Deposits Mobilizationand Financing Management

STUDY MATERIALS
TOPIC 1: THE FUNCTIONS OF DEPOSITS IN THE

ECONOMY
LEARNING OUTCOMES
Upon completion of this module, a student is expected to be able to:
a. explain the concept, credit creation and its roles in the economy
b. identify different categories of deposit types and structures;
c. critically analyze relationships of deposits, investments and consumption;
d. synthesize the deposit functions, economic expansion and wealth creation.
This chapter has multiple objectives in mind. The main objective is to learn about
deposits in financial institutions and its roles in the economy. One should be able to
understand the importance of deposits to financial institutions and how they function in
credit creation process, economic expansion and wealth creation. Deposit is also inter-
related to other important economic variables such as investment and consumption. This
relationship will be discussed to enable students to integrate the different elements related
to deposits and its roles in the financial and economic system.
1.1 INTRODUCTION
Deposits are defined as funds placed in a financial institution by economic surplus units
such as households, corporations, investors and government. These funds can either be
from cash, claims to money, like checks placed in depositors’ accounts, bank loans or
money from investments (Van Dahm, 1975). Financial institutions such as commercial
banks, merchant banks, finance companies and discount houses are granted licenses by
Bank Negara Malaysia, the central bank, to accept deposits from their customers. These
institutions are called deposit-taking institutions. Other financial institutions that do not
comply with the definition in the Act are non-deposit taking institutions and hence, are
prohibited from taking deposits from the public. Examples of non- deposit taking
financial institutions are factoring or leasing companies.
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The importance of deposits to an economic system is paramount in several ways. To
individuals such as households and the general public, deposits represent customers’
savings or their financial assets (Deposit creation…). By depositing money in a bank, the
customers expect the bank to safeguard their savings, to utilize them into productive
investments for a satisfactory rate of return or to enable them to facilitate their payment
transactions. At minimum, a customer expects that he gets back a dollar that he puts in a
bank and the bank has a contractual obligation to honor the claim on demand or upon
withdrawal.
To a bank, either operating conventional banking or Islamic banking, deposits is its main
source of funding for which it uses to produce income. Some literature has cited that
deposits contribute 75 percent of a bank’s total fund (Rose, 1997). Banks use customers’
deposits mainly to give out loans to deficit economic units or borrowers. Besides loans,
banks also mobilize deposits by purchasing trading securities, investments and maintain
some as cash in hand to meet withdrawals on demand. The larger the amount of deposits
a bank receives from its customers, the better is its capacity to give out loans and the
higher is the interest income. Because of this positive relationship between deposits, loan
and interest income, banks are competing intensively and aggressively among other
deposit-taking institutions to obtain higher deposits by offering attractive deposit rates or
rates plus other appealing packages depositors. Islamic banks are equally aggressive in
attracting additional deposits.
To the economy, bank deposit is the main source of money supply that can be mobilized
to generate economic growth and wealth creation. By giving out loans to borrowers and
investors, banks create credits (Abdul Gafoor, 1996). Banks’ ability to create credit
enable them to supply money to borrowers, suppliers and investors to conduct economic
activities, such as opening up plants, funding their working capital requirements,
financing their business expansion or increasing their investments. Such economic
activities create job opportunities, increasing productivity and income, which
subsequently lead to wealth creation in the economy. For interest-bearing deposits,
interest rate is very important. When market interest rates rise, so would deposit rates and
this would attract higher deposits to flow into the economic system.
In the philosophy of Islamic finance, money is required to be mobilized in productive

investments. There should not be idle money. Whoever holds idle cash or demand
deposits exceeding the nisab over a year, must pay zakat. According to Saiful Azhar
(2005), this is one way how Islam discourages people to hold idle cash for an indefinite
time. Deposits are equally important to Islamic banks as a source of funds as in
conventional banks. But unlike its counterparts, Islamic banks need to comply to Shariah
principles which prohibit any payment of interest or a fixed return on deposits. To attract
idle cash or deposits from the public for sustaining their financing activities and wealth
creation, Islamic banks are offering deposits whose returns are based on wadiah,
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mudharabah or qard hasan. The mudharabah or profit-loss sharing basis of Islamic
banking is conceived as more production oriented and growth promoting than its interest-
based counterparts. Further, the replacement of interest with profit-loss sharing principle
is also said to increase investment opportunities in the economy (Islamic Bank
Bangladesh Limited, 2006).
Looking from both conventional banking and Islamic banking perspectives, deposits are
important to generate economic growth and wealth creation. This chapter will discuss
further on deposits and its roles in the economy in 6 parts. Following Section 6.1 which
covers Introduction are Section 6.2 and 6.3 which explains the concept and deposit roles
in credit creation process followed by wealth creation and economic expansion in section
6.4. Section 6.5 shows the different types and structures of deposits as reported in the
financial statements of banks. Section 6.6 elaborates the relationship between deposit,
investments and consumption in deposit modeling and Section 6.7 ends with a summary
of the chapter.
1.2 CONCEPT AND THEORIES ON DEPOSITS
This section explains the concept and theories related to deposits in the context of
conventional and Islamic banking.
1.2.1 Concept
Three main concepts of deposits will be discussed here. These are deposits as a source of
funds, as liabilities of banks and the returns from deposit mobilization.
1.2.1.1 Source of Funds
A bank has three sources of funds namely (i) bank’ capital, (ii) bank’s reserves or
retained earnings and (iii) deposits. Among the three sources, deposits form the main
component of a bank’s source of funds. The basic concept is that deposits are the
foundation upon which banks thrive and grow. They provide the most raw materials for
bank loans and other investments (Rose, 2002: 387) from which a bank derives its main
source of interest income. Despite increasing diversification towards fee-based income
from projects and financial advisory services, banks are relying greatly on interest-
bearing deposits and assets to generate interest income and profits ( Rose, 1997 ). Hence,
banks compete aggressively to source more deposits from its customers, which can be
government, suppliers, corporations, investors or households.
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Deposit is also as an integral source of funds for Islamic banking. However, unlike
conventional bank, an Islamic bank cannot use its deposits to make profits. This is
because under Syariah principles, one cannot trade on non-commodity items and money
is treated as a non-commodity item. Under this concept, deposits are prohibited to be lent
out with a purpose to make or to maximize profit (Siddiqi, 1986, Sudin Haron 2005).
Syariah permits only if deposits are lent out to ease the burden of the needy ones for
promoting economic activities and for the wealth of the society. . Islam upholds the
belief that the returns of good deeds one does today will be reaped not only today but also
in the world hereafter.
1.2.1.2 Liability
Traditionally, a bank “borrows” or utilizes a large proportion (approximately 80%) of its

customers’ deposits to give loans to borrowers. A bank’s deposits, then, are he amounts
that it owes to its customers (Money and Banking…). Hence, deposits are the
principal liability of banks. The significance of this conduct is that in the event that the
bank is liquidated, the depositors have the first claim on the proceeds of sale of the
bank’s assets (Rose, 2002: 119).
A specified amount of the deposits is allocated to meet the statutory reserve requirement
ratio (SRR) imposed by a central bank. By definition, SRR is the percentage of deposits
that commercial banks must maintain as required reserves (Madura, 2003, BNM
Statistical Bulletin, 2006) in a central bank. This item is recorded as “Statutory deposits
with Central Banks” in the asset side of the Balance Sheet of a commercial bank (see
Table xxx). For many countries, SRR ratio is sometimes used as monetary tool to control
money supply in the economic system (Mishkin and Eakins ). The ratio varies between
countries. For Malaysia, SRR is currently set at 4%,. Besides SRR, a commercial bank
may utilize the remaining amount of deposits to purchase interest-bearing short-term
money market instruments (which are termed as trading securities) and for investments
(stocks, shares and medium to long-term securities).
A simplified version of a bank Balance Sheet in T-account is shown here to illustrate

deposits and bank operations. Suppose Bank A has a paid up capital of RM 3 million and
Reserves of RM10 million. The bank’s equity totals to RM13 million. Assuming, Bank A
customers deposits RM100 into their current accounts, the bank puts the RM100 in its
vault and adds RM100 in the customers’ current account. The RM100 deposits will show
up as a liability while the RM100 million deposits in the bank vault will show up as
assets on the bank’s balance sheet. The RM100 million assets can be in the form of cash,
loans, statutory deposits and investments. The T-account of Bank A appears as in Table
1.
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Table 1: T-account of Bank A Balance Sheet
Assets Liabilities
(Figures in RM million)
Cash 10 Deposits 100

Loans 76
Statutory Deposit with 4 Paid-up capital 5
Central Bank
Investments 25 Reserves 10
Total Assets 115 Total Liabilities and Equity 115
Similar to conventional banking, deposit of an Islamic bank is a liability. The concept of

deposit as “borrowing” in Islamic banking started during the leadership of Ar-Zubair al-
Awwan. (Sudin Haron, 2005). Ar-Zubair treated the money entrusted to his father for
safe keeping as “borrowing”. Under this concept, he was able to use the money for
economic purposes. The deposit became safer since as a borrower, Ar-Zubair argued that
he is responsible to pay back the money to the owner. The change in the concept of
deposit from trust (wadiah) to borrowing consequently enabled the people to use the
money to operate business based on the principles of qirad or mudarabah as well as to
share the profits from the business. Similar to conventional bank, not 100 percent of the
deposit amount is lent out to borrowers. An Islamic bank is still subjected to SRR ratio
but the percentage of deposit is percent (4% for conventional banking). The remaining
amount is utilized to purchase liquid assets and investment and Islamic trading securities.
(c) Return
The third concept related to deposit is return. For consenting to mobilize their deposits,
depositors are rewarded with a pre-determined rate of return by the conventional bank.
The rate of return depends on the type of deposits, the deposit amount, the length of the
maturity periods and the bank’s cost of funds. In conventional banking, market interest
rate is very instrumental in determining the deposit rate.
The concept of return for depositors in Islamic banking is different from conventional
banking. Based on Syariah principles, riba’ or interest is prohibited and a predetermined
fixed rate or a guaranteed return on investment is strictly not acceptable. Al-Quran states
that:
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“That which you give as interest to increase the peoples’ wealth increases not with God;
but that which you give in charity, seeking the goodwill of God, multiplies manifold”
(Surah al-Rum, verse 39)
The underlying trust in prohibiting a fixed or guaranteed return on deposit is that there is
an existence of an element of uncertainties in any project or investment ventures financed
by the bank from mobilization of its customers’ deposits. (Sudin Haron, 2005). The
prohibition is based on the arguments of social justice, equality and property rights
(Iqbal, Z. 1997). It is argued that there is justice if profits are determined ex-post because
it shows successful business venture and creation of business wealth. On the other hand,
return if determined ex-ante (in the form of predetermined interest) is a cost that is
accrued, irrespective whether the business venture is profitable or a loss. In the event of a
loss, this may not create wealth at all. In terms of equality, Islam demands that borrowers
and lenders share rewards equally and that there should be a fair distribution of the
wealth created in the economy.
The profit and loss sharing (P-L) basis is a basis of return where the bank shares business
risks with the borrower in return for shares in the profits of the business venture. It is
based on mudharabah dan musyarakah principles. Profit and loss sharing concept is a
unique feature of Islamic banking and is increasingly getting popular among investors
especially in times of economic uncertainties.
In addition to the P-L basis, there are other modes of return or rewards payable to
depositors depending on the type of deposit accounts he has with the Islamic bank Table
xx shows the types of account and principles used to compute return to depositors
Table 2: Deposit accounts and Principles Applied in Return Computation
Account Type Principles Applied
Current Account qard hasan or wadiah
Saving Account wadiah,mudharabah or qard hasan
Investment Account pre-determined share of profits
Islamic Negotiable Certificate of Deposit mudharabah or qard hasan
(Source: Sudin Haron, 2005)
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1.2.2 Theories
Several theories and principles are explained in this section to provide better
understanding of deposits and their role in wealth creation and distribution in the
economy.
1.2.2.1 Financial Intermediation Theory
The Theory of Financial Intermediation describes four economic functions of deposit-

taking financial institutions: (i) financial intermediation (ii) information specialist, (iii)
delegated monitors, and (iv) payment and financial services provider (see Black, 1975;
Benston and Smith, 1976; Leland and Pyle, 1977; Campbell and Kracaw, 1980;
Diamond, 1984). Black (1975) and Benston and Smith (1976) explained that, banks as
financial intermediaries are in a position to obtain confidential information (while
assessing loan applications), and access privileged information both on the demand and
supply side of the market (Park, 1997 and Mishkin, 1998). With this information, banks
are able to match financial needs of capital surplus units (those with excess funds) and
capital deficits units (those that require funds) locally and globally. To capital surplus
units, banks offer convenient financial services in order to attract deposits from them and
then loaning those funds to capital deficit units This intermediation activities take place if
there exists a positive spread between the expected yields on the loan given to borrowers
and the expected interest rate (costs) to be paid to the depositors (Rose, 2002).
In the context of delegated monitor theory, depositors have delegated the role of
safekeeping their savings to their bankers as well as entrusting them to invest their
savings prudently for better returns. Thus, banks have the fiduciary relationship with their
clients to ensure no depreciation in deposit value or losses through bank staff negligence
or excessive risk taking. They are also being entrusted with keeping depositors’ and
borrowers’ accounts strictly confidential as financial information is costly. In another
context, banks are also being delegated to assess information correctly and sufficiently to
arrive at sound investment and loan decisions. In this case, after loan disbursement,
depositors expect banks to act as their agents to monitor the loans accounts and financial
position of the borrowers in order to ensure smooth loan repayments and interest income
generation. It is therefore important that banks execute their delegated monitoring
function honestly, effectively and efficiently so that shareholders’ wealth is maximized.
1.2.2.2 Information Asymmetry
The ability of banks to monitor their borrowers’ conduct and credit worthiness depend
greatly on the extent of information available. Some information is not made accessible
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to bankers, while others have. This uneven distribution of information known as
information asymmetry sometimes leads banks to making poor credit decision resulting in
large non-performing loans. In cases where banks have inside information, they are in a
better position to choose financial instruments with better risk-return features. This
provides them with greater opportunities to give better returns to their depositors.
1.2.2.3 Diversification Theory
Diversification Theory postulates that a well-diversified portfolio can reduce risks.

