Iqbal et.al. (1998) distinguish two models of Islamic banks based on the structure of the assets.[1] The first is the two-tier mudarabah model that replaces interest by profit-sharing (PS) modes on both liability and asset sides of the bank. In particular, in this model all assets are financed by PS modes of financing (mudarabah). This model of Islamic banking will also take up the role of an investment intermediary, rather than being a commercial bank only (Chapra 1985, p. 154). The second model of Islamic banking is the one-tier mudarabah with multiple investment tools. This model evolved because Islamic banks faced practical and operational problems in using profit-sharing modes of financing on the asset side. As a result, they opted for fixed-income (FI) modes of financing. The FI instruments include murabahah (cost-plus or mark-up sale), installment sale (medium/long term murabahah), bai-muajjal (price- deferred sale), istisna/salaam (object deferred sale or pre-paid sale) and ijarah (leasing).[2]

On the liability side of Islamic banks, saving and investment deposits take the form of profit-sharing investment accounts. Investment accounts can be further classified as restricted and unrestricted, the former having restrictions on withdrawals before maturity date. Demand deposits or checking/current accounts in Islamic banks take the nature of qard hasan that are returned fully on demand. Using PS principle to reward depositors is a unique feature of Islamic banks. This feature, however, changes the nature of risks that Islamic banks face. Some important issues related to Islamic banks are discussed below.

– Islamic Bank: Commercial Bank or Investment Intermediary?

The Islamic bank described above appears to have characteristics of both investment intermediary and commercial bank. The ownership pattern of the Islamic bank resembles that of a commercial bank as the depositors do not own the bank and do not have voting rights. In Islamic finance parlance, this means that while musharakah contract characterizes the equity owners, deposits take the form of mudarabah contracts.[3] An Islamic bank, however, has similarities with an investment intermediary as it shares the profit generated from its operations with those who hold savings/investment accounts. After paying the depositors a share of the profit, the residual net-income is given out to the shareholders as dividends.

–  Asset-side versus Liability-side Mudarabah

The PS contract on the asset side and liability side of an Islamic bank are different. Historically, mudarabah and musharakah were partnerships for specific projects. The fund provided by the fund-owner (rab-ul-maal) to the fund-user (mudarib) is not debt, as the ownership of capital remains with its provider during the life of the project. Upon the completion of the project, capital and share of profit is returned to its owner. An appropriate contemporary financing technique using PS modes would be diminishing musharakah principle in which the bank sells off its shares to the entrepreneur in installments.[4] Though the nature of mudarahah contracts on the asset side of an Islamic bank will be different from the traditional model, the contract may still attach funds to individual projects for a relatively longer time. This, however, is not the case with the mudarabah contract on the liability side (i.e., deposit). The deposits can be withdrawn by their holders at relatively short notice.[5] In other words, whereas on the liability side the contract is usually unrestricted (in terms of liquidation), on the asset side it is restricted (funds flow after the contract matures).

– Equity versus Deposits on the Liability Side

Other than ownership feature pointed above, equity holders and depositors are fundamentally different in some other respects. These differences can be viewed from two perspectives. One way to look at the difference is the attitude of the equity-holders and depositors towards risk and return. Depositors will be more risk averse than equity holders and opt for a low risk/return deposit contracts (Gangopadhyay and Singh 2000). The implication is that the equity holders are willing to take up more risks that are compensated by a higher expected rate of return.[6]

Another important difference between equity and deposits relates to liquidity. When a depositor needs cash, he can withdraw funds from his deposits reducing the liability of the bank. Note that with restricted deposits this can be done at a cost. An equity-holder in need of cash, however, sells securities in the secondary market without affecting the equity-capital held by the bank. As will be seen, this difference has important implications on the balance sheet and liquidity management of the bank (discussed in section 5).

– Primary and Secondary PS Assets

Islamic banks may differ from investment intermediaries in one important way. This difference relates to the role of the institutions in the financial system. Whereas most investment intermediaries are asset managers, banks are involved in financing. The former institutions deal in the secondary markets where only the ownership of existing securities (secondary PS assets) change hand. Other than initial public offerings (IPOs), investment intermediaries’ activities do not directly affect the capital of firms. While Islamic banks can invest in securities (as mutual funds do), PS modes on the asset side of a bank are designed to be financing instruments. In other words, Islamic banks can directly finance firms (primary PS assets), thereby increasing their capital and productive capacities. Financing primary PS assets can be done on the principle of diminishing musharakah. As the shares of primary PS assets cannot be traded in secondary markets, they are not as liquid as secondary PS assets.

– Nature of Risks

Using PS modes changes the nature of risks that banks face. As demand deposits are considered as qard-hasan or debt and its repayment is guaranteed, the bank faces financial risks in using these deposits. By sharing the returns with the saving/investment depositors the bank eliminates financial risks but introduces some other risks. As the depositors are rewarded on a profit-loss sharing (PLS) method, they share the business risks of the banking operations of the bank. Rewarding depositors with banks’ variable profit introduces some additional risks (AAOIFI 1999, p. 7). First is ‘fiduciary risk’ that arises from breaching of investment contract or mismanagement of funds by the bank. Second, ‘displaced commercial risk’ is the transfer of the risk associated with deposits to equity holders. This arises when under commercial pressure banks forgo a part of profit to pay the depositors to prevent withdrawals due to a lower return.[7]

The withdrawal possibility due to lower rate of return is a unique feature of an Islamic bank as returns on their deposits can vary. Depositors want to protect the real value of their assets. In an Islamic environment the real value of deposits will decline not only due to inflation, but also due to zakat dues. A variable rate of return on saving/investment deposits further introduces an additional source that may affect real value. PLS returns on deposits add to the uncertainty regarding the real value of deposits. Asset preservation in terms of minimizing the risk of loss due to a lower rate of return may be an important factor in depositors’ withdrawal decisions. From the bank’s perspective, this introduces a ‘withdrawal risk’ that is linked to the lower rate of return. A recent survey of 17 Islamic financial institutions indicates that these institutions consider withdrawal risk more serious than some of the traditional risks (like credit risk, market risk, liquidity risk, etc.) that financial institutions face.15 In our model of an Islamic bank, we use withdrawal risk and point out how the displaced commercial risk arises when discussing operational aspects in Section 5.

WRİTER: Habib Ahmed


[1] Iqbal, et.al. (1998) mention three models, the third one being the case where Islamic banks work as agent (wakeel), managing funds on behalf of clients on basis of fixed commission.

[2] For a discussion on these modes of financing see Ahmad (1993), Kahf and Khan (1992), and Khan (1991).

[3] One difference between musharakah and mudarabah is that while in the former the financier has a role in management of the project, it does not in the latter case.

[4] For a discussion on diminishing musharakah see Bendjilali and Khan (1995).

[5] Restricted investment accounts may be relatively less liquid. Nevertheless, these deposits can be withdrawn at a cost in a relatively shorter period of time. For a discussion on the nature of mudarabah deposits in Islamic banks, see Ahmad (1997).

[6] Empirically it has been found that rate of return on equity is much higher than can be explained by the risk-premium. This is termed as the ‘equity premium puzzle’ in the literature. See Kocherlakota (1996) and Mehra and Prescott (1985) for a discussion on equity-premium puzzle.

[7] There is no formal Shariah approval that permits transferring profit from the owners of the bank to depositors, there appears to be no Fiqhi objections to do the same. For example, Fahmy (2001,  p.22) is of the opinion that as long as there is positive profit (no loss),  the owners of the bank can opt to transfer a part of their profit to the depositors.

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