Shariah-Compliant Structures for a Deposit Insurance Scheme
The issue of protecting bank deposits has been a major concern of regulatory and supervisory authorities and international standard-setting organisations for financial institutions. Their interest has focused on several aspects, including determining the responsibilities of central banks for deposits and the extent to which they should contribute to ensuring the availability of a minimum level of liquidity for depositors in the central banks’ capacity as lenders of last resort and as the foremost authorities responsible for protecting deposits. In addition, statutory reserve requirements were imposed on banks in order to protect depositors in the event of financial shock. Other international and local prudential standards were formulated to ensure efficient management of depositors’ liquidity in order to overcome any financial crisis. However, the increasing intensity of financial crises whose effects were felt beyond the region where they originated made it of paramount importance to put in place additional prudential plans for the insurance of banks’ deposits. Thus, the idea developed of establishing institutions to insure banks’ deposits. The general unofficial framework of the concept can be traced back to the early 19th century. It later took an official institutionalised form in 1924 in the Republic of Czechoslovakia, which established a scheme for deposit insurance whose aim was to energise the banking sector after the calamities that had befallen the country during World War I. The United States followed suit in 1933, in the wake of the onset of the Great Depression, which had led to the temporary suspension of operations of 9,000 banks and the bankruptcy of 4,000 others in the first four months of the crisis, during which depositors lost nearly USD3.1 billion. As a result, the Federal Deposit Insurance Corporation was established in 1933. Canada adopted the same concept in 1967. Afterwards, the idea of establishing such institutions was adopted extensively in other countries, including Arab countries such as Lebanon and Jordan. In the context of Islamic finance, the idea of establishing Islamic deposit insurance institutions came at a later period, with Sudan becoming the first country to introduce an Islamic deposit insurance system in 1996, followed by Turkey, which in 2001 developed a deposit insurance system that was administered by the participatory banks of Turkey to protect Islamic deposits. However, in 2005 the Islamic system became part of the conventional system. In that same year, Malaysia and Indonesia followed suit by establishing deposit insurance schemes, with the only difference being that in the case of Malaysia the Islamic and conventional deposit insurance systems operate separately from each other, while in Indonesia both Islamic and conventional deposits are protected under the conventional deposit insurance system. 
The Nature of Bank Deposits
Bank deposits – or, in other words, investment accounts, especially unrestricted investment accounts – are trust-based deposits in the possession of an investment manager, whether in his capacity as a muḍārib or investment agent. The investment manager can be held liable for these accounts only in cases of misconduct, negligence, or breach of contract. In normal cases, an investment manager is just a trustee, not a guarantor. However, a trustee becomes a guarantor in any of the three above-mentioned cases, and such guarantee can be deemed the first way to protect investment deposits.
Transgression means an investment manager does what he should not do, such as using deposits to further personal interests or disregarding the contract terms. (The latter is one example of transgression, which most scholars refer to in combination as “transgression and negligence”.)
Negligence is omission of any of the requirements of deposit management in terms of preserving deposits and securing operations by requiring appropriate guarantees as called for by the existing circumstances. AAOIFI Sharī‘ah Standard No. 45 on capital protection states: “If the investor sets a condition that certain Sharī‘ahcompliant tools are to be adopted for capital protection, the trustee must comply with the condition; otherwise, he must guarantee the capital.”
Breach of contract refers to the entrepreneur’s violation of the terms agreed to with the capital provider. For instance, the capital provider may stipulate that the entrepreneur is not to travel with the money, or is not to trade in a particular commodity, or is not to sell on credit. Upon agreement, the entrepreneur must comply with such conditions. Although some Sharī‘ah scholars deem setting such conditions passable, it is preferable not to apply them in the case of a trustee since this ruling is controversial, and it is always preferable to choose generally acceptable, undisputable rulings.