Diversification can be in the form of assets or geographic locations. Accordingly, if a
bank can diversify its loans portfolio by giving loans to many borrowers (that is
observing the Single Customer Limit guideline of Bank Negara Malaysia), or disburse
the loans into several sectors and/or in many geographic locations, the lending bank can
reduce its risk exposure, resulting in increased safety for its depositors (Rose, 2002). On
the other hand, banks are taking risks by their willingness to accept risky loans while
issuing low-risk securities to its depositors. To compensate them for bearing the risks
such as credit risk or the probability of loan defaults, banks built in the risk premium in
their loan pricing. If a certain loan is perceived to be very risky, the lending bank will
built in higher risk premium, resulting in higher interest rate charged to the borrower.
The concept of diversification theory is also applied to bank deposits. A bank diversifies
its deposits base by maintaining many types of deposits such as saving deposits, current
or demand deposits, fixed deposits or investment deposits in Islamic banking. While
saving and demand deposits allows customers to draw money at anytime, fixed deposit or
investment deposits have certain maturity periods (that is 3, 6, 9 or 12 months). A bank
discourages customers to withdraw their money before the maturity periods because the
money has been invested or lock-in in certain investments. If there is a need for early
withdrawal, the customer has to give prior notice to the bank otherwise they have to pay a
penalty fee. Such diversification reduces a bank’s liquidity risk, that is the risk of not
having sufficient funds to meet customers’ immediate claims.
1.2.2.4 Segmented Market Theory
According to this theory, investors choose securities with maturities that satisfy their
forecasted cash needs (Madura, 2003). Commercial banks choose to hold assets with
short-term maturities to match their short-term liabilities. This strategy may avoid
mismatch between assets and liabilities of the banks. If borrowers and investors
participate in assets or liabilities whose maturities can satisfy their particular needs,
markets are segmented. In other words, depositors may shift their deposits from long-
term maturities to short-term maturities or vice versa if the timing of their cash needs
change. According to Segmented Market Theory, the choice of holding long-term
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maturities or short-term maturities is pre-determined according to the need rather than
expectations of future interest rates (Madura, 2003: 63).
1.2.2.5 Liquidity Premium Theory
This theory states that some investors may prefer to own short-term rather than long-term
securities because a shorter maturity represents greater liquidity. In this case, they may be
willing to hold long-term securities only if compensated with a premium for the lower
degree of liquidity. However, the preference to hold the more liquid securities may
change over time, so does the yield curve. If the demand for short-term maturities is
greater at a particular point of time, it may cause an upward pressure on the yield curve.
Hence, the liquidity premium may also changes accordingly (Madura, 2003: 61)..
1.2.2.6 Syariah Principles
In addition to the Banking and Financial Institutions Act, 1989, deposits in an Islamic
bank in Malaysia, are governed by the Syariah principles. While deposits in conventional
banks are promised with pre-determined rate of interest (except for current deposits), this
is not applied to deposits in Islamic banks. The fixing in advance of a positive return is
strictly prohibited by Syariah (Cert “: 47). The rationale for this prohibition of a pre-
determined rate of return is explicitly expressed by Imam Razi as quoted in Muhamad
Umar Chapra, (2005: 52): “when asked what was wrong in charging interest when the
borrower was going to employ the funds borrowed in his business and thereby earn a
profit, his answer is as follows:
“While the earning of profit is uncertain, the payment of interest is pre-determined and
certain. The profit mayor may not be realized. Hence, there can be no doubt that the
payment of something definite in return for something uncertain inflicts a harm”
(Razi, op.cit:87).
Islam only recognizes return on capital (deposits) after all costs have been accounted for,
and it may be positive or negative since it depends to a great extent on factors beyond the
control of entrepreneur. Hence, Islam prohibits a pre-determined positive rate of return in
the form of interest but seeks return in a profit and loss sharing basis (Muhamad Umar
Chapra: 57).
Below are two commonly used principles governing deposits of an Islamic bank.
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(a) Wadiah
Wadiah is quite similar to savings account in conventional banking where a depositor

places or deposits his money in an Islamic bank. In doing so, the customer trust his
banker to manage his savings in the most professional manner, that is the bank should
keep proper records of its client’s accounts and investing his savings in profitable, halal
ventures. The bank has to secure the agreement of its depositor to utilize the deposit and
be responsible for its risks management and possible outcomes. Hence, the bank acts a
custodian to the customer’s deposits and undertakes the commitment (or guarantees) to
return the customer his savings on demand. However, the bank is not bound to pay its
depositor with a fixed return but in line with the Syariah concept of profit sharing, the
Islamic bank may reward or hibah part of the benefits to the depositor for the use of his
money. The reward may be in the form of cash or in kinds. In Malaysia, it is a common
practice of an Islamic bank to declare a percentage of the bank’s profit as hibah to Al
Wadiah depositor. This practice allows an Islamic bank to contribute efforts in creating
and distributing wealth to people or the ummah at large.
(b) Mudharabah
Mudharabah is a principle most commonly used in Islamic finance and banking. The
principle suggests that a person that has capital will give his capital to another person that
he trusts to run a business venture. He will not interfere with the business but rather give
the partner the independence to run it. In return, the partner will return back the amount
of capital that he borrowed plus a share of the profit at the end of the business period. In
essence, both parties have a right to the business profits because one party provides the
capital and the other, his expertise.
In the context of deposit, the depositor provides capital to an Islamic bank to run banking
operations. For the deposit mobilization, the depositor is entitled to a share of the profits
agreed by the depositor and the bank. The share can be a third or a half of the profits
depending on prior agreement between the depositor and the bank. This agreement is set
at the beginning of the contract. However, the bank does not guarantee the depositor that
the business must be profitable although the bank will conduct the investment on best
efforts basis to ensure it is profitable. Nevertheless, in the event of a business failure, the
depositor will bear the losses.
1.2.2.7 Deposit Protection
Since banking business is risky business (Oyathullah, 1997), banks are very vulnerable to
unusual risks and as such, there are good reasons to protect deposits (Garcia, G., 1997).
Among the reasons is to protect depositors’ confidence in the bank’s soundness. If
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depositors lose their confidence about the safety of their money and the integrity of the
bank, there might be a bank run or sudden heavy withdrawals not only from a particular
bank but also from other banks which might cause instability in the financial system. As
such, deposits are subjected to several regulations to protect the depositors and the
banking system. One such regulation is Deposit Insurance. Although theory suggests that
unregulated financial system is best for the economy (Garcia, G., 1997), Deposit
Insurance is seen as an effective tool to protect deposits and the collapse of the banking
system.
1.3 DEPOSIT TYPES AND STRUCTURES
There are several types of deposit accounts offered to capital surplus units to place their
savings. Each deposit type has different structures from which depositors can choose to
suit their investment needs. This section explains the types and structures of deposits in
both conventional and Islamic banking system.
1.3.1. Types and Structures of Deposits in a Conventional Bank
Deposits are divided into 3 types:
1.3.1.1 Demand Deposits
1.3.1.2 Savings Deposits
1.3.1.3 Fixed Deposits
1.3.1.4 Negotiable instruments of deposits (NIDs)
Demand deposits are deposits payable on demand or after due notice. They are
sometimes called current or checking account deposits that pay no interest (Ireland,
2005). Holders of demand deposits are largely individuals, partnership and corporations
(Van Dahm, 1975).These parties maintain certain amount of deposits in their current
accounts. This type of account allows the depositor to write drafts or checks in payments
for goods and services that the bank has to honor immediately. This facility makes
demand deposits very important to the economy because it significantly improve the
efficiency of payment and transmission process, making business transactions safer and
faster (Rose, 2002). A demand or current account deposit is an asset for the depositor
because it is part of the depositor’s wealth. Conversely, it is a liability to a bank because
it is obliged to pay the depositor when he withdraws funds from his account. In Malaysia,
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only commercial banks are allowed to offer demand deposits or current account facility
to their customers.
Demand deposit represents the lowest cost source of funds for the bank and the does not
need to pay interest to the depositor. In other words, current account holders do not earn
interest since the funds in the accounts are for transactional purposes. The bank,
however, charges a demand depositor a small amount of money to cover the costs for the
services rendered to him. The services include the issuance of the check book, processing
the checks and storing cancelled checks, maintaining the depositor’s account and
issuance of monthly statements (Mishkins and Eakins, 2000).
A customer needs to have an introducer or referee t o open a current account. The

introducer must be someone known to the bank to ensure that the account is not opened
by unscrupulous or undesirable person. Having opened a current account, the customer is
given a check book. The bank undertakes to honor any demand (check payments) made
by the customer provided there are available funds in the accounts. A customer can also
make arrangement with the bank to overdraw his current account via an “overdraft
facility”. The amount and the duration of the overdraft facility have to be mutually
agreed by the customer and the bank.
(a) Types of demand accounts
There are several categories of demands or current accounts available in a Malaysian

commercial bank. These are as follows:
• Individuals
• Joint
• Sole Proprietorship
• Partnerships
• Companies and
• Partnerships.
Each of these categories requires different forms to open the account because of different
legal entities.
(b) Non-resident Account
A non-resident is allowed to operate a current account. However, banks are required to

designate all non-resident current accounts as external. This regulation is also applied for
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saving deposits, fixed deposit and negotiable instruments of deposits. The Exchange
Control Guideline of Bank Negara Malaysia defines a non-resident person as:
• A non-Malaysian citizen
• Malaysian citizen with PR status abroad and resides abroad, or
• Foreign embassies, high commissions, supranational, central banks or
• Business entities established abroad
• Non-residents with entry permits or work permits who are renewable upon
application
• A joint account in the names of a married couple where the husband is a non-resident
• A joint account where the account holders are not a married couple, but where at least
one of them is a non-resident.
Saving deposits are deposits kept in the savings accounts at a bank. Under normal
circumstances, a bank undertakes the commitment to pay back the depositor the amount
of money saved in his saving account after netting off his withdrawals. However, there
are exceptions to this commitment. A bank may face a situation where it could not pay
back the amount due when it incurred heavy losses, insolvent or experienced a sudden
deposit run. In such tight liquidity position, the bank can borrow from the central bank
and the central bank, as a lender of last resort will lend the bank sufficient funds at a low
rate (or soft loan) which enables the bank to honor its commitment to its depositors.
Another factor that provides assurance to depositors is the imposition of the Statutory
Reserve Requirement (SRR) ratio which binds a bank to maintain a specified percentage
of its deposits at the Central Bank. This reserve also ensures liquidity to the needy bank.
With these regulations, a depositor is confident to maintain saving deposit as a safe,
convenient, yet income – yielding instrument.
Banks will invest the funds in saving accounts in trading, investment securities and loans.
This mobilization allows the banks to reap better returns and pay a pre-determined rate of
interest to saving deposits holders. For example, the following are the interest rate paid
to saving deposits by the leading commercial bank in Malaysia.
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Table 3: Maybank Rates as at February 2006.
Saving Deposits Account

