Treasury Department Improvement in Islamic Banks - Essay Example

?THE WAY AND NEED TO IMPROVE UPON TREASURY DEPARTMENT IN ISLAMIC BANKS BANK: A bank is defined as a financial which does all or any of the following activities: receives deposits from customers, honors negotiable instruments drawn on them, advances loans to its customers, and invests in the market securities, issues cashier’s checks and drafts. Professor Geoffrey Crowther has defined the bank as follows: “A bank is an institution which takes the debts of other people to offer its own in exchange, and thereby to create money. The banker may be a dealer in debts but indebtedness is only the obverse of wealth and it would be equally permissible to describe the banker as a liquefier of wealth.” Both of these definitions describe the functions of a bank. If we comprehend both definitions into fewer words, a bank may be called a financial institution which deals in money. ISLAMIC BANKS: Islam has laid down certain principles and rules in every aspect of human life. These principles have had a great impact on the living standards and behaviors of Muslims all over the world. This also distinguishes the life style of Muslims from other nations. Islam has also laid down certain rules and regulations for the management and performance of financial activities in the society. They may be, to some extent, repugnant to the financial standards generally observed all over the world. ‘Islamic Banking is defined as a banking business the objectives and functions of which do not involve and include any element repugnant to the teachings of Islam’ (Interpretation). The rules framed for Shariah banking are strictly in accordance with the teachings of Holy Quran and Sunnah of Prophet (Peace Be upon Him). These banking rules sometimes affirm the rules of modern banking system while on the other times they contradict these rules. One of the main guideline given by Islamic banking system is the prohibition of ‘Interest’ or ‘Ribah’. ‘Interest’ is the main feature of modern banking system. However, it is prohibited in Islam. This prohibition has distinguished the Islamic banking system from all other banking systems. So, Islamic banks do not offer interest on deposits neither they charge interests on the loans forwarded to their customers. However, Islam does not prohibit trading or other businesses conducted for the purpose of making. Moreover, investment in any such business is also permitted by Islam. So, one of the main aspect of Islamic banking system emerges from these guidelines. Islamic banks do not generate profits by way of charging interest on the loans given to its customers. The main source of income for them is the investment in the business. These businesses use these investments for achieving their goals and making profits. The bank is a stakeholder of such businesses and thus has a share in the profits of these businesses. These profits are then divided by the bank among the depositors. The main feature of the Islamic banking system is the compliance with the rules and regulations of Shariah. However, the interpretation of Shariah may be different in different parts of the world. However, this problem is overcome by constituting a body called Shariah Supervisory Board. The body consists of Ulemah who are well-versed in Islamic law and may make recommendations to the banks for compliance with Shariah rules. The board also defines the status of products and transactions in the eye of Islamic law. The sources of funds for a bank working in compliance with Shariah are more or less same as that of other banks. The main source of funding is the amount deposited by the depositors and the customers of the bank. The deposits can have any of the following forms; demand deposit, time deposit or saving deposit. Another major source of funding is the paid-up capital of the bank. Such capital is paid by the shareholders or in other words owners of the banks. Bank reserves and retained earnings are also a major category of the bank’s funds. According to S.Mishkin, 70% of the total bank funds consists of deposits by the customers while, the paid-up capital contribute 6% only. Another source of funding is the call money in inter-banking processes, placement or financial market instruments. Funds may also be created by the liquidity of the credit from the central bank of the country. TREASURY DEPARTMENT IN BANKS: TREASURY: The word ‘Treasury’ has been extracted from the word ‘Treasure’. Treasure means wealth or anything equal to wealth. The word ‘Treasury’ means a place of depositing, keeping and disbursing the funds of a corporation. It also includes the keeping of money, gold, diamond and anything that constitutes wealth. It is obvious from the above discussion that a bank is an institution which deals in money. It takes deposits from its customers and from Government organizations in the form of money. It also receives gold from the customers for the purposes of bailment and pledge. All these valued items are kept in treasury of the bank. The bank also makes payments to its customers on account of cash withdrawal or loan. It also has to pay certain sums to the government on account of different charges. All these disbursements are also made from the treasury constituted in the bank. Thus, the