As to guaranteeing the capital in fiduciary contracts (ʿaqd amānah), AAOIFI Sharī‘ah Standard No. 5, paragraph no. 2/2/1, states:
“It is impermissible in contracts based on a trust relationship, as in agency or deposit contracts, to require a fiduciary to provide a guarantor or a pledge of security because such a condition is against the nature of fiduciary contracts; such a condition is applicable only in cases of transgression, negligence, or breach of contract. This is particularly impermissible in partnership (mushārakah) and profit-sharing (muḍārabah) contracts, since it is not permitted to require an entrepreneur/managing partner, investment agent, or one of the partners to guarantee the capital or promise a guaranteed profit. It is also impermissible to market such transactions as guaranteed investments.”
AAOIFI Sharīʿah Standard No. 45 concerning capital and investment protection, paragraph 3/6, affirms: “In an investment contract, it is absolutely impermissible to obligate the business conductor to guarantee the capital except in cases of transgression, negligence, or breach of the terms of the contract.”
Procedural Arrangements for an Insurance System for Investment Deposits in Banks
Procedural arrangements for an insurance system for investment deposits in banks can be divided into two categories, as follows:
(a) partial arrangements; and
(b) comprehensive arrangements.
Partial arrangements include:
(a) voluntary guarantees;
(b) reserves against losses;
(c) diversification of investment assets;
(d) sureties; and
Investment deposit guarantees may take this form:
“A third party having a public interest, such as the state, or an interest similar to public interest, such as a guardian or parent, may pledge to voluntarily bear the capital loss without the right to seek reimbursement from the investment manager; for example, the government guaranteeing investment projects. For such a guarantee to be legally valid, the third party must have an administrative capacity independent from that of the investment manager, and neither party should have a direct nor indirect ownership stake of one third or more in the other.”
In the latest amendments made to the AAOIFI Sharīʿah Standards, such proprietary relationship is permitted up to 50%. Unless it exceeds this percentage, the third party may guarantee the capital loss arising from an act of transgression or negligence on the part of the investment manager. Meanwhile, the guarantor may not derive any benefit from such guarantee and maintains the right to claim the amount he has paid from the investment manager.
Reserves against Losses
Reserves can be maintained to cover capital losses, provided that such reserves are taken from the investors’ capital, not from the entrepreneur’s profit share. Before the introduction of AAOIFI’s Sharīʿah Standards, an accounting standard was issued titled “Reserves and Allocations”, and such a reserve was named an “Investment Risk Reserve”.
Diversification of Investment Assets
This diversification is meant to generate appropriate returns and reduce risks. Examples of such diversifications, in brief, are as follows:
(a) combining tangible assets, such as real estate, commodities and the like, and monetary assets such as shares, ṣukūk, etc.;
(b) combining the evaluated assets of two different transactions;
(c) applying cost-plus sales, lease contracts and partnership contracts; and
(d) applying cost-plus sales along with earnest money (‘arbūn) contracts where compensation is guaranteed in case the customer fails to execute the contract.
Sureties are intended to secure obligations and prevent debt loss or procrastination in repayment. Means of securing obligations include recording debts in writing, witnesses, guarantees, pledges, cheques and promissory notes. Deposits can be protected by pledges, guarantees, letters of credit, etc., to secure any debts resulting from exchange contracts and to guarantee thereby their recovery.
Options are among the means to protect deposits from arising losses. The most important of these are:
(a) Cash option: This is a right maintained by a contracting party to terminate the contract due to lack of payment. For instance, a lessor may terminate the contract if the lessee fails to pay the rent or delays payment or fails to pay one or more installments on time. (b) Stipulated option: This is a right maintained by either or both transacting parties to terminate the contract throughout the option period.
Islamic Cooperative Insurance (Takāful)
Takāful (Islamic insurance) is an agreement between individuals exposed to certain risks to mitigate the resulting losses by paying contributions of a charitable nature.Such contributions may be on the basis of commitment to donate or waqf or cooperative participation, as stated in the latest resolution of the International Fiqh Academy of the Organization of Islamic Cooperation (IFA–OIC) on the topic. An example of a takāful arrangement to protect investment deposits is mentioned in AAOIFI Sharīʿah Standard No. 45, paragraphs no. 4/1, 4/2 and 4/3, which state:
“Cooperative insurance can help protect investment deposits through the following Sharī‘ah-compliant capital protection methods:
- Offering takāful for an investment account to protect the capital or cover the risk of transgression, procrastination, death or bankruptcy. Investors may personally carry out the administration of the cooperative insurance contract, or the investment manager may do so in its capacity as their agent;
- Offering takāful to cover assets leased in ṣukūk and other instruments against damage and basic maintenance risks;
- Offering takāful to guarantee exports and investments.”
