows to make premium payments to the central deposit insurance program and will require that “depositors” into Islamic banks and windows be afforded deposit insurance protections equivalent to those afforded to depositors in conventional banks.  It is not yet clear how Shari`ah-compliant depositors will be treated in respect of this deposit insurance.  Possibly they will be permitted to decline any deposit insurance payments that may be tendered to them (such a resolution was effected in the United Kingdom).  We will consider this matter in a future Client Alert and/or blog posting.

Islamic banking model #1: Two-tier mudaraba

We begin our discussion of the core Islamic banking models by focusing on the two-tier mudaraba model and investment deposits.  This requires, as background, a brief introduction to the mudaraba contract because that contract is used on both sides of the bank's balance sheet and integrates assets and liabilities.  The first-tier mudaraba contract is between the investor or funds provider (the depositor) and the bank.  The mudaraba agreement provides for a sharing of profits on investment of those deposited funds as between the depositor and the bank.  The second-tier mudaraba contract is between the bank, as investor or funds provider, and third-party entrepreneurs who are seeking funds and agree to share profits with the bank according to the percentages stipulated in the second-tier mudaraba contract.  In the two-tier mudaraba model, both the mobilization of funds (first-tier mudaraba) and the utilization of funds (second-tier mudaraba) are conducted on the basis of profit and loss sharing.

A mudaraba contract structures and defines a type of partnership arrangement in which (i) one or more persons (the “rabbul-mal”) contribute money (or other capital) and (ii) the other person (the “mudarib”) provides services, such as investment of the money provided by the rabbul-mal.  In the banking context, each “depositor” that places funds as an investment deposit is a rabbul-mal.  The mudarib is the bank that manages the investment of those deposited funds.  Those funds are held in trust by the mudarib for the benefit of the depositor rabbul-mal and the bank must use its best efforts to accomplish the objectives of the mudaraba contract.  Frequently, in Islamic banking, there are relatively few restrictions on how the bank may invest those funds.

A defining characteristic of the mudaraba is that losses from the operation of the mudaraba must be borne by the depositor (rabbul-mal) absent misconduct, default or breach of contract by, or negligence of, the mudarib.  The mudarib suffers the loss of its services, and therefore no loss of capital.

Allocation of profits to the bank and the depositor is specified in the mudaraba contract, usually in terms of ratios or percentage allocations or on the basis of a points system that takes cognizance of the amount of the deposit and the time for which the deposit is maintained.  As the investment of a depositor’s funds is usually effected jointly with funds from all depositors, these allocations take into consideration the respective amounts and timing of all investment deposits by all depositors. Profits earned by the depositors are often calculated as a percentage of total banking profits.

A generic two-tier mudaraba model is illustrated in Figure 1.  At the first tier (between the investor (depositor) and the bank), the investors enter into a mudaraba contract with the bank to share profits accruing on the investment account in accordance with defined ratios, percentages or formulas.  It is impermissible to guarantee a return to the depositor. The investors then deposit (or contribute) their funds in investment accounts.  The liability and equity side of the bank’s balance sheet shows the deposits or contributions accepted on a mudaraba basis. These are not liabilities (the capital is not guaranteed).

They are a form of limited-term, non-voting equity.

At the second-tier, the mudaraba contract is between the bank (as the funds supplier and rabbul-mal) and entrepreneurs (mudarib), who share the profits from investment operations according to the terms of this contract and in accordance with specified ratios, allocations or formulas.  Again, guaranteed returns to the rabbul-mal (the bank) are impermissible.

It is apparent from the foregoing description that the asset and liability sides of the bank's balance sheet are fully integrated, thereby minimizing the need for asset liability management, which, in turn, provides stability against economic shocks.

The two-tier mudaraba model has no reserve requirements for the investment accounts because these are profit and loss sharing accounts.  Demand deposits may be accepted in the two-tier mudaraba model.  These deposits provide no returns and are repayable to the depositor on demand, at par.  Thus, they are treated as liabilities of the bank, but frequently have no specific reserve requirements.

Islamic banking model #2: Two windows

The two windows model utilizes both demand deposits and investment deposits. The model divides the liability side of the bank’s balance sheet into (a) a demand deposits window and (b) an investment balances window.  The choices regarding allocation of a depositor’s funds into each of the two windows are left to the depositor.  The demand deposits yield no returns as the deposit is returnable on demand, at par.  These amounts are treated as liabilities.  The bank may earn a service fee for safekeeping services rendered by the bank in connection with the demand deposits.

As a regulatory matter, and quite differently from the two-tier mudaraba model, the reserves applicable to the demand deposits will be 100%.  This is because the funds are treated as amanah safekeeping deposits and do not bear the right of the bank to use the funds to generate further profits on a fractional reserve basis.  The reserve requirement applicable to the investment deposits will be 0% as these amounts are to be invested, are subject to losses, and may not be guaranteed.

Islamic banking model #3: Wakala (agency)

Shari`a Standard No. (23) Agency (“Standard 23”) of the Accounting and Auditing Organization for Islamic Financial Institutions (“AAOIFI”), § 2/1, defines wakala as "the act of one party delegating the other to act on its behalf in what can be a subject matter of delegation“.