Return on Deposit
Nominal Rate Effective Rate
Credit balance (RM) (% p.a) (% p.a.)
Up to 2,000 0.25 0.25
5,000 0.35 0.35
30,000 0.80 0.80
Premium Deposit Account

Nominal Rate Effective Rate
Credit balance (RM) (% p.a) (% p.a.)
Up to 1.76 1.77
50,000
100,000 1.95 1.96
Saving accounts are primarily for small savers, which are mostly individual customers.
These savers form a stable deposit base for banks (Jee, 2003). The accounts are
traditionally characterized by saving books where each deposit and withdrawal is
recorded in the saving book. However, with the advance of technology and introduction
of automated teller machine (ATM), banking transactions can be done electronically.
Besides depositing cash and checks into his savings account electronically, a customer
can transfer cash into another saving or current account via ATM. Most banks now
introduce auto-sweep service. This facility automatically transfers a customer’s credit
balance from a current account into his savings account where it will earn interest.
Alternatively, if a customer does not have sufficient funds to honor checks drawn on his
account, the auto-sweep facility will immediately transfer funds from his savings account
to his current account to meet the claims (Jee, 2003). This auto-sweep facility is an
innovation to savings accounts and the facilities offered have attracted large savers to
keep their funds in savings accounts. Banks are also offering higher interest rates for
large savers.
(a) Calculation of interest on saving accounts
Interest on saving account is calculated based on the balance outstanding in the account
and credited to the account half –yearly or per monthly basis. The method of calculating
of interest is as follows:
Interest =Principal (P) x Times (T) x rate p.a. (I)
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Where:
P = outstanding balance at the end of each day
T = no. of days divided by 365 days
I = Interest rate per annum
(b) Withholding Tax
In Malaysia, interest received from saving accounts is subjected to a 5% withholding tax.

However, following 1996 Budget, interest received up to RM100,000 is exempted from
the tax. From non-residents, the withholding tax is 15% p.a. (Jee, 2003).
(c) Types of Saving Accounts
Savings account can be divided into 5 types. There are:
(i) Individual Saving Account
To open individual account, a customer has to come in person to a bank to fill the
necessary information and produce personal identification such as an identification card.
The customer’s signature will be used to verify his withdraw slips.
(ii) Joint Account
Joint account allows two persons or more to operate the savings accounts. A bank
requires identification and signature of the two depositors. In addition, they have to fill
and complete a Joint Account Mandate Form. In terms of operating the account, the bank
will request for a specific instruction such as “ Any one to sign” or “All to sign” or “Any
two to sign” for withdrawal transaction. The Mandate Form also contain a clause on
survivorship which gives power to the bank to pay the remaining balance in the savings
account to the surviving party in the event of death or bankruptcy of any one of the
account holders.
(iii) Club, societies and association
The bank will request for important documents such as
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• a certified copy of the rules and regulation,
• a certified copy of the license issued by the Registrar of Societies
• a certified copy of an extract of the resolution passed by the club or association
committee
• Signatories and identification cards of the office bearers.
For this account, the bank will also request the applicants to fill the Mandate Form and
the conditions to operate the account.
(iv) Trustee Account
The Bank will require a Trust Deed to open the Trustee Account. The trustee can either
operate individually or jointly in case of having two trustees.
(v) Minors
Minors are those savers below 12 years old. For this category, the parents or guardians
need to open and operate the accounts for them.
1.3.1.3 Fixed Deposits or Times Deposits
Fixed Deposits or Times Deposits are interest bearing deposits. In this type of accounts,
depositors keep their savings or deposits in a bank at a specified amount for a fixed
period at a fixed rate of interest. The time period which measures the maturity period of
the deposits ranges from one month, >1-2 months, >2-3 months, >3-6 months, >9-12
months, >12-15 months,>15-18 months, >18-24 months and >24 -36 months. The
different time period differentiate the category of fixed deposit. For example, deposit for
1-month period is called a one-month fixed deposit, a 6-month period is called a 6-month
fixed deposits.
Fixed deposits account holders can be government, statutory bodies, financial institutions
(commercial banks, merchant banks, and finance companies), business enterprises and
individuals. Based on BNM Statistical Bulletin January 2006, individuals form the
largest component of depositors in fixed deposit category (Refer to Table xxxx). Except
for the one-month fixed deposit account, banks are allowed by Bank Negara Malaysia to
receive any amount from its customers for fixed deposit accounts whose maturity periods
are greater than one month. For the one-month fixed deposit account, the minimum
amount allowed is RM 5,000.00.
- 16
Banks are required to display the fixed rates offered for the different categories of fixed
deposit accounts. Below is an example of the rates offered by Maybank to its fixed
deposit account holders.
Table 4: Maybank Rates as at February 2006.
Fixed Deposit Account

Maturity period Fixed Deposit Rate
(% p.a.)
1 to 2 months 3.20
6 months 3.30
9 months 3.40
12 months 3.70
(Source: http//:www.maybank2u.com.my)
(a) Calculation of interest on fixed deposit accounts
Interest on fixed deposit is calculated based on simple interest computation as follows:
Interest (I) = Principal (P) x Time (T) x Rate quoted
Where:
P = principal or amount of fixed deposit
Time = period from the deposit date to maturity (number of days )
Example 1: En. Ahmad places RM10,000 in a one-month deposit account from 24

January to 24 February, 2006. The interest is fixed at 3.30% per annum. The
interest is calculated as:
Interest = Principal (P) x Time (T) x Rate quoted
= RM80,000 x 3.3 x 31
365 x 100
= RM224.2192
If on February 24, 2006, the customer rolls over the fixed deposit and the interest for
another one month for 4.0% p.a., the interest will be:
- 17
Interest = Principal (P) x Time (T) x Rate quoted
= RM 80224.22 x 3.3 x 31
365 x 100
= RM 272.5426
(b) Withholding Tax
In Malaysia, interest received from fixed deposit accounts is subjected to a 5%

withholding tax. However, following 1996 Budget, exemption is given on the followings:
(i) interest up to RM100,000 for maturity period less than 12 months

(ii) fixed deposits whose tenor is 12 months or more.
1.3.1.4 Negotiable instruments of deposits (NIDs)
NIDs are interest- bearing instruments or certificates traded in the money market. They
represent written acknowledgement by banks duly signed and dated. The
acknowledgement states that “a specified sum of money has been deposited in this bank
(name of the bank ) on this date (the date) payable to bearer on (due date) upon surrender
of the certificates at the rate of interest (the interest rate) per cent per annum until
maturity” (Dahm, 1975).
There are four typesof NIDs traded in the Malaysian money market. These are:
(a) Short-term Negotiable Certificate of Deposits

(b) Long-term Negotiable Certificate of Deposits
(c) Zero-coupon Certificate of Deposits
(d) Floating Rate Negotiable Certificate of Deposits
A NID has a nominal denominated in multiples of RM150,000 up to a maximum amount

of RM10 million per certificate. The certificate is issued by the depository bank
nominated by the depositor. The de depositor can buy this certificate from the authorized
issuer and can sell these certificates in the money market. Upon maturity, the depositor
will present the certificate to the issuer for payment. Issuing banks are allowed to buy
back and redeem back their own NIDs provided that the NIDs have been issued and are
outstanding for at least 3 months (Jee, 2003).
- 18
In summary, Demand deposits, Saving deposits, Fixed deposits and NIDs are collectively
grouped as “Deposits from Customers” in a Balance Sheet of a commercial bank. These
types of deposits and Deposit and placements of banks and other financial institutions are
recorded as liability items in the Balance Sheet of a commercial bank. While government,
statutory bodies, business enterprises and individuals are depositors, financial institutions
can both be the depositors as well as the ones receiving the fixed deposits from other
financial institutions. In other words, if Bank A has excess cash that it does not need to
use for the next 6 months, it can place the funds in another bank fixed deposit account.
Table 5 illustrates the composition of deposits from customers as stated in the Annual
Report of a commercial bank.
Table 5: Maybank Berhad as at 30 June 2003
Group (RM ‘000) %

Deman 19,362,900 17.20
d 20,046,047 18.32
deposits 68,819,305 62.91
Savings 1,165,057 1.07 100
deposits 109,393,30 .0
Fixed 9
deposits
NIDs
1.3.2. Types of Deposits and Structures – Islamic Banking
Deposits offered by an Islamic bank are divided into 3 types:
1.3.2.3 Investment Deposits
1.3.2.4 Negotiable Instruments of Deposits
Demand deposits facility is available in Islamic banks. This account allows an account
holder to a checking or current account. He may withdraw his money at any time or
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conduct payments using checks for which the bank has to honor. Similar to a
conventional bank, an Islamic bank offers similar services to its customers for a fee and
no benefits are given to demand deposits holders.
Banks operating Islamic banking in Malaysia do offer saving deposit facilities to their
clients. However, there are several differences between saving deposit in a conventional
bank and saving deposit in an Islamic bank. For conventional bank, saving accounts are
interest- bearing accounts but they are not in the case of Islamic bank. The difference lies
in the concept used. Instead of interest based as in conventional banking, the operations
of saving deposits in an Islamic bank in Malaysia is based on al-wadiah yad dhamanah
or guaranteed savings. In other Muslim countries, saving deposits are operated based on
mudharabah or profit-loss sharing concept (Sudin Haron, 2005). Based on al-wadiah yad
dhamanah concept, an Islamic bank in Malaysia may reward its customers with cash
which represents a certain percentage of the profit earned.
Table 6 illustrates the composition of deposits in Islamic Banking Scheme as stated in

the Annual Report of a commercial bank.
Table 6: Maybank Berhad as at 30 June 2003
Group (RM ‘000) %

Demand deposits 2,308,331 20.95
Savings deposits 1,502,179 13.63
General Investment Deposits 6,844,963 62.11
Special Investment Deposits 1,478 0.01
NIDs 363,887 3.30
11,020,838 100.0
Table 6 shows that the largest component of deposits in Islamic banking of Maybank is
General Investment Deposits (GIDs), followed by Demand Deposits, which comprises
62.11 percent and 20.95 percent of the total deposits respectively. The main maturity
structure of GIDs and Special Investment Deposits is due within six months followed by
six months to one year. Table xxx of Maybank conventional banking highlights different
deposit composition. Under conventional banking, the largest and second largest
components of deposits are Fixed Deposits (62.71%) and Savings Deposits (18.32%)
respectively. In contrast to the Maybank Islamic banking, demand deposits of its
conventional banking ranked the third largest component. However, the maturity
structure of deposits is similar between the bank’s Islamic banking and conventional
deposits where most deposits are due to mature within six months followed by six months
to one year. These structures suggest that investors may prefer to own short-term rather
than long term securities because a shorter maturity represents greater liquidity. This
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supports Liquidity Premium Theory. The deposit structure also indicates the application
of Segmented Market Theory where the choice of long-term versus the short-term
maturities is pre-determined to suit the customers’ forecasted needs (Madura, 2003).
1.3.2.3 Investment Deposits
Investment accounts in an Islamic bank are time deposits accounts accepted by the banks
on the explicit understanding that the deposits will be invested in projects on a profit and
loss sharing or al mudharabah concept. These accounts bear no interest, and there is no
guarantee of capital, nor of profit. Under the arrangement, the bank will use the deposits
for investment purposes. The profit will be shared between the bank and the customers.
At the same time, the investment account holders bear part of the losses if the project
failed. There are currently two investment accounts: General Investment Deposits and
Special Investment Deposits
1.3.2.4 Negotiable Instruments of Deposits
There are two types of negotiable instruments of deposits based on Islamic principles.
These are (1) Negotiable Islamic Debt Certificate (NIDC) based on the concept of Bai’
Bithaman Ajil and (2) Islamic Negotiable Instruments of Deposits (INID) based on Al-
Muharabah.
1.4 DEPOSIT EXPANSION AND CREDIT CREATION
One of the special features about a commercial bank is its ability to offer current account
to its depositors. The current account allows deposits to expand in the banking system.
The process of deposit creation and credit creation starts at two levels (Rose, 2002):
1.4.1 At micro level
As discussed in the early part of the chapter, a bank receives deposits from customers and
mobilizes the deposits by giving loans to its borrowers. When a borrower is granted a
loan, he will sign a loan agreement or a promissory note, and in turn, he will receive loan
amount which will be credited into his account as deposits. Thus, in granting loans,
deposits are expanded and credits are created. The borrower can spend the credits or the
loanable funds in his name for payments through his current account by issuing checks.
The people who received the checks can cash them, thereby increasing currency in
- 21
circulation or deposit the checks in their own current accounts. If the checks are cashed,
then deposits are drained from the banking system. However, if the checks are deposited
either in the same bank or other banks, the amount of deposits in the banking system are
not affected.
1.4.2. At macro level
At macro level, deposits are expanded when a bank places its excess funds in another
bank for investment, hence creating new deposits. The bank with excess deposits
(relative to its immediate needs) can lend money to another bank that is facing tight
liquidity. This inter-bank borrowing creates credits and this credit is recorded as deposits
and placements of banks and other financial institutions – a liability item in the
borrowing bank’s balance sheet. Thus, credit is created not only when a bank grants a
loan to customer but also when a bank borrows funds from another bank in the money
market and deposited them in its account.
By regulation, a bank is only required to keep aside a specified percentage of deposits it