Risk Guarantee Institutions and their Funds
These funds are based on founding an institution with the necessary administrative capacities. The institution then raises resources through its capital, subscriptions by affiliated institutions, fees, commissions on transactions, and profits generated from the institution’s investments. Added to these are grants, endowments and donations collected after acquiring the funds needed as assets, as well as any other resources approved by the institution’s board of directors in accordance with the applicable laws.
Contributors are all the participating financial institutions, whether they were involved in the institution’s incorporation or joined afterward. Here the problem arises of combining Sharī‘ah-compliant and conventional institutions. A separate institution may be established for each, or the unified institution should take into consideration the distinctive character of Islamic banks. This includes applying Sharīʿah-compliant investment methods and avoiding the mixing of funds of the two types of financial institution. The ideal format would be to invest all the resources collected from all participants in compliance with Islamic Law. That is, irrespective of the source of funds (whether Islamic or conventional institutions), the unified institution should invest all according to Islamic principles and rulings. In case an institution does not adopt a dual system, another problem arises from the participation of all institutions, Islamic and conventional, to cover the losses of any. Islamic banks can cover their losses using the resources contributed by any institution, based on the juristic principle that a change in ownership is treated like a change in the cause of ownership [making the wealth subject to new rulings based on the new status]. With regard to conventional banks, when they need to cover their losses, it must be taken into account that not all their transactions involve violations of Islamic principles – for example, current accounts, agency for investment, and various other banking services. It is also worth noting that the collapse of one bank may trigger a domino economic collapse; therefore, such banks are to be assisted in consideration of public interest.
Deposit Risk Guarantee System
It is compulsory to put in place a system and policies regarding the means of guaranteeing deposit risks in terms of types of risk and fulfilment of the Sharīʿah conditions and prudential requirements for each type of deposit. It is compulsory that the fundamental system be endorsed by the Sharīʿah committee and that the resolutions of the Sharīʿah committee be endorsed, along with precise financial and accounting standards, etc. The balance sheet and financial statements of the Islamic financial institutions should be audited in line with the standards applied in the country.
The question has been raised whether the participation of financial institutions in the capital or the subscriptions [of the guarantee system] contravenes the prohibition of a managing partner bearing financial risks. The solution to this is that the subscriptions are not directed to one depositor or to specific accounts; thus, the subscriptions are not considered a direct guarantee of deposits.
Ensuring Sharī‘ah Compliance of the Institution’s Activities
A deposit risk guarantee institution must have a Sharī‘ah board or at least a Sharī‘ah advisor. The board of directors must also include a non-executive director from among the members of the Sharī‘ah board to ensure that all the activities and operations of the institution are Sharī‘ah-compliant, that its investments are sound, and that revenues are purified when necessary. It is preferable to channel the incomes from Sharī‘ah non-compliant activities to charity.
The Board of Directors and the Executive Management
As previously stated, the board of directors should include a member from the Sharī‘ah board (a non-executive director so as not to create a conflict of interest with the system of the Sharī‘ah board). The board of directors is primarily responsible for planning and directing. Among its most important duties are:
(a) endorsement of the general policy and annual plans of the institution, following the approval of the Sharī‘ah board;
(b) endorsement of the systems adopted by the institution, following the approval of the Sharī‘ah board;
(c) endorsement of the annual budget and financial statements of the institution;
(d) follow-up and evaluation of the performance of the executive management;
(e) endorsement and development of the deposit risk guarantee system when necessary and obtaining accreditation of it from the regulatory and supervisory authorities, following the approval of the Sharī‘ah board;
(f) submitting periodical and upon-demand reports to the regulatory and supervisory authorities.