treasury plays a key role in the proper functioning of the activities of the banks. TREASURY DEPARTMENT: As the treasury in a bank is very important and plays a key role in the functioning of the banks. So, it is necessary for the banks to manage their treasury so that it can be used and utilized in an effective and efficient manner. And so that the functions of the banks can be performed successfully. The activities for the treasury management are very crucial in the both elements of a financial market i.e. money market and capital market (Ross, Westerfield, Jaffe,Jordan).For this purpose, there comes a need of constituting a proper department which deals only with the bank treasury. This department is called the treasury department of the bank. The main function performed by a treasury department of a bank is the monitoring, measuring and also controlling the interest rate risk (IRR). Interest Rate Risk (IRR) is the risk which varies with the variation in the interest rates prevailing and existing in the market. The measuring and controlling of the IRR is important in this respect that it adversely affect the value of the assets and liabilities of the bank. While calculating and monitoring the Interest Rate Risk (IRR), the treasury department of the bank put particular emphasis on the determination of the net interest income. It also determines the sensitive relation between the changes in the Interest Rate Risk (IRR) and Net Interest Income (NII). The evaluations of these comparisons help in overseeing a multiple of ways of activities regarding asset and liability management. Treasury department may also be charged to take steps to keep Interest Rate Risk (IRR) within the guidelines set by the Asset/ Liability Committee (ALCO). The steps taken may include swapping interest rates and planning the future contracts. Some other functions are also performed by the treasury department. One of them is fund transfer Pricing (FTP). In case of larger banks, FTP manages and controls the funding requirements of the whole bank as well as its individual divisions. It also performs the functions of bank’s management reserves, managing the capital requirements of the bank and also managing the insurance requirements of the bank. TREASURY DEPARTMENT IN ISLAMIC BANKS: OBJECTIVES: The treasury department in Islamic banks has a number of objectives to be achieved. The most important among these is to ensure that the liquidity is sufficiently available to meet up all the liabilities of the banks; whether current or future. It also plans to maximize the return on its assets. As the treasury department is responsible for the management of the funds, so it is also among the objectives of the bank that the funds are created, kept and operated in a cost effective manner. The management of funding is also important in order to meet the strategic objectives and operating needs of the bank. The treasury department is also required to identify and also to minimize the risks that have a bearing upon the financial position of the bank. There are also some other objectives which are considered as secondary objectives of the treasury department. These include the arrangement for the government charges such as taxes. The creation and management of customer credit is also important, especially in this growing stage of the Islamic banking system. It is also the objective of the treasury department to provide finance to its customers. The roles of treasury in Islamic banking system include the organization and movement of the bank’s funds in its departments, funding the bank for liquidity purposes and setting borrowing rates for the banks within the limits set by the Central banks. FUNCTIONS: The treasury department in Islamic banks also performs the functions explained above but with such modifications as explained and directed by the Shariah Board. The treasury department main function in Islamic banks is the maintenance of reserves and the liquidity requirement and the management of the two kinds of funds i.e. shareholders’ funds and the depositors’ funds. Shareholders’ funds consist of general reserves, paid-up capital, retained earnings and share premium (Mohd Nasir bin Mohd Yatim & Amirul Hafiz bin Mohd Nasir). The liabilities of such institutions are customers’ deposits which consist of saving account deposit, current account deposit, general or special investment deposits and restricted as well as unrestricted investment deposits. The treasury department, in Islamic banking, has the responsibility to maximize the return on its assets. This is achieved by investing as much amount of cash available as possible. In the period when the bank is gaining surplus, the treasury department focuses its attention on the financing and investing activities so as to maximize the gains and return on its initial capital investment. The surplus amount is used for investment and financing after paying off any statutory charges. However, in the period of deficit, the focus of the treasury department is shifted to manage for the enough liquidity to make keep the debt-equity ratio less than 1 so that the business can be carried on as a going concern. The treasury department allocates the liquidity of the bank through managing reserves and assets of the bank. In this regard, the