received from customers. This is the Statutory Reserve Requirement discussed earlier in
the chapter. (The same requirement is applied to Islamic banks). The remaining amount
of deposits which is called excess reserves are the amounts that the bank can loaned out
to customers, buy financial instruments in the stock market and money market and
maintain cash in hand. The proportion of the excess reserves to be allocated to loans,
investment securities, trading securities and cash are the prerogative of the bank. Hence,
one might see variation in the allocation choices between banks. These allocations form a
diversified portfolio of assets for the bank. Based on Theory of Diversification, this
diversification of bank assets may mitigate the risks associated with banking activities,
consequently enhances the bank’s profits.
However, a bank could not lend out more than its excess reserves (Rose 2002). By large,
banks allocate more than seventy percent of the excess reserves to loans. As customers
spend the proceeds of their loans, part of the excess reserves flow out to other banks in
the banking system, giving the banks deposits from which to create credit as well.
Therefore, banks in the entire banking system can create multiple deposits and credits
through their lending activities.
The extent to which credits are created is determined by the following formulae.
Amount of new money created = 1/SRR x excess reserves.(Rose, 2002).
- 22
If SRR is 10%, then each dollar of excess reserves would create new deposits in the
amount of:
Amount of new money created = 1/SRR x excess reserves

= 1/0.1 x $1
= $10
Suppose a customer deposits RM 1000 in cash into his account. Assuming that the SRR
is 10 percent and using the formula above, the bank can advance up to RM9000 in loans
on the strength of this cash deposits. This is credit creation. Thus, this credit creating
mechanism allows a commercial bank to grant advances and loans several times more
than any individual can with the same amount of money. The ratio of 1/SRR is also
called demand deposit expansion multiplier.
The following T-accounts illustrate how the deposit expansion and credit creation takes
place.
(i) Assuming Bank A has the following Balance Sheet position.
Asset Liabilities + Equity

RM RM
Cash 100,000 Demand Deposits 2,000,000
Reserve at Central Bank 2,900,000 Equity 5,000,000
Investment securities 3,000,000
Fixed Assets 1,000,000
7,000,000 7,000,000
If Reserve ratio = 10%, Deposits = RM2,000,000
Required Reserve at central bank = 1/10 x 2,000,000

= RM200,000
Total reserves = Cash + Reserve at Central Bank

= RM100,000 + RM2,900,000
= RM3,000,000.
Excess Reserves = 3,000,000 – 200,000

= RM2,800,000
(ii) Deposit and credit creation
Amount of new money created = 1/RR x excess reserves

= 1/0.1 x 2,800,000
= RM28,000,000
- 23
Hence, with deposit multiplier of 10%, deposits of Bank A expand by 10 times and Bank
A now has new deposits amounting to RM28, 000,000. If Bank A wishes to mobilize the
deposits to give loans, the transaction is recorded as follows:

RM RM
Loans +28,000,000 Demand Deposits +28,000,000
(iii) With the increase in deposits and loans, the Balance Sheet of Bank A in (i) is now
as follows.

RM RM
Loans Reserve at 100,000 Demand Deposits 2,000,000
central bank 2,900,000 New demand deposits 28,000,000
Securities 3,000,000 Equity 5,000,000
Loans 28,000,000
Fixed Assets 1,000,000
35,000,000 35,000,000
(iv) The new Balance Sheet shows that a single bank can safely lend and create
demand deposits up to the amount of excess reserves. If it tries to lend more than
its excess reserves, it will face shortage of funds as soon as its borrowers spend
the proceeds of the loans and upon clearing of those checks issued by the
borrowers (Ritter, et al, 1996).
(v) When more banks participate in expanding deposits (through the operations of
demand deposits) and creating credits through giving loans, the banking system as
a whole will experience multiple deposits creation which is the reciprocal of the
reserve requirement ratio.
(vi) However, deposits may contracts when there are leakages in the banking system
such as when customers cash the checks or when loans are repaid or securities
being sold. When borrowers repay their loans, the lending bank will deduct the
amount repaid from their demand deposit (current) accounts, consequently
reducing the balances in their current accounts or demand deposits. Similarly,
- 24
when people cash checks, money flows out of the circulation in the banking
system into the hands of the people. Hence, there is less credit creation when
people increases cash in hand or reduces their loans.
1.5 FUNCTIONS OF DEPOSITS IN THE ECONOMY
1.5.1 The main functions of deposits in the economy are:
1.5.1.1 Main Determinant of Money Supply

1.5.1.2 As an important factor of production
1.5.1.3 Serve as an attractive investment avenues for savers and investors
1.5.1.4 Credit creation and deposit expansion in banking system
1.5.1.5 Barometer for interest rate changes and financial stability
1.5.1.1 Main Determinant of Money Supply
As the main components of money, deposits play significant roles in the economy The
components of money supply in the economy can be classified as M1, M2 and M3. These
money components are basically from bank deposits. For instance, BNM Statistical
Bulletin, (2006) and Aziz (2002) define the components as:
M1 = coins and currency notes and demand deposits.
M2 = M1 + quasi money
Quasi money = (savings deposits + fixed deposits + NIDs issued + Repurchase

Agreements) of the private sector at the commercial bank
M3 = (savings deposits + fixed deposits + NIDs issued + Repurchase

Agreements) of the private sector at finance companies,
merchant banks, discount houses and Bank Islam Malaysia
Berhad.
MB = Monetary base = currency + reserves.
Hence, any changes in deposits will have a direct impact on money supply and liquidity
in the financial system. Further, contraction in money supply resulting in tight liquidity
will force the market interest rates and cost of funds to increase. Conversely, expansion
in money supply through growth in deposits will lower down the interest rate and cost of
- 25
funds. Since loans and financial instruments in conventional banking are interest based,
changes in interest rates directly affect loan pricing, interest income and financing risks.
Movement from currency and demand deposits in preference of quasi money also reflects
the liquidity preference to movements in interest rates (Aziz, 2002).
1.5.1.2 As an important factor of production
Factors of production are capital, land, labor and raw materials. Deposits, which represent
savings of capital surplus units provide funds to capital deficit units who needs them for
production of goods and services. Without deposits in the banking system, banks could
not provide loans or financing to businesses, corporations, government or individuals to
conduct economic activities for economic growth and wealth generation. The flow of
funds in direct finance involves the transfer of deposits from capital surplus units to
capital deficit units while indirect finance involve the use of financial institution s as
financial intermediaries that bridge funding gap between depositors and consumers’
financing needs at lower costs. .
1.5.1.3 Serve as an attractive investment avenues for savers and investors
Deposits in banks are characterized by different types (saving deposits demand deposits
and time deposits) and maturity structures. This gives ample choices for savers to choose
the types of deposits and maturity periods that can meet their anticipated cash
requirements. The conventional banks which offer a pre-determined rate of return on
deposits over a fixed time period provide safe, profitable and low risk investments for
savers and investors. The Islamic banks which offer returns on deposits on a profit-and
loss sharing and partnership basis provide equally attractive investment avenues for
depositors. Table xxx shows the position of Deposits By Type and Holder of Banking
versus Islamic Banking System as at November 2005.
(a) By Type
Banking System Islamic Banking

RM million % RM million %
Demand Deposits 81,731.4 15.9 13,757.3 22.1
Investment Deposits - - 40,124.7 64.5
Saving Deposits 60,269.0 11.7 8,281.8 13.3
Fixed Deposits 317,619.0 61.6 - -
NIDs 55,851.4 10.8 - -
515,470.4 100.0 62,163.80 100.0
- 26
(b) By Holder
Banking System
DD FD SD NIDs
Federal Govt 1,200.0 372.3 - 70.0

State Govt. 655.7 4,044.2 - 700.0
Financial Institutions 2,339.8 24,192.1 2.1 38,003.8
Statutory Authorities 2,447. 0 8,670.8 - 91.9
Business Enterprises 55,413.2 80,368.2 -
Individuals 19,675.3 196,623.4 60,237.0 669.8
81,731.0 314,271.0 60,239.1 39,535.5
Islamic Banking
DD ID SD
Government 3,686.5 8,793.8 -

Financial Institutions 1,062.3 5,935.8 3.5
Business Enterprise 5,411.7 18,831.8 -
Individuals 3,596.8 8,563.3 9,288.4
13,757.3 42,124.7 9,291.9
Where : DD = demand deposits, FD = Fixed Deposits, SD = Savings Deposits

NID = Negotiable Instruments of Deposits, ID = Investment Deposits
1.5.1.4 Credit Creation and Deposit Expansion
In the earlier sections of this chapter, we have discussed the unique ability of banks to
create credits and deposits expansion. This feature accentuates the importance of deposits
in the economy since deposits enable banks to create credits through banks’ lending
activities. The operations of demand deposit through checking accounts enable the
multiplying effects of deposits to take place in the banking system and this helps to
increase money supply in the economy. Economic developments and investment
spending in Malaysia, to a large extent, has been funded by bank credits as indicated by
high loan to GDP ratio.
- 27
1.5.1.5 Barometer for interest rate changes and financial stability
One of the roles of deposit is acting as a monetary tool to control interest rate and
financial stability. During the 1997 Asian Financial Crisis, Bank Negara Malaysia has
used SRR (that is the amount of deposits at the central bank) as a monetary policy tool to
control money supply and interest rate. The SRR ratio, which was set at 12 percent of
deposits prior to the AFC, was gradually reduced to 4%. With lower SRR, banks have
more excess reserves to lend out as loans to their customers. Simultaneously, new
deposits increase by the same amount, resulting in an expansion in money supply and
decreasing interest rates. Low interest rates and ample money supply stimulated
economic activities, restored financial stability and created wealth to the economic units.
1.5.2 Islamic Views
Islam views mobilization of deposits as vital to the economy as well. For, economic
“wastes” are forbidden in Islam and “economizing” is an Islamic virtue (Ariff,
2005:117). However, the economic principles of Islam are unique and different than the
western economic theories. The conventional economic theories such as “competition,
maximization of profits, and interest as a reward for savings” are not accepted. Islam
emphasis on co-operation rather than competition as stated in the al-Quran (2:18):
“Then strive together (as in one race) towards all that is good”
Maximization of profits is forbidden in situations of monopolistic position, oligopoly or

monopoly, resulting in abnormal profits (Ariff, 2005). Interest on capital or deposits is
also not acceptable in Islam as one cannot pre-determine rate of return on capital while
the outcomes of the project that the capital is invested in is uncertain. Thus, the return on
deposits such as on Investment Deposits accounts depends on profits and losses sharing
basis.
Excess money balances or capital surplus in Islamic economics can be channeled in three
possible ways: (i) hoarding (ii) lending and (iii) investment. Islam discourages hoarding
of excess funds because idle money imply economic waste and negative real returns due
to time value of money. Islam permits mobilization of deposits to financial institutions as
direct lending in the form of “current deposits” or to government as indirect lending in
the form of purchases of government bonds. Mobilization of excess money balances into
investments is permitted since profits and losses which carry positive and negative
returns are shared between an Islamic bank and the entrepreneur.
1.6 DEPOSIT MODELING
- 28
Bali (2000) developed a currency-deposit model to derive the welfare cost of inflation in
the United States by taking into consideration monetary aggregates (currency, demand
deposits, monetary base and M1) and scale variables (income and consumption). Using
Error Correction Model, the model expressed in double log function is simplified as
follows:
Double log
WCBailey = f (currency/GDP, currency/ Cons, Deposits/GDP, Deposit/Cons,