Among the most important duties of executive management are the following:
(a) proposal of the general policy, annual plans, budgets, and the financial and internal system of the institution;
(b) submission of final accounts for the financial year to the board of directors;
(c) reporting periodically to the board of directors about the activities, plan implementations, and financial status of the institution, and providing any other data required by the board of directors to fulfill its responsibilities.
Models of Deposit Risk Guarantee Systems
Models of the guarantee system for current and investment deposit risks will be briefly discussed in chronological order.
Bank Deposit Security Fund (BDSF) – Sudan
As stated on its official website, the BDSF, headquartered in Khartoum, was founded pursuant to a special act authorised by the National Transitional Council in accordance with the provisions of Decree No. 5 of 1991 and approved by the President of the State on 17 February 1996 in order to achieve the following objectives and goals:
(a) A compensatory role exemplified in its guarantee of deposits in guaranteed banks, protection of the rights of depositors and compensation for losses upon their occurrence through cooperation and mutual support on the part of monetary authorities, banks and the depositors themselves.
(b) Establishment and management of cooperative insurance portfolios, which include a cooperative insurance portfolio for guarantee of current deposits and for accounts governed by the same rules. The participants are banks, the government, and the Central Bank of Sudan and cooperative insurance portfolio. For guarantee of investment deposits and for accounts governed by the same rules, the participants are only investment depositors.
(c) A significant preventive role complementary to the regulatory role of the Central Bank of Sudan, exemplified in seeking to achieve stability and soundness of guaranteed banks and fostering confidence in them by guaranteeing clients’ deposits, especially those of small depositors, and by regularly analyzing their financial status. The BDSF management pays special attention to the preventive role to ensure its effectiveness in early discovery of the weaknesses of any bank. This assists in timely execution of corrective measures, in coordination and consultation with the Central Bank of Sudan through a joint coordinating committee that meets periodically.
Based on the preceding points, the deposit guarantee system applied in Sudan is founded on the idea of two takāful funds. The participants in the first fund are the banks, which guarantee current accounts and other similar accounts, as well as the government, represented by the Ministry of Finance and the Central Bank of Sudan. The government is allowed to contribute to this takāful fund because it falls under public interest. Participants in this fund pledge to make annual contributions, which are invested in Sharī‘ahcompliant instruments by the board of directors of the banking deposit guarantee fund. In accordance with that, holders of current accounts and other similar accounts will be compensated in the event that any participating bank is dissolved or liquidated. Each account holder would be compensated for the amount of their account up to the limit for such accounts. Participants in the second takāful fund are the investment account holders along with the government, represented by the Ministry of Finance and the Central Bank of Sudan, as is the case for the first takāful fund. The main difference between the two lies in the lack of participation by the banks in the second takāful fund. This is consistent with the fatwā issued by the Supreme Sharī‘ah Supervisory Council, which considers their participation impermissible because it would be a form of capital guarantee by the managing partner (muḍārib).
Deposit Protection Scheme – Bahrain
In 1993, the Kingdom of Bahrain founded a deposit protection council that was primarily concerned with the protection of conventional deposits. The system was amended in 2010; the Central Bank of Bahrain (CBB) launched a protection scheme for deposits and unrestricted investment accounts on 13 January 2011, in its Decree No. 34 of 2010, promulgating “Protection of Deposits and Unrestricted Investment Accounts” in accordance with the provisions of Article No. 177 of the Central Bank of Bahrain and Financial Institutions Act No. 64 of 2006. It is worth noting that the CBB presented the general outline of its plan to protect deposits and unrestricted investment accounts, particularly those of small depositors and investors, to the Sharī‘ah Supervisory Council of the CBB. After listening to the presentation and seeking clarification on certain points by the CBB, and after the wording of the decree was modified in accord with the Sharī‘ah Supervisory Council’s suggestions, the Sharī‘ah Council approved the scheme as Sharī‘ah-compliant in its basic concept and in the regulations put in place to ensure the independence of the fund for the protection of deposits and unrestricted investment accounts. This is in consideration of it being a type of takāful in which voluntary contributions are made to specifically cover the risks to which current account holders and investment account holders in retail Islamic banks may be exposed. On this basis, the Sharī‘ah Supervisory Council approved the decree promulgating “Protection of Deposits and Unrestricted Investment Accounts”.