primary reserves are allocated first to meet any differences between the assets and liabilities of the bank. Primary reserve consists of cash and the statutory reserve. Statutory reserve is the amount kept by a bank with the Central Bank. All the banks are required to keep certain amount as its statutory reserve. The amount is determined after due consideration of the bank’s liabilities and the prevailing economic conditions in the society. This amount usually forms a proportionate part of the bank total liabilities. The treasury department in Islamic banks is also required to preserve an amount as such. In determining the assets and liabilities of an Islamic bank, a concept known as Al-bai’ al-dayn is usually preferred to other concepts. This concept refers to the trading of debts and their exchange with cash as their consideration. The consideration is calculated at discounting basis. (Mohd Nasir bin Mohd Yatim & Amirul Hafiz bin Mohd Nasir). The bank also possesses secondary reserves. If the primary reserves fail to counter the mismatch between assets and liabilities of the bank, the secondary reserves are applied by the treasury department to settle the case. The secondary reserves of Islamic bank consist of interbank investment and Islamic securities. Islamic securities are the securities the issuance of which is allowed by the Shariah Board. Besides the reserves, the earning assets and the non-earning assets may also be applied for the liquidity allocation. The earning assets are the assets that produce income for the bank without a need to do any work on it. It consists of Investment participation funds, financing assets, Murabahah, Mudarabah, Musharikah and Musharikah Mutanaqisah. While non-earning assets consists of fixed assets. NEED OF IMPROVEMENT IN TREASURY DEPARTMENT OF ISLAMIC BANKS: There are a number of problems faced by the Islamic banking system. However, most of these problems, either directly or indirectly, relate with the management of the treasury and the functionality of the treasury department. An insight into these problems justifies the need for improvement in the treasury department of the Islamic banks. The identification of these problems also help in planning the ways through which improvements can be made and also assists in the implementation of these techniques. These problems are described below: PROBLEMS FACED BY ISLAMIC BANKING SYSTEM: 1. LIQUIDITY PROBLEM: One of the main problems faced by the Islamic banks is the liquidity problem. The treasury department has to device policies and to manage their funds in such a way that the bank can meet their liquidity obligations for smooth running of the banking business. In order to comply with the Shariah requirements, the Islamic banks strictly avoid interest based instruments and the instruments must have to be asset-based. This limits the number of liquidity instruments available with the Islamic banks. These instruments are a source of covering the liquidity problems such as the management of excess liquidity and liquidity shortages. Generally, if a mismatch between assets and liabilities occurs in the banks, a number of mechanisms such as use of marketing instruments, access to the interbank market and lending money from Central bank can be used by the conventional banks. However, this is not possible in case of Islamic banks as all these mechanisms are interest based and hence, prohibited in Islamic banking system. As Islamic banks’ operations are different from those of the central banks, the central banks cannot provide support to the Islamic banks in case of occurrence of a liquidity gap. That is why, it is said that in case of Islamic banking system, there is no institution which can act as a lender of the last resort. The support can only be obtained from the general pool of liquidity. 2. ABSENCE OF ISLAMICALLY ACCEPTABLE INTER-BANK MARKET: Interbank marketing plays a vital role in the effective and efficient conduct of banking business. In interbank marketing, the banks exchange different types of currencies with one another. This is done either by the banks directly or via electronic brokers. The interbank money markets created and performing under Shariah governing rules are called Islamic interbank marketing. The Islamic interbank money market also plays a vital role in conducting their business functions. It provides Islamic banks with funding facilities and also serves as a means of monetary policy transmission in according with Shariah rules. It also allows the banks with surplus balance to transfer funds to the banks facing deficit. Thus, a system is automatically setup maintaining stability in the economic society. Thus, it also assists the treasury department of the Islamic banks to manage their funds and funding requirements efficiently and effectively. However, a major weakness occurs in the Islamic interbank money markets is the limitation of their number. These money markets either do not exist or exist in a very small number. This has limited the interbank marketing function of Islamic institutions. This, in turn, has implications on the management of funds and the funding provided by such banks. 