MB/GDP, MB/cons, M1/GDP, M1/Cons)
Where:
WC = welfare cost of inflation
Currency = coins and currency notes
Cons = consumptions
MB = monetary base
M1 = monetary aggregates
Deposits = demand deposits
The finding shows that the estimated welfare cost of inflation is sensitive to money
demand function and the definition of money. Each monetary aggregate (currency,
demand deposit, monetary base and M1), income and consumptions (scale variables)
yields substantial gains in moving from zero inflation to optimal deflation rate needed to
bring interest rate to zero. The deflation rate is found to be 3%. The study also shows
that it is very important to incorporate the effect of currency and demand deposits in
determining the welfare cost of inflation. If these two variables are not accounted for, the
effect of inflation on the economy might be overestimated.
A Multiple Deposit Model shows the linkage between changes in money supply and the
monetary base by taking into account depositors’ decision to hold cash and banks’
decision to maintain excess reserves. Reynolds (2004) mathematically expressed the
relationship as follows:
Change in money supply (M) = money multiplier (m) x Monetary Base (MB)….(1)
Given that:
C = desired level of currency
ER= excess reserves held by banks
D =checkable deposits
rd = the required reserve rate set by the central bank
RR = required reserves
- 29
And assuming that C and ER grow in proportion to D, we have the following ratios:
C/D = currency ratio = constant

ER/D= excess ratio = constant
Total reserves in the banking system (R)
R = RR + ER …………………………………… ………… (2)
Where, RR = rd x D……………………………………………(3)
Substituting Equation (2) into (1),
R = (rd x D) x ER……………………………………………….(4)
MB = Currency (C) + reserves (ER)……………………………(5)
Alternatively,
MB = C +{ (rd x D) + ER} …………………………….(6)
Substituting equation (6) into (1), the changes in money supply can be modeled as
follows:
M = 1 + {C/D} ……………………………..(7)
rd + {ER/D} + {C/D}
The Multiple Deposit model in Equation 7 shows that a change in money supply is
the product of money multiplier and monetary base. This statement implies that
regulators can control money supply by changing the required reserve ratio (rd) or
the required reserves.
1.7 SUMMARY
This chapter has focused on deposits and its functions in the economy covering both the
conventional and Islamic views. Three main theories together with the Shariah and
Islamic economic principles have been addressed to provide greater appreciation of
deposits and its roles in the economy. The importance of deposits to an economic system
is paramount in several ways. To individuals such as households and the general public,
deposits represent customers’ savings or their financial assets. By depositing money in a
bank, the customers expect the bank to safeguard their savings, to utilize them into
- 30
productive investments for a satisfactory rate of return or to enable them to facilitate their
payment transactions. To a bank, either operating conventional banking or Islamic
banking, deposits is its main source of funds for which it uses to produce income.
Different deposit types and maturity structures are included so that one can draw
differences between conventional and Islamic deposits.
To the economy, bank deposit is the main source of money supply that can be mobilized
to generate economic growth and wealth creation. By giving out loans to borrowers and
investors, banks create credits and experience deposit expansion. T-accounts illustrate
how the credit creation takes place and the importance of reserve ratio and excess
reserves in deposit and credit creation process. Banks’ ability to create credit enables
them to give loans to borrowers, suppliers and investors to conduct economic activities
which lead to creation of job opportunities, increasing productivity and income, which
subsequently produce wealth to the economy.
- 31
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McGraw – Hill Irwin, New York.
Rose, P. S. (1997). “Money and Capital Markets, Financial Institutions and Instruments
In A Global Market Place”, 6th Edition. IrwinPublications, New York
Siddiqui, M. Nejathullah. (1986). “Teaching Economics in Islamic Perspectives, Saudi

Arabia, Scientific Publishing Centre, King Abdul Aziz University, Saudi Arabia.
Saiful Azhar Rosly.(2005). “Critical Issues on Islamic Banking and Financial Markets”,
DinamaS. Kuala Lumpur. Malaysia.
Sudin Haron, (2005). “Sistem Kewangan dan Perbankan Islam, Kuala Lumpur Busness
School Sdn. Bhd., Kuala Lumpur. Malaysia.
Bali, Turan G. (2000). US Money Demand and the Welfare Cost of Inflation in a
Currency-Deposit Model, Journal of Economics and Business, vol.52:233-258.
Van Dahm, Thomas E. (1975). “Money and Banking”. An Introduction to the Financial
System, Carthage College. USA.
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STUDY MATERIALS
TOPIC 2: THE THEORIES AND PRINCIPLES

RELATED TO DEPOSITS
LEARNING OUTCOME
(a) How money affects economic activities.

(b) The religion of Islam and its influence the demand and supply of Islamic deposits
(c) Saving behaviour of Islamic banking customers
2.1 INTRODUCTION
Economic theories related to deposits are important component in the understanding the
money supply and monetary policy. Basic money supply or M1 consists of the monetary
base (ie coins and currency) and demand deposits, while M2 includes time deposits. The
same applies for Islamic banking, although the contracts on which demand and
investment deposits are structured are not similar with conventional deposits.
The central bank can influence changes in the price level, income and employment by
changing the level of money supply through its monetary policy instruments such as
reserve requirement, discount rates and open market operation.
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For example, when a recession hits the economy where sales and spending are down and
unemployment on the rise, the central bank usually pursues an expansionary monetary
policy aimed at reducing the level of interest rates to stimulate aggregate demand.
To do so, it will increase the money supply by say, reducing the statutory reserve
requirement. This leaves the banking sector with new reserves ie more cash to make
loans. It increases liquidity and reduces the level of interest rates.
2.2 THE ECONOMIC THEORIES RELATED TO DEPOSIT
The reduction of interest rates will now make many investment opportunities more
viable. This is because, decision to invest usually deals with comparing cost of
borrowings (i) and the project’s expected rate of return (r) also known as the internal rate
of return (IRR). For example, when r = 7 per cent while i = 9 per cent, cost of borrowing
is higher than the project’s expected return, firm will not borrow and the project will not
be undertaken as it will only lead to loss. In other words, the firm will not invest in the
project and no increases in investment spending will take place.
But when the central bank increases the money supply by making more excess reserves
available to make loans, interest rates will decrease. If it falls from 9 per cent to 5 per
cent, then many projects at r = 7 per cent are now viable since r > i.
Case 1: i > r Investment decision : Do not invest
Case 2: i < r Investment decision: Invest
- 35
Ms
i AD
i AS
E F
i1
AD 1 =C + I 1
Md
I
0 Md1 Demand for

0 I 1 Investment 0 Y1 National Y
money output
Figure 1: The Transmission Mechanism

Md: Demand for money
Ms : Money Supply
i: interest rates
In the market for money, the demand and supply
I: Investment of money determine the level of interest rate (i 1 ).
C: Consumption Investment spending I 1 is generated at i 1 level of
AD: Aggregate Demand Interest rate with the corresponding aggregate
AS: Aggregate Supply demand AD 1 and level of national output Y 1
Y: National Output
With lower cost of funds, business finds it affordable to borrow to buy capital goods
while consumers will spend more at lower cost of credit. In this way, aggregate spending
will increase and help increase sales and employment. In short, increasing the money
supply will reduce the level of interest rate which then increases investment and
consumption. In other words, it stimulates business and household spending and brings
the economy out of the recession.
Investment and consumption are both influenced by the level of interest rates. By
manipulating the money supply, the level of interest rate will change that in turn will
affect business and household spending. In this way, the central bank is able to control
the price-level, income and employment.
The transmission mechanism is thus, an important component in understanding monetary

policy and its impact on economic stability. It explains how changes in the money supply
will affect aggregate demand and finally affecting the price-level and national output. See
Figure 1 and 2.
Another example is contractional monetary policy. When the economy is heating up, an
increase in the price-level will increase cost of running business. An inflationary
economy will increase cost of funds and reduces investments as well as household
spending. Usually, inflation is caused by too much money chasing too few goods. To
combat this type of inflation known as demand pull inflation, the central bank pursues a
policy of contraction.
- 36
This is done, say by raising the reserve requirement that leaves less reserves in the
banking sector. With lower reserves, bank cannot make new loans and thus creates less
deposits. When lower deposits are available in the bank, money supply will fall which
then increases the level of interest rates. Investment and consumer spending will decline
and thus putting less pressure on the price-level.
Ms
i i AD AS
E F
i1
C+I
G
i2
Md
I =f(i)
0 M1 M 2 Demand for
0 I1 I2
0 Y1 Y2
Y
money Investment National
output
Figure 2: Expansionary Monetary Policy
A reduction in the statutory reserve requirement makes more exce ss reserves

available for banks to make loans leading to more deposit creati on and hence an
increase in the money supply. The subsequent fall in the level of interest rate
leads to an increase in investment which raises the level of agg regate demand.
With higher investment and consumer spending, the level of natio nal output
increases.
Since deposits are part of the money supply, it is important to understand how deposits
are created. The theory of deposits explains how bank deposits are created. This process
of deposits creation leads to changes in the money supply and affects the general well-
being of the economy. For this reason, it is important to understand well how deposits are
created in conventional and Islamic banking.
One can obtain total deposit created by the banking system from an initial deposit from
the formula given below:
TD = D / R …………(1)
Where:
TD: Total deposits created
D: Initial deposit
R: Statutory reserve requirement
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Suppose statutory reserve requirement is set at 5 per cent and initial deposit of $100
million. Total deposits created by the banking system amounts to $2 billion.
$2000 million = $100 million / 0.05
From the total money created by the banking system, the deposit multiplier can be
obtained using the following formula:
MD = TD / D ………(2)
Where:
MD: Deposit multiplier
TD: Total deposits created
D: Initial deposit
Given TD = $2000m and D = $100m, Deposit (money) multiplier in the above example
is 20. That is:
$2000m / $100m = 20
The deposits multiplier says that total deposits will increase by the multiple of 20 from a
given initial deposit. If initial deposit is $500m, then the banking system can create up to
$10,000 million total deposits.
The process of deposit creation makes a lot of assumptions. The simple model of deposits
creation assumes the following:
1. Transactions conducted through the checking system only. That is, bank loans are
given in chekable. Borrowers pay their purchases using checks as well.
2. Excess reserves are used to make loans only. That is, no investments in securities.
Banks also do not keep idle balances ie excess reserves = 0
3. All deposits are demand deposits or checkable deposits,
4. There are no leakages ie. customers do not keep idle cash in their pockets for
transactional purposes.
Our illustrations shows deposit creation in three ie. Bank A; Bank B; Bank C.
BANK A
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Asset Liability
Reserve Requirement $5 million Deposit $100 million
Loans $95 million
BANK B
Asset Liability
Reserve requirement $4.75million Deposit $95 million
Loans $90.25 million
BANK C
Asset Liability
Reserve requirement $4.51 million Deposit $90.25
Loans $85.74 million
In the above illustrations, assume an amount $100m is placed in Bank A. Bank A puts
aside $5m as reserve requirement which it cannot use to make loans. The remaining
balance $95m will become excess reserves ie. money not yet lent out to customers. Since
the bank pays interest on the $100m deposit, it must right away make loans to earn
interest. Assume that Bank A makes a $95m loan to Jayacity corporation where it uses
the proceeds to pay Maju Industries who then deposit the payment in its bank ie. Bank B.
In Bank B, 5 per cent is kept aside as statutory reserves while the balance $90.25m is
used to make new loans. Assume Bank B makes the loan to Setia Ventures where the
loan is used to pay Bangun Enterprise, which it then deposited in Bank C.
The balance sheets for Bank A, B and C shows that from the initial deposit of $100
million in Bank A, new deposits are created in Bank B ($95 million) and Bank C
($90.25) million. But the story does not end here. The deposit creation continues until no
more loans are available for borrowers. In a nutshell, the total deposit created is shown
below:
$100m + $95m + $90.25m + $85.74m + $81.45m + …… = $2000 million
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In this sense, banking companies posses power to create money as they create deposits.
The central bank can do so by printing money, that is coins and currency also known as
the monetary base or high-powered money.
The central bank control money creation in the banking system by manipulating
monetary policy instruments such as reserve requirement to affect the amount of excess
reserves available to the banks.
Reserves means cash not utilized in the bank. Under a fractional banking system, once a
bank receives deposits, say $100m, the asset side will record a new total reserves (TE)
amounting to $100m. Total reserves can be broken down into two, namely the required
reserves (RR) and excess reserves (ER). Thus
TE = RR + ER ………(3)
Required reserves (RR) do not generate interest income. The same applies to excess
reserves (ER). Usually the bank as a profit maximizing firm, will make sure that the
excess reserves are converted into loans so as to earn interest.
The central bank can influence the deposit multiplier and hence money supply by
manipulating monetary policy instruments which in turn will affect the amount of excess
reserves (ER) available in banks. For example, if the central bank is expansionary. It will
reduce the reserve requirement (RR), to say 3 per cent, thus increasing the excess
reserves (ER) in banks as shown below:
Case 1: RR = 5 percent
TE = RR + ER = $5m + $95m
Case 2: RR = 3 per cent
TE = RR + ER = $3m + $97m
With more excess reserves in the hands of the banking firms, more loans are now
available to borrowers and more new deposits created from the process of deposit
creation.
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The increase in excess reserves also means a higher deposit multiplier. This is true since,
higher excess reserves leads to more loans which in turns creates more and bigger
deposits. Thus the size of the deposit multiplier is inversely related to the reserve
requirement ratio as shown below:
MD = TD / D
TD = D / R
When R = 0.05
TD = $100m / 0.05 = $2000m
MD = $2000 / 100 = 20
When R = 0.025
TD = $100m / 0.025 = $4000m
MD = $4000 / 100 = 40
The process of deposit creation in Islamic banking will be similar with conventional
banking when it runs on a fractional banking system and adopt fiat money as a legal
tender. Under a fractional banking system, the bank will put aside a fraction of deposits
as reserves (ie cash balances) and uses the remaining balance (ER) to in its financing
activities such as al-bai bithman jil, murabahah, and ijarah thumma al-bay’.
The conventional system uses the contract of debts to mobilize deposits that gives them
the right to use the deposits to make loans. The same applies for Islamic banks as they
apply the contract of wadiah dhamanah and al-mudarabah to mobilize deposits. Both
contracts allow the bank to use deposits to finance its investment activities. In this way,
the contracts of Islamic deposits make way for Islamic banks to adopt current fractional
banking system.
The process of money creation in Islamic banking system will make assumptions similar
to the conventional system. One difference is that Islamic banks do not make loans to
customers but contracted their purchases under the contract of deferred sale that
eventually amounts to credit financing. The other difference is that Islamic banks only
use al-bai-bithaman ajil (BBA) contract in its deferred sale products.
Table 1: Muamalat Bank
Asset Liability
Reserve Requirement $5 million Islamic Deposits $100m
Bai-bithaman Ajil $95 million
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Table 2: Bank Shariah
Asset Liability
Reserve Requirement $4.75m Islamic Deposit $95m
BAI-BITHAMAN AJIL $90.25M
Table 3: Falah Islamic bank
Asset Liability
Reserve Requirement $4.51m Islamic Deposit $90.25
Bai-bithaman ajil $85.74
Theoretically, under the BBA contract Muamalat bank buys the asset from the supplier,
say Mega Industries on cash basis for $95m. It will then sell the asset to her customer
Koperasi Bersatu at a mark-up price, say $140m payable over 8 years. In this manner, the
bank makes direct check payment to Mega Industries. In the conventional system, the
bank issues a $95m check to Koperasi Bersatu. However, it will not affect the deposit
story since, Mega Industries will deposit the $95m payment into its account in Bank
Shariah.
Total deposit created in the Islamic banking system remains the same with conventional
banks. The deposit multiplier remains at 20.
Bank Muamalat Bank Shariah Falah Bank