Regarding the new deposit protection scheme, the CBB declared:
“The new scheme has overcome the disadvantages of the previous scheme, most importantly in having funds available to the system instead of depending on liabilities which are difficult to collect in a short time without leaving an adverse effect on the banking and financial system. In order to maintain a level playing field and encourage healthy competition between conventional and Islamic banks, the new scheme provides protection for unrestricted investment accounts of Islamic banks as well as deposits of conventional banks. The new scheme requires establishment of two separate funds (a conventional fund and an Islamic fund), each with its own legal entity and budget separate from the Central Bank of Bahrain, but maintained and managed by one board. Funds are accumulated separately in advance, based on regular contributions offered by the member banks. The board will decide on the investment policy for the money of both funds, and the Central Bank of Bahrain will have the responsibility of executing that policy without compensation and without charging any fees, and it is obliged to invest the Islamic fund’s money in a Sharī‘ah-compliant manner and under the supervision of the Sharī‘ah Supervisory Council. The two funds cover all eligible accounts, which include all types of deposits in conventional and Islamic banks in addition to the unrestricted investment accounts in Islamic banks.”
One of the distinguishing characteristics of the deposit insurance system in Bahrain is that it does not require two separate takāful funds for current account holders and unrestricted investment account holders, which is the way the system is set up in Sudan. In Bahrain, there is only one takāful fund for both types of accounts, and protection of unrestricted investment accounts is not considered as a capital guarantee by the investment manager (muḍārib). That is because the protection offered by the Islamic banks’ fund for this type of account is not stipulated in the contract signed by the bank with the investment account holder; rather, it is a voluntary undertaking of the Islamic banks through their participation in the Islamic banks’ fund.
Deposit Insurance Corporation – Jordan
In the Hashemite Kingdom of Jordan, the law of the Deposit Insurance Corporation was issued by the Central Bank of Jordan in 2000. The law stipulated as follows:
“Article 3: The provisions of this Law shall apply to all Jordanian banks and branches of foreign banks operating in the Kingdom, with the exception of: Branches of Jordanian banks operating outside the Kingdom; Islamic banks licensed to operate in the Kingdom, unless any one of them decides to join the Corporation to have its deposits insured.”
The law included a number of articles that were not approved by the Sharī‘ah boards of Islamic banks in Jordan. Therefore, a suggestion was made to modify the law, and a project was undertaken to draft the modifications needed to make it Sharī‘ah-compliant.
One of the suggested modifications was establishment by the Islamic banks of a fund called the Deposit Protection Fund that would work on the principle of mutual support and mutual cooperation, with contributions to it being voluntary and charitable. The Deposit Protection Fund has a financially independent legal identity within the structure of the Deposit Insurance Corporation. It is comprised of two separate funds; the first is a takāful fund for current accounts and accounts operating under similar rules as well as the non-invested portion of investment accounts. It is supplied by the annual subscription fees paid by Islamic banks. The second is a takāful fund for the invested portion of investment accounts. The annual subscription fees that are paid by Islamic banks acting as agents of the investment account holders go into it. Investment accounts for specific projects are exceptions to the accounts covered by the rules of the modified law of the Deposit Insurance Corporation. It is worth noting that the modifications to the law were in accordance with the fatwā issued by the Council for Fatwa and Islamic Research and Studies in its eighth session, held on Thursday, 4/11/1413 AH (20 September 2012 CE), which stated that the modified law is based on mutual cooperation and solidarity and that the contributions to the fund in accord with the law are voluntary and charitable in nature. The objective behind it is the protection of people’s wealth in Islamic banks from the risks to which that wealth is exposed. The Council supported the law’s emphasis on the necessity of obliging Islamic banks to guarantee the accounts that are loans to them. As for unrestricted investment accounts, the Council took the view that the annual subscription fees paid to the Deposit Insurance Corporation should be charged to the account holders since the fees are intended to mitigate their risks.