3. SLOW GROWTH OF ISLAMIC FINANCIAL INSTRUMENTS: The financial instruments which comply with the rules and regulations governed by the Shariah are called Islamic financial instruments. The Islamic financial instruments mainly consist of Sukuk, Islamic Mortgage Backed Securities (MBS) and Islamic Future Contracts. Sukuk is a certificate that is an evidence of the payment of the amount specified therein to the issuer of the certificate and its holder is the owner of assets as mentioned by the instrument. Islamic Mortgage Backed Securities (MBS) are the securities issued with the backing of a mortgage created under Shariah rules. Another Islamic financial instrument is future contract. This consists of an agreement to sell or buy a commodity or a financial instrument at some later date. The contract must comply with the Shariah rules in order to become a perfect Islamic financial instrument. However, the financial instruments, especially the instruments of short term liquidity, complying with the Shariah rules are very limited. Moreover, the pace of development and growth of the Islamic financial instruments is also very slow. Due to their slow development pace, the treasury department of Islamic banks is unable to raise funds by issuing securities. 4. SHARIAH INTERPRETATION DIFFERENCES: The Islamic banking is governed by Shariah laws which evolving from the teachings of Quran and Sunnah of Holy Prophet (Peace Be Upon Him). However, the interpretations of these teachings are made by Ulemah. There is a common impression that Ulemah relating to different institutions construe the situation differently. The Shariah boards have an equal authority in this respect. This causes an uncertainty in the acceptable Shariah ways of running the banking business and also uncertainty in the risk assessment both for the customers and for the bank. However, the differences in interpretation are not as much uncertain as described by different bankers and economists. It is obvious that the Islamic scholars are in complete agreement with each other about what make up Islamic banking. Where the differences occur, these are mostly based on the application of concepts and Shariah laws and not on the substance. Such differences can be commonly seen among the judges in law courts. For example, there is a difference of views among the Ulemah about the banking products and transactions. There is also a difference of opinion in the handling of the liquidity issues. Some institutions prohibit the acceptance of instruments based n interest while some permit the acceptance of such instruments in case of ‘Dharurah’. Some institutions declare many derivatives as ‘haram’ perceiving these to be based on gambling. However, differences in Shariah interpretation are very much misunderstood among the public. Mostly, the customers have little knowledge about the logic behind such differences in interpretation. They think these differences to be the basis for an uncertain behavior of the functions of the treasury department and also of the banks. The customers think it very much uncertain in investing and depositing their funds in Islamic banks due to such reason. 5. OTHER PROBLEMS: Besides the problems discussed above, some other problems are also faced by the treasury department of Islamic banks. One of the major problems is the compliance of the Islamic banks with the requirements of Shariah board. Any non-compliance may cause a distress and mistrust among the people about the banks. So, creation and maintenance of market participants’ trust is very crucial for the banks. A number of revenues in banks are generated due to fluctuations in the interest rates in the market. Though, interest rate is not a factor in Islamic banking but the commissions generated may also be dependent solely on the movements in the market. Thus, it is the responsibility of the treasury department and also its requirement to keep a look on the changing market circumstances and their impact on its performance. Islamic banks also take up only risk sharing funds. It means that where the profit is obtained by the depositor, there is also a risk of a loss and the loss shall also be charged to the depositors’ funds. This has a great bearing upon the responsibilities of the treasury department because it is the treasury department which makes investments from the depositors’ funds. There is also a risk known as foreign exchange risk may occur. The losses occur due to alteration in the foreign currency exchange rates. The treasury department, before making any investment or advancing any loan, must take into account the period of return and the forecast of the future economic conditions. Some other operational risks may also occur but these may have adverse effects if the same are found to have contradictions and are opposed to Shariah rules. WAYS OF IMPROVING TREASURY DEPARTMENT IN ISLAMIC BANKS: SOLVING LIQUIDITY PROBLEM: The problem of liquidity is very crucial in the Islamic banking system. To solve this problem, various techniques have been developed and used by the Islamic banks. Some of these techniques are discussed below. i. Commodity Murabaha:- One of the main methods of dealing with the liquidity problem in Islamic banking is the commodity murabaha. It is a short-term finance form dependent on the contract of murabaha. It also involves the selling and buying of commodities in the market. ii. ABC Islamic Fund:- Another