$100m + $95m + $90.25 + $85.74 + …….. = $2000m
If the central bank is pursuing a contractionary monetary policy, it will do so by

increasing the statutory reserve requirement to, say 10 per cent. The relationship between
the reserve requirement and the deposit multiplier remains an inverse one. In this way,
the size of the deposit multiplier will become smaller as shown below:
TD = $100m / 0.1 = $1000m

MD = $1000m / $100m= 10
2.3 THE ISLAMIC ECONOMIC PRINCIPLES RELATED TO DEPOSITS
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An understanding about the Islamic economic principles of deposits is a significant
element in the business of Islamic banking since the demand and supply of Islamic
deposits (i.e. the market for Islamic deposits) are expected to observe the rules and
regulation ordained by God.
By doing so, the market for Islamic deposits is expected to be free from any form of
unfair and inequitable transactions. It will generate a deposit market where justice
prevails from which people will gain benefits (manfaat) and utility from the services
rendered.
Economic principles usually govern the behaviour of market players. In the deposit
market, it is important to examine the principle behind behaviour of savings which leads
to the supply of deposits. In other words, what motivate people to supply deposits? Are
they less sensitive to profits?
When the deposit market is governed by Islamic principles, then it is believed that the
market always clear itself. That is, severe shortages or surplus of deposits may not exist
in the Islamic deposits market. In this way, economy should be more stable and free from
unwarranted volatilities as funds for business spending are readily available in the
banking sector.
Economic principles are guidelines that people use in their economic decision making. In
Islam, these principles are derived from the Quran and Sunnah. They are in essence a
body of knowledge. Economics primarily deals with the problem of choice arising from
scarcity. To make the correct choice man is expected to do so with knowledge.
Making a choice without knowledge can mean choosing by way of conjecture and
guesswork. It can lead to misallocation of resources and adversely affect economic
growth and development. Rational choice alone is inadequate since reason has its
shortcomings.
Making a choice using reason is good but using reason alone as the source of knowledge
can lead to bad choices. This is because, man who use reason alone can never be free
from temptations and evil desires and in many cases will make them irrational instead.
For example, the ‘herd mentality” demonstrates the irrationality of people in the stock
market. The same applies in shopping behaviour. With huge discounts on offer, people
buy things they don’t need ie. they do not actually maximize utility.
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To guide mankind into make the correct choice, the Islamic economics says that choice
must be made on the basis of knowledge revealed by God. This knowledge is therefore
divine in nature. It teaches man about right and wrong, about reward and punishment and
about the relationship between man and God as well as among man. This knowledge is
given in the Quran and the Hadith. Reason and experience are also useful but both must
submit to the supremacy of revelation (wahy).
Islamic economic principles are predominantly based on revelation. But some are based
on common sense and reason (‘aql). Choosing what goods to produce requires
knowledge from God as this will define the permissible (halal) items from the prohibited
(haram) items. But how much one should produce and using what technique of
production do not require the Quran to give answers. This can be readily handled by
reason and factual evidence In this way, no conflict shall exist between revelation and
reason and sense experience. This is an important principle in Islamic economics.
When behaviour of human being comes under investigation, especially in a social context
- the role of revelation becomes supreme. Man who is in need of guidance do so to live a
happy life, including economic and business activities. In the economic life, there are a
number of Islamic principles relevant for Islamic banking applications. These are given
as follows:
1. The contract (‘aqd) on which the deposit products are engineered must be valid
(sahih).
2. The income generated from the investment of deposits must contain some degree
of a) risk-taking (ghorm) b) work and effort (kasb) and c) responsibility (daman)
It must be noted well that people who places their money in the Islamic investment
account do so to earn some profit. This is because mudarabah deposit is one form of
investment instrument. People can invest in stocks and unit trust funds but some may
choose bank deposits if they feel the returns are good enough. In no way we can say that
Muslims who supply deposits are not concern about returns. The very nature of
mudarabah deposits is income generating. It’s profit orientation is never overlooked as
depositors have chosen to supply deposits with a clear understanding about the Islamic
principle of risk and reward.
In Islamic jurisprudence, these principles can be found in the Islamic legal maxims
(qawaid fiqiah). By definition legal maxims are divine principles that one can use in
making a ruling about the behaviour of the believer (mukallaf). These principles are
constructed by Muslim jurists and are based on explicit Quranic verses as well as the
Hadith. One example is that “profit must be accompanied with responsibility” (al-kharaj
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bil-daman). Another is about risk-return relation - “no reward without risk” (al-ghorm bil
ghonm). Since the market for deposits consists of the banking firm and depositors, it is
important that the decision to supply deposits by depositors and the decision to mobilize
deposits by banks are made on the basis of the legal maxims.
In the market for Islamic deposits, the incentive system for the demand and supply of
deposits is built on the basis of Islamic prohibitions of riba. When Allah swt prohibits
riba, it implies that profits arising from loans are unlawful (haram). This is because
profits from loans are both fixed and collateralized. So it only favour the lending party
who will receive profits without taking any risk. By doing so, it introduce injustice into
the business since borrowers must pay up eventhough they are not capable of doing so,
say due to loss of job or declining earning capacity.
In the conventional deposit market, particularly in the supply of deposit - a bank actually
borrow from the depositors at a fixed interest rate. In other words, depositors gave the
bank a loan (qard) with a fixed interest payment. This payment is an interest expense and
constitutes a cost to the bank. It also riba as deposits are created out of a loan (qard)
contract between the bank and the depositors.
Sdeposit = f ( interest rate, inflationary expectation)

Ddeposit = f (interest rate, expected profit)
The incentive to supply deposits is based on one most important factor, namely the rate of
return which is fixed and predetermined. Depositors who receive interest income from
deposits have not actually conformed to the Islamic principle of “no reward without
risk” since the returns are fixed and contractual in nature. In this way, Islam does not
accept deposits using interest as the cost of deposits.
The suppliers of deposits are also sensitive to inflation. They will lose purchasing power
when deposits are withdrawn at maturity without significant premium to compensate the
loss. Usually, lenders will be worse off during inflation. If less is done to compensate
loans from depreciation during inflation, the supply of deposit will decline. If depositors
expect the rate of inflation will be higher than interest rate of deposits, they will supply
less deposits. By doing so, the level of interest rates will increase. In this way,
inflationary expectation can influence the supply of deposits and subsequently, the level
of interest rates.
Likewise, bank as the demanders of deposits are willing to pay interest to depositors. As
the borrowing party, a bank pays the lender i.e. depositors, interests as this motivates the
depositors to place their money with the bank.
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In theory, the higher the interest rates – the higher is the supply of deposits. People are
motivated to postpone current consumption when the compensation for doing so is
attractive. This positive relationship between supply of deposits and interest rates actually
reveal the behaviour of the economic man. But in the Islamic system of deposits, the
incentive to supply deposits can no longer be associated with a fixed and predetermined
reward. By virtue of the principle of al-ghorm bil ghonm, reward must be accompanied
with risk. One must put her money at risk in order to earn profits. This principle must be
applied in the Islamic deposit market.
Islamic deposits usually serve two main functions, namely:
1. Transaction function : Wadiah Dhamanah current and savings account

2. Investment function : Al-Mudarabah Investment account
1. Transaction function
Current accounts or demand deposits do not pay any returns, both in conventional and
Islamic banking. But conventional saving deposits pays interest while Islamic savings
deposits do not. The transaction function of Islamic deposits (ie demand deposit and
saving deposits) is conducted via the contract of wadiah dhamanah. It has no profit
motive.
By virtue of the transactional nature of wadiah dhamanah deposits, depositors are only
interested in deriving benefits from the facility offered by the product. The benefits shall
include the ease of cash withdrawals on call as well as protection of deposits. The bank
serves as a custodian or safe-keeper to the deposits but is allowed use them to generate
income from say, murabahah or ijarah financing. But financing activities do not
guarantee fixed income to the bank as it (ie bank) may incur losses arising from bad
debts.
Wadiah dhamanah deposits however are protected even if the bank earns nothing from
financing. In return for the protection, all income earned from financing activities shall
solely belong the bank and depositors do not hold any legal claims on bank’s earning.
The trade-off between capital protection and ex-post rate of return is one important
economic principle of wadiah dhamanah deposits.
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That is, depositors stand to receive returns but only as gifts (hibah). In this way, the
distributional model of wadiah dhamanah does not provide any guaranteed sum or return
to the depositors. If any, returns are given without any equivalent countervalue, say risk-
taking. Wadiah dhamanah customers exposure to capital risk is zero. Thus, by virtue of
the principle of al-ghorm bil ghonm, they do not deserve to receive any income or profits
from the deposits.
In economics, hibahs are determined ex-post meaning it is set only when the outcome is
actualized. But actualizing outcome, say making RM100 million profits from murabahah
financing does not mean that the bank must or obligated (wajib) to distribute the profits.
In this way, the supply curve of wadiah dhamanah deposits may be a flat one since the
incentive to save does not revolve around the rate of returns but for safe-keeping and
convenience purposes.
b) Investment function
But the same does not apply to the al-mudarabah investment deposits. This is because al-
mudarabah deposits are meant for investments with explicit agreements about profit
distribution and the role of capital and knowledge. Here the economic principle of risk-
return shall apply well to the contracting parties in the mudarabah transaction between
the bank and the depositors.
The Islamic economic principle on risk-return relationship is none other than that adopted
from the legal maxim “al-ghorm bil ghonm” which means that “no profit can be gained
without taking risk”. Since Islamic investment account as a product is based on the
mudarabah contract (i.e. trustee partnership), incentive to place money in mudarabah
deposits must revolve around profits. It is business and nothing more.
When the performance of mudarabah deposits outperform interest-bearing fixed deposits,