In the wakala or agency model, the bank acts as an agent or wakeel for and on behalf of the investor-depositors and investment deposits on a fixed fee basis. A generic wakala-based deposit and investment model is graphically depicted in Figure 2.  The bank generally has broad discretion as to how to invest the deposited funds (so long as the investments are Shari`ah compliant) and notifies the depositor of the profits and losses.  Frequently, the bank will retain profits in excess of a specified rate of return as an incentive fee.  The depositor, as principal (muwakkeel), is responsible for all risks associated with the transaction except for those relating to the agent’s misconduct, fraud, breach, default or negligence.  Guarantees of the deposit are generally impermissible.  The terms of the contract are determined by mutual agreement.

On the liabilities and equity side of the bank’s balance sheet, the bank's relationship with the investor-depositors might be based on a mudaraba, amanah, wakala or wadi`a.  On the assets side of the bank’s balance sheet, the bank has more choices and freedom to invest the depositor’s investments.  There is a broad range of asset investment possibilities, including mudaraba, ijara (lease), istisna` (construction or manufacture financing), murabaha (cost-plus sale), salam (forward sale), and musharaka (partnership).

A wakala is a non-binding contract.  The principal or the agent may withdraw at any time by (a) mutual agreement, (b) unilateral termination, (c) discharging of the obligation, (d) destruction of the subject matter, or (e) death or loss of legal capacity of the contracting parties.  There are some exceptions to the non-binding nature of the contract.  The contract may become binding where (i) the agent is paid, (ii) the rights of third parties are implicated or involved, (iii) the agent starts a task that cannot be stopped without causing damage or injury to the agent or the principal, or (iv) either the principal or the agent promises not to revoke the contract for a specified period.

Agency arrangements can be general and comprehensive or specific and restricted (although the Ḥanafīs and Mālikī, as a classical matter, have ruled general wakala arrangements invalid as they may lead to excessive uncertainty (gharar)).  The agent can be paid or unpaid.  Where the agent is paid, the rules of ijara (for services) are applicable.

Demand Deposits: Qard Hassan and Wadi`a

The qard hassan structure applicable to savings and current account deposits builds upon the concepts set forth in AAOIFI Shari`a Standard No. (19), Loan (Qard) (“Standard 19”).  That standard defines a qard as the transfer of ownership in fungible wealth to a person upon whom it is binding to return wealth similar to it.  The aim of the qard hassan structure is to provide depositors with guaranteed safekeeping of deposits and to allow banks to use the deposits for its banking and business activities.

The deposited amount is treated as a benevolent loan.  The bank is entitled to use the deposited funds without authorization from the depositor.  The bank has an obligation to repay the principal amount of the loan and the principal amount of the loan is guaranteed.  No dividends or returns are due in respect of the deposits.  However, the bank is permitted, in its discretion, to provide, as a gift (hibah) to the depositors, a return on the deposits, although that gift may not be pre-agreed in the deposit contract.

Wadi`a-based deposit structures are also used for savings and current deposits.  A wadi`a (or ida - deposit) is a deposit for safekeeping.  The deposited property must be owned and deliverable and a form of property that can be possessed physically.

There are two general types of wadi`a arrangements: wadi`ayadamanah and wadi`ayaddhamanah.  Wadi`ayadamanah refers to safe custody based on trust.  The custodian must treat the property with the same degree of care as if it were his or her own property and has a duty to protect the property from being lost or damaged.  The custodian is not responsible for damage to the property unless it is due to misconduct, fraud, breach, default or negligence.  The custodian is not entitled to profits gained from the contract and any benefits that accrue from the deposit belong to the owner.  Anything other than safekeeping of the property (e.g., hiring or lending of the deposited property) requires the permission of the owner.  The custodian must return the deposited property to the owners upon the depositor’s request.

Wadi`ayaddhamanah is the more common type of wadi`a in Islamic banking circumstances.  It involves guaranteed safe custody in which the custodian guarantees the return of the property.  It is a combination of two contracts: wadi`a, or safekeeping, and dhaman, or guarantee.  This arrangement may arise if the custodian uses the property for business purposes, destroys the property, or mixes the property with other property in a manner in which the original property cannot be differentiated.  The custodian is entitled to use the deposited property for trading or other business purposes.  The custodian has a right to income derived from the utilization of the deposited property and, at the same time, is liable for any damage or loss to the disk deposited property.  The custodian owns the profit and therefore has no obligation to give a portion of the profit on the property to the depositor, but may do so as a matter of gift (hiba) so long as that is not pre-agreed.  The gift concept, in both forms of wadi`a, is controversial among Shari`ah scholars.  The custodian must return the deposited property to the owners at upon the request of the depositor.

Future articles

Future Client Alert articles will address various types of retail and wholesale products used by Islamic banks and windows and various types of financing and investment products used in the Islamic finance and investment industry.

As the Sultanate of Oman prepares to roll out its new legal and regulatory framework for Islamic banking in the coming months, we will be covering Islamic banking in the Client Alert to educate readers on this important and growing field.  This article is the first in a series by Curtis partner Michael J.T. McMillen, an Islamic finance specialist based in our New York office who provides support to our Islamic banking practice in Oman and throughout the Middle East region.

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