mode of addressing the liquidity problem of Islamic banks is ABC Islamic fund. The objective of the fund is to protect the shareholder by giving him maximum security. It also provides realistic profitability rate and instant liquidity. The fund is invested in mudarabah and murabaha transactions. Shares in the funds are valued on daily basis with reference to the net value of the assets’ funds. Any benefit resulting from the appreciation in the fund’s value will transfer to the customer. However, if the customer’s share in fund fall in value, the customer will receive the amount previously paid for the purchase of such shares. Thus, decrease in value will not be prejudice to the customer’s share. iii. Islamic Private Debt Securities:- Islamic Private Debt Securities is also a mode used by Islamic banks for managing the liquidity problem in the Islamic Banks. However the debt securities issued under Baye al-thamam al-ajil and murabahas are disputed securities in the eyes of Shariah scholars. iv. Musharakah certificates:- The issuance of Musharikah certificates under the ownership of the Islamic banks can manage the liquidity problem in the Islamic banks. These certificates can be used in commercial banks against the Islamic banks. The Musharikah certificates issued under this technique are equity-based certificates. v. Islamic Inter-bank Money Market:- Islamic Interbank money market also helps to solve the liquidity issue. The interbank money market is involved in the activities of buying and selling Islamic financial instruments and also performing activities of inter-bank investment. The Islamic financial instruments traded in Islamic Inter-bank Money Market are Islamic accepted bills, Islamic private securities, Islamic mortgage bonds and green bankers acceptance. Under mudarabah mechanism, a bank taking part in interest free banking may invest surplus liquid funds into another bank. These funds may be invested for a period of 12 months. The problems which are being faced by the treasury department of Islamic banks emphasized the need for improvement in the treasury department in order to overcome the problems as far as possible. Because many problems may be overcome by improving the treasury department and its functions. The modern study regarding improvement in treasury departments has largely emphasized on some key changes to be made in this regard. It is also considered that offering of new services and products may also improve the operations of the treasury department. That is why, it is now possible to use more structured and formalized methods in order to improve the treasury department functions. Introduction of new and advanced systems may assist in improving the overall functionality and efficiency of the treasury department processes and operations. An effective treasury management system may affect treasury operations to great extent and thus improve the functionality of the treasury department. . However, there is a great need to deeply examine that the systems have been completely understood from treasury operation perspective. This can only be done by using the components of the treasury function. Another method of improving the treasury department is to centralize or decentralize the treasury functions which is best suited to the bank in given circumstances. The proper management of the treasury functions by the proper persons may bring efficiency in the treasury operations which is one of the key objectives of the treasury department functions. An adequate analysis regarding centralization/ decentralization viewpoint can assist in formulating goals regarding improvement of treasury department. The forecast accuracy also affects the functionality and effectiveness of the treasury departments. The more accurate the forecast, the more properly and effectively the funds can be managed in rder to maximize return on its assets. To achieve excellence in the treasury department in a long run, a methodology is used that allows the treasury department to improve its operations over a long period of time. The treasury is designed in such a way that it is compatible with the economic situation and environment of the country. An effective Shariah board is also essential for the effective working of the treasury department in Islamic banks. The board should consist of competent scholars well-versed in Islamic law as well as the financial issues relating to banking system. It is also necessary that the treasury department should also contain the personnel who have knowledge of the financing issues and also a reasonable knowledge of the Islamic rules regarding Islamic banking. CONCLUSION: Thus, the treasury department plays a significant role in the success of a bank. It also creates perceptions about a specific banking system. In Islamic banking system, it is the treasury department which performs all the functions so as to maintain compliance with Shariah laws. The introduction and management of Islamic instruments, prevention of interest-based instruments, banking without the involvement of Ribah and funding and investing in a manner described by the Quran and Sunnah of Holy Prophet (Peace Be upon Him) are all the functions of the treasury department of Islamic banks. 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