more people are expected to place their money in the Islamic banks. But the risk
associated with mudarabah deposits is market related. Systematic risks are risks of
capital loss due to say, economic recession and natural calamities that often destabilize
markets and therefore prices. They are not controllable by the contracting parties.
Mudarabah deposits are not sparred from systematic risks. Depositors can see their
savings depleting. There is no capital protection in mudarabah deposits. Instead,
systematic risks are endogeneous in mudarabah.
In fact, the Islamic principle of risk-return actually pointed to the fact that risk ie ghorm
predominantly refers to systematic risks. However, mudarabah investments are also
exposed to operational risks as human error and negligence may jeopardize the
- 47
mudarabah venture. The mudarid (ie the agent-manager) can abuse his responsibility.
Thus, moral hazard is a serious factor to account for in decision making when people plan
to place their savings in the mudarabah deposits.
Bearing in mind that mudarabah deposits are exposed to both systematic and operational
risks, the decision to place savings in mudarabah deposits can be a challenging one.
Since mudarabah deposits and incomes are not guaranteed, the bank that acts as the
mudarib must be able to convince depositors that placing their money as mudarabah
deposits is a good investment. It should be able to show depositors their good track
records and capacity to perform well in the mudarabah ventures. Since mudarabah
deposits are risky, depositors expect more returns for each investment made. In fact any
successful mudarabah deposits should outperform interest income derived from fixed
deposits.
Finally, the Islamic principle of deposits in essence defies the law that guarantees the
right of creditors to interest payments. This is because the law of depreciation must hold
for all creatures and creations of God. It is common knowledge that all things in this
world will undergo wear and tear. They lose value over time. This is a law in nature. In
Islam, God is the only Being that cannot depreciate as He is the Creator and therefore all
creation of God must depreciate. In this way, keeping money from the natural process of
depreciation is akin to treating it like God.
The Holy Quran says, “Everything thereon is vanishing, there remaining only the Face of
Your Lord, the Possessor of Majesty and Generosity (55:26-27).
Submitting money to the law of depreciation is one of the essense of the Quranic ban on
riba. Money must be allowed to depreciate and this means that it must be open to both
possibilities of appreciation and depreciation. Both will take place when money is
channeled into trade and commerce (al-bay’). The Quranic prescription of al-bay’ (trade
and commerce) as an anti-thesis of riba, confirms that money must be put back into its
natural place as God’s creations.
When money is invested in trading and commercial activities (al-bay’), it can either
appreciate or depreciate in value as trade is subject to market volatilities. When the
venture is profitable, the investor gets back the capital plus profit. The value of the
investible capital has appreciated. Likewise when business incurs losses capital
depreciation is inevitable. In this manner, money obeys the law of depreciation. It no
longer assumes the attributes of God.
- 48
A broader measurement of money M2 is M1 plus interest bearing savings and fixed
deposits. It is here we can see how rich people can sit on their money and yet able to
secure interest as a guaranteed return.
In a financial system based on interest, when money is put into circulation the form of
debt ie deposits, it defies the law of depreciation. What this means is simply that money
now become the object of worship as the interest-based financial system guarantees that
money in interest-bearing bank accounts can only move in one direction that is to
increase and appreciate in value.
In the financial system today, when people hold cash, they will see the purchasing value
of their cash holding to depreciate over time eaten by inflation. Once the money is spent,
say into trading and commercial activities, the money too is subject to the law of
depreciation since there is a possibility that business may fail and owners of capital will
see their investments vanishing.
But when money is put into circulation in the form interest bearing instruments such as
bank deposits, loans and bonds, money has defy the law of depreciation since interest
guarantees capital appreciation by virtue of the payment of interest. In making the
payments and receipts of interest arising from debts as lawful and civilized act, man has
made money equal to God.
The Quran says, “He is the God, other than Whom, there is none; He is the Knower of the
unseen and the seen, the Merciful and the Compassionate. He is the God other than
Whom there is none, the Sovereign, the Holy, the One with peace and integrity, the
Keeper of Faith, the Protector, the Mighty, the one Whose Will is Power, the Most
Supreme (59:22-23)
As a summary, it is true to say that when money earns interest, appreciation of money is
guaranteed. But in Islam, everything else depreciates except Allah swt. When
appreciation of money is guaranteed through payment and receipts of interest, people
seemed to have treated money like God.
Al-wadiah dhamanah and mudarabah deposits in principle have dutifully obey the law
of depreciation as both provide no fixed contractual payments as evident in many
interest-bearing deposits. In the former, the bank holds the prerogative to give some form
of returns as gift (hibah) while the latter is solely based on performance. In this way,
Islamic deposits have in general observed the principle of risk and reward that Islam truly
enjoins in the promotion of justice and equity in the market place.
- 49
2.4 THE SAVING BEHAVIOUR OF CUSTOMERS
In conventional economics, people will supply deposits only when they decided to save
instead of spending their income on current goods and services. The decision to save, that
is postponing current consumption is much influenced by the amount of money needed to
compensate them from postponing current spending. This saving behaviour is explained
by the concept of time-value of money (TVM).
Time preference indicates the extent of a family’s preference for current consumption
over future consumption. The rationalization of interest as a price of credit began when
people believe that present consumption is superior to future consumption. People prefer
the present because the future is uncertain. They also think that present wants are more
keenly felt than future wants. Also, people think that the present goods possess a
technical superiority over future goods. That is, the passage of time allows the use of
more roundabout methods of production that are more productive.
In this way, the concept of time value of money examined people preferences about
spending their income today or in the future. If people prefer current consumption to
future consumption, then they are said to adopt a positive-time preference (PTP) outlook.
They believe that current consumption brings more satisfaction than future ones.
Therefore, people who are asked to postpone current consumption (i.e. creditors) must be
compensated for the benefits the pleasure foregone today.. They do so because it is firmly
believed that the future is uncertain and risky, thus one may not know how much utility
he or she can enjoy out of future spending as opposed to current spending. In a nutsell,
the PTP concept says that 1 dollar today is worth more than 1 dollar tomorrow.
However, some people do not believe that future spending is inferior to current spending.
Instead they are truly convinced that they can derive more satisfaction or utility if money
is spent not now but in the future. By believing so, the decision to save is based on the
negative time preference (NTP) model.
For example, when people are not sure whether they can secure permanent or lifetime
job, spending all their money today is not a good idea at all. Without a job in the future,
money becomes a scarce commodity and thus spending them during difficult time yields
higher utility. The NTP concept believes that 1 dollar today is worth less than 1 dollar
tomorrow which is opposite to the positive time preference (PTP) model.
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Finally, there are also some people who feel indifferent about spending their money today
or tomorrow. They believe that money spent today always yield the same level of utility
as money spent tomorrow. This is the neutral time preference model. People with neutral
time preference do not care less about when to spend.
Conventional economics actually believed that people prefer current consumption to

future consumption. This is the dominant view in global financial markets today. This is
only because they believe the future as uncertain and people have no idea what the future
has to offer them. Changes in tastes and preferences or the price-level may alter and
reduce the level of utility of happiness derived from future consumption. On the contrary,
when people buy goods today, they can instantly enjoy the utility derived from spending.
In this way, one dollar today is worth more than one dollar tomorrow.
The belief that current spending generates more satisfaction than future spending (ie PTP)
paves the way for the rationalization of interest-rates as the reward for saving. In other
words, people who save will forego the satisfaction derived from current consumption.
The same level of satisfaction cannot be realized when they spend the same money, say
one year from now.
For example, if John spends $1000 today, he enjoys say, 1000 units of utility known as
utils. According to the concept of PTP, the same money spent next year will only yield
less utility say, 900 utils. In this way, John has no incentive to save his money unless his
savings is guaranteed to yield 1000 utils. To do that, John expects to be compensated for
the loss of utility from future spending. Suppose $1 is equivalent to 1 util. In order to
guarantee John 1000 utils from future spending of $1000 ie his savings, he must be given
an extra $100 equivalent to 100 utils. See the illustration below:
a) Spending $1000 today generates 1000 utils
b) Spending $1000 next year will generate only 900 utils
c) Extra payments needed to motivate people to lend out their money

(ie. postpone current consumption)
$1100 = $1000 + $100 [more in nominal value]
(1000 utils) (900 utils) (100 utils) [constant utility)
The additional sum $100 is the interest that John receives as an incentive to save. In a
banking framework, when John decided to place his savings in bank deposits, he acts as a
lender while the bank acts as the borrower. As a lender who supplies deposit, the interest
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income constitutes a legal claim to John. Likewise when the bank makes loans to
customers, it also charges them interest.
The saving behaviour in conventional economics is therefore dependent on the reward or

compensation for waiting ie postponing current consumption. By virtue of positive time
preference (PTP), creditors demand interest while debtors pay interest. But the same
cannot apply to saving behaviour in Islam. Although Islam has to some extent recognizes
the concept of positive time preference, it does not implicate or bring about the payments
and receipts of interest as evident in conventional economics.
THE FACT THAT ISLAM FORBIDS INTEREST AS RIBA IT DOES NOT

MEAN IT IS AGAINST THE CONCEPT OF POSITIVE-TIME
PREFERENCE (PTF). INDEED, ISLAM HAS GIVE DUE RECOGNITION
TO PTF AS EVIDENT IN THE SAYINGS OF PROPHET MUHAMMAD
(PBUH). THE PROPHET (PBUH) SAID, “ VIRTUOUS ARE THEY WHO
PAY BACK THEIR DEBTS WELL”.
IN THE ABOVE HADITH, DEBTORS ARE ENJOINED TO PAY MORE

THAN THE PRINCIPLE LOAN (QARD) RECEIVED. ONE MAY ASK
WHY THIS IS SO? ONE REASON IS GRATITUDE. THE DEBTOR IS
THANKFUL FOR THE LOAN HE GETS AND BENEFITED FROM. HE
KNEW THE CREDITOR HAS FORGONE HIS CURRENT CONSUMPTION
FOR THE SAKE OF HELPING HIM WITH THE MONEY. HE ALSO
RECOGNIZES THAT THE CREDITOR HAS RELINQUISHED THE
OPPORTUNITY TO EARN RETURNS FROM LOAN GIVEN AWAY.
THESE RETURNS ARE UNKNOWN AS THEY ARE SUBJECT TO
BUSINESS RISK.
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IN THIS MANNER, ONE DOLLAR TODAY IS SEEN MORE VALUABLE
THAN ONE IN THE FUTURE. AS A TOKEN OF APPRECIATION, THE
DEBTOR PAYS MORE. UNLIKE RIBA, THE INCREMENTAL AMOUNT
IS NOT STATED UPFRONT AND DOES NOT CONSTITUTE A LEGAL
CLAIM OF THE LENDING PARTY.
IN ISLAM, THEREFORE RECOGNIZING PTP DOES NOT IMPLY

AWARDING A CONTRACTUAL INCREASE ON THE PRINCIPLE LOAN.
ANY INCREASE FROM AN ISLAMIC LOAN (QARD) CAN ONLY BE
STATED AT MATURITY AND NOT UPFRONT AS NORMALLY
PRACTICED IN INTEREST-BEARING LOAN CONTRACT. THE
INCREMENT WHICH IS VOLUNTARY IS SET BY THE DEBTOR. IT IS
GIVEN AWAY OUT OF GOODWILL. IN CONTRAST, THE INCREMENT
FROM RIBA LOANS IS CONTRACTUAL AND SET BY THE CREDITOR.
Apart from interest-rate, savings behaviour in the conventional system is also influenced
by disposable income and tax rates. But interest-rate is the most important factor
affecting savings. For example, when interest rates go up, people usually place their
money in bank deposits as investments. Investment in stocks may not be a good idea
since future cash flows of companies will fall due to higher cost of running business.
People expect that holding shares can lead to capital losses. Investors may find bonds a
good substitute to stocks. An increase in disposable income, say due to lower tax rates
or job promotion may also increase savings. Likewise, people may want to buy bonds if
tax rates on capital gains are reduced or even waived by the authorities.
In Islamic economics, spending behaviour of household is expected to influence their

saving behaviour as well. For example, consumers who practice moderation (zuhud), will
secure more surplus income ie. savings compared with those who are extravagant (tadrif).
The moderation behaviour is approved by Islam and applicable only on the consumption
of luxuries (kamaliyat).
Under a zuhud lifestyle, Muslims live a simple life although they can afford luxuries.
While Islam does not prohibit Muslims to consume luxury goods, Muslims are free to
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choose their lifestyles. They can live a simple life or lead a luxurious one as long as they
do not fall into debt or amass wealth from illegal sources. They too must spend on basic
necessities (daruriyat) and make spend well for their families.
Savings in Islam does not mean keeping money as idle balances. All savings must be
injected back into circulation. It must be invested. If money is kept as idle balances,
people who need money for working capital or to purchase plant and machinery will not
be able to do so. Without money to spend business will cease to exist and the economy
will fall into a recession with grave implications on growth and employment.
Savings can be put into many financial products. People can save by buying stocks and
bonds or unit trusts. They can also save by buying insurance policy. But usually most
people save in bank deposits.
In conventional (ie neoclassical) economics, decision to save and the decision to spend or
consume are explained by rational choice. In rational choice theory, people are said to
behave rationally in their spending behaviour. To behave rationally, people would have
to:
• Be aware of all available product alternatives