Perbadanan Insurance Deposit Malaysia (PIDM)
PIDM is an independent government institution established in 2005 to provide guarantees for current accounts in the Malaysian banking sector. When it was first established, PIDM was exclusively concerned with insuring the deposits of conventional banks. However, in December 2010 PIDM expanded its scope to include Islamic insurance on bank deposits, and the Takaful & Insurance Benefits Protection System (TIPS) was founded. The law requires Islamic banks to join this institution and pay annual contributions to have their deposits insured in cases of insolvency. These are classified as a guarantee for a fee by the Shariah Advisory Council of Bank Negara Malaysia, which ruled the practice to be permissible.
It is worth mentioning that, as of 1 July 2015, PIDM stopped insuring investment accounts set up on the basis of muḍārabah, mushārakah or investment agency. It now only insures deposits in current accounts and other accounts subject to similar rules.
The objectives of PIDM include the following:
(a) promotion of public confidence in Malaysia’s financial system by protecting insurance policyholders against loss of their benefits;
(b) reinforcing and complementing the existing regulatory and supervisory framework by providing incentives for sound management of financial system risks;
(c) minimising costs of the financial system by finding minimum-cost solutions to resolve the problem of insolvent members;
(d) contributing to the stability of the financial system by dealing expeditiously with insolvent insurer members.
It is clear from the foregoing discussion that legislative and regulatory bodies as well as international standard-setting organisations for Islamic finance have established a set of preventive measures to protect all types of banking deposits. Some of the measures are partial and associated with the investment project itself. Among them are third-party voluntary guarantees, preventive measures against investment risks, and diversification of investment portfolios so that if one asset incurs a loss the others will compensate for it. They also include provision of security measures to protect the investment and the use of options such as an option to annul in case of failure to pay and a stipulated annulment option.
Other arrangements are more comprehensive. They include application of Islamic cooperative insurance (takāful) or establishment of institutions specifically for deposit insurance. With regard to applicable models, the paper highlighted a number of models applied in deposit insurance institutions across several jurisdictions such as Bahrain, Sudan, Jordan and Malaysia, as briefly mentioned earlier. The survey of these models reveals that some institutions give considerable attention to Islamic banks by subjecting them to clear rules and regulations, whereas others include Islamic financial institutions half-heartedly. It is also noted that some institutions declare that all types of deposits are covered, including investment deposits, while some others do not include investment deposits. To conclude, the methods used to protect Islamic bank deposits are plentiful and various enough to reassure customers. Still, regulators and supervisory bodies should exert more effort to develop innovative methods to protect deposits.
2 See www.iadi.org/docs/DP-DI_From_Shariah_Perspective_(Final)_Sep2011_to_IADI. pdf
4 Ibid., Sharīʿah Standard No.
5, p. 56. 5 Ibid., Sharī‘ah Standard No. 45, p. 740.
6 Ibid., Sharī‘ah Standard No. 45, p. 741.
7 Ibid., Sharī‘ah Standard No. 5, p. 56.
8 Authored by a group of scholars (1990). Al-Mawsūʿah al-Fiqhiyyah al-Kuwaytiyyah, (Dhāt al-Salāsil: Kuwait). Vol. 20, p. 181.
9 The Accounting and Auditing Organization for Islamic Financial Institutions (2010). op. cit., Sharī‘ah Standard No. 34, p. 557.
10 Ibid., Sharī‘ah Standard No. 1, p. 14.
12 Ibid., Sharī‘ah Standard No. 45, p. 741.
13 See www.cbos.gov.sd/node/7145.
14 See www.cbb.gov.bh/ar/page_1.php?p=Deposit_Protection_Scheme.
15 Seewww.dic.gov.jo/arabic/index.php?option=com_content&task=view&id=8&Itemid =11.
16 See www.pidm.gov.my/For-Public/Takaful-Insurance-Protection/What-Is-TakafulInsurance-Protection.