• To be able to correctly ranking each alternative in terms of its benefits and
disadvantages
• Be able to identify the one best alternative.
The same applies to savings, in the sense that people should be able to decide what
savings products are best for them. Should they save in stock and bonds, land and
properties or bank deposits.
The principles of savings in Islam generally looks at the guidelines explaining the action
and behaviour of Muslims regarding their saving behaviour and therefore the supply of
deposits. To understand the underlying principle of saving, one needs to also understand
some fundamentals of Islamic economics such as:
1. Objective of the household or business who supply deposits

2. Concept of wealth and the principle of wealth creation
The objective of savings is best described in the Quranic story of Prophet Yusof (may
God be pleased with him) where the importance of savings is highlighted in its true color.
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Surah Yusof (12:3-49) tells the story of a Pharaoh in Egypt who had a strange dream
about seven fat cows. He also saw in his dream seven green ears of wheat and seven
withered or dying ears of wheat.
He asked his advisors to interpret the dream, but no one is good enough to do so. Prophet
Yusuf who is well known for his honesty and special ability to interpret dreams was
brought to see the Pharoah.
In his interpretation about the dream, Prophet Yusuf enlightened the Pharoah about the
future problems of Egypt. He also suggested the remedies. He said that Egypt will enjoy
seven years of prosperity with abundant harvests. In modern times, this may be taken to
mean high economic growth. Prophet Yusof advised the people of Egypt to cultivate
their crops diligently and use a reasonable amount for food and sustenance while storing
the remaining surplus. This is because when prosperity comes to an end, Egypt will
suffer from serious drought for seven long years when no crops would grow. But with
the reserves in store, the people of Egypt could survive the seven bad years.
Prophet Yusuf cautioned the Pharoah not to consume all the reserves but to leave the best
portions for seeds to cultivate later when rains filled the Nile. In other words, people
must set aside money for savings and investment. To postpone current consumption to
make way for production of future goods was one of the main messages that Prophet
Yusuf wanted the Pharaoh to do for his people.
The incentive to save can also be examined at the micro level of Muslim behaviour. In
Islam, savings will always means surplus income to be placed for investment purposes,
thus keeping money in circulation. All savings must be invested again in the economy.
Otherwise it is tantamount to hoarding (ihtikar)
The basic idea of savings is to avoid hoarding money as the latter is prohibited in Islam.
When people hoard money, there is less currency around to use. It will frustrate
business transaction and put production to a halt since there is no money available to pay
suppliers and workers. Hoarding money will put money out of circulation and therefore
reduces sale and purchases.
When people hoard money for fear of losing them, they must know that the idle money is
subject to Zakat. For example, Ali places his $20,000surplus in his safe-deposit buried
under his house. At the end of the year, he must pay 2.5 per cent zakat ie $500 from the
idle balances. Zakat in this manner is a penalty for the hoarding behaviour where he will
find his money to fall in value to $19,500. If the money is keep idle for years, it will soon
depreciate in nominal value and Ali losses his money to his own ignorance.
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For this reason, Muslims must save and invest their surpluses so that the value of the
savings increases over time despite the payment of zakat. Zakat on idle balances is
penalty on hoarding behaviour and eventually leads to the depreciation of wealth if kept
unchecked. In this way, zakat both purifies wealth as well as penalizes those who choose
to hoard wealth.
To prevent this unnecessary depreciation, zakat will force people to spend their cash
balances either for nafaqah, sadeqah or investment ie. savings in bank deposits, unit trust
funds or investments in projects based on the partnership principles. Doing so will allow
money to circulate in the economy, which then help reduce shortfall in business spending
and capital formation For example, when money is put in circulation via investment,
zakat income and individual wealth will both increase. This is illustrated in the following
examples:
Case (1) Hoarding

Idle cash (i.e. wealth/mal) at year end = $20,000
Zakat = 0.025 x $20,000 = $500
Cash balances (wealth) after Zakat = $19,500
Case(2) Savings
Cash invested = $20,000
Profit = 10% = $2,000
Wealth/mal = $22,000
Zakat = 0.025 x $22,000 = $550
Wealth after zakat = $21,450.
From the above illustrations, it is clear that in Islam wealth is not an end by itself.
Wealth is a means to attain happiness (sa’ada) and success (falah). To do so, Islam
enjoins man to spend it well (infaq) and not to indulge in hoarding. By spending, it can
mean many things such as:
1. Consumption of basic necessities (daruriyat)

2. Consumption of comfortables (hajiyat)
3. Consumption of luxuries (kamaliyat)
4. Savings in bank deposits, mutual funds, stocks, properties etc.
5. Sadeqah as ‘amal jariah (continous good deeds)
6. Zakat obligation
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To attract people to save in Islamic bank deposits, the banking firms are expected to
invest deposits into projects with high yield potentials. If Islamic deposits can outperform
investments in unit trusts and other equities products, it should be able motivate more
people to save. This will increase capital formation much needed for economic growth
and development.
SUMMARY
This chapter explains the economic theories related to deposits and the saving behavior of
consumers both from the conventional and Islamic perspectives. Savings can be put into
many financial products. People can save by buying stocks and bonds or unit trusts or by
buying insurance policy. But usually most people save in bank deposits. In conventional
economics, decision to save and the decision to spend or consume are explained by
rational choice. In rational choice theory, people are said to behave rationally in their
spending behaviour. Savings in Islam does not mean keeping money as idle balances. All
savings must be injected back into circulation. It must be invested. The role of zakat and
the underlying motivations for savings in Islamic economics are also discussed in this
topic,
REFERENCE
Mishkin Frederic S. “The Economics of Money, Banking and Financial Markets”,

Harper Collins, 1995, New York, pp. 367-379.
Rosly, Saiful Azhar. “Critical Issues on Islamic Banking and Financial Markets”,
Authorhouse, Bloomington, 2005
Hadjimihalakis Micheal G., and Hadjimihalakis Karma G. “Contemporary Money”,

Banking and Financial Markets, IRWIN, Chicago 1995 pp. 448-471
Hubbard, R.Glen. “Money and the Financial System”, Addison-Wesley Publication,

1994.
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STUDY MATERIALS
TOPIC 3: DEPOSITS MOBILIZATION BY

CONVENTIONAL FINANCIAL
INSTITUTIONS
LEARNING OUTCOMES:
a. Understand the importance of deposit mobilisation within a bank.

b. Understand the nature of deposit mobilisation.
c. Identify different categories of deposits, types and characteristics.
d. Analyze relationships of deposits, investments and financing.
e. Analyze the differences of cost of deposits.
f. Understand the differences between conventional and Islamic savings account.
3.1 INTRODUCTION
Deposit mobilisation is one of the crucial functions of a conventional financial
institutions or banks to satisfy one of the requirements of a “banking business”, i.e.
sourcing of funds or borrowing money from customers.
Continuous and adequate deposit mobilisation would ensure the bank shall be able to
sustain its business of lending and investing, thus incurring profit for future growth.
Nevertheless, different types of deposits have different and distinct characteristics and
features which in consequence impose different risks and costs to the banks. Therefore, in
many cases, deposit mobilisation strategy relies heavily to the banks’ asset and liability
management policy.
In a relationship between bank and depositors, the rights and duties for both parties vary
according to the nature of deposit mobilisation. The ability of the bank to fulfil their
duties is an important measure of the bank’s acceptance by the public, or by far as a
comparison yardstick with other banks.
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3.1.1 Deposit mobilisation of a bank and its importance
a. Introduction
Banks mobilise deposits as their primary source of funds. Having optimal

deposits level, banks shall be able to lend the funds to generate interest on
lending. In addition to lending, the deposits fund can be placed in certain
investments avenues which suits the banks’ or the deposits’ objectives.
Deposit mobilisation is a continuous function for a bank to ensure the sum

total of deposits at any time adequate to maintain the current level of
lending and investments especially to compensate the withdrawals made
by depositors. Usually, the deposits level is kept slightly or certain
percentages above the lending and investments level to ensure the bank
has adequate cash reserves to meet expected withdrawals and also
recurring withdrawals. The cash reserves are called Liquidity Reserves.
Deposits bring costs to the banks, either on the maintenance of the

deposits and its transactions or on the interest payout onto the deposits
upon deposit maturity.
b. How Bank Mobilises Deposits
Bank receives deposits from individuals, organisations and businesses,

initially by opening an account with the bank itself. Based on the types of
deposits, minimum initial deposits are set together with the rules and
regulations governing the accounts.
Subsequent deposits can be made into the accounts, except for time
deposits where the amount is fixed until deposit maturity.
Depositors maintain deposits with specific banks due to many factors, but
in particular trust and confidence with the banks are the major factors.
Once these are established, the banks continuously attract depositors and
deposits by providing convenience banking, quality services, excellent
brand association and higher interest payout.
However, there are instances where depositors put their money into the
banks mainly for security purposes, i.e. the banks to protect their money
from loss and theft and also warrant the deposits from investment loss. As
such in Malaysia the government provides guarantee upon deposits placed
with commercial banks.
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Banks are competing against each other to attract deposits and new
depositors. Normally interest payout rates, locations and services are the
main attractions to the mass market. However, some banks are going into
the niche markets and thus providing specific attractions to the targeted
market segment. One example is the pensioners group, where specific
products are developed with special features which suit their lifestyles.
Sometimes banks do promotions with door-gifts, lucky draw, establish

savings clubs, “staff get customers” programme and else to ensure the
depositors’ base and deposits keep growing and to instil loyalty to the
depositors.
Some deposits products have also grown from a single purpose deposits to
combined purpose products to meet higher expectations from customers.
For example, attachment of insurance scheme, combination with debit
card, etc.
c. The importance of deposits
Deposits are the primary source of funds for a bank, which facilitates the
uses of funds (loans and investments). The higher the deposits amount, the
bigger the lending and investments portfolio can be maintained by the
banks to sustain its expansion and future growth.
The banks must have adequate deposits to meet the lending volume
required by the public and at the same time maintain extra cash for
withdrawals by depositors. The cash reserve is a component of liquidity
reserves which measure the ability of the bank to meet its expected
withdrawals and recurring withdrawals. The withdrawals made from the
reserves are oddly-offset against new deposits which the banks should
continuously mobilise. The inability to get sufficient deposits could result
in negative fund situation.
The level of deposits growth also indicates the bank’s performance in

relation to customers’ satisfaction on interest payout and services
rendered.
d. Deposits as key liquidity indicator
Deposits are made mainly in cash, the most liquid asset for banks. Once
withdrawal requests are made by depositors, banks must immediately
provide cash for that particular purpose. As compared to other liquidity
components such as short term investments which take time to be
converted into cash, it is rather wise for a bank to simply get more
deposits beyond the withdrawal amount.
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However, the percentage of the cash reserves must be kept at optimum
level. Idle cash does not create profit, but in fact, brings additional costs in
terms of storage and insurance. Therefore, by maintaining cash reserves at
optimal level enables bank to generate maximum profits from lending and
investment activities.
The costs for cash reserves are mainly on the storage and insurance. The
storage of cash reserves involves the requirement for adequate vault
rooms, cash in-transit security and cash handling at branches. The
insurance costs are to cover the amount of cash available anytime at
branches or in-transit from loss, fire and theft. It generally covers the
maximum cash amount allowed at branches or in-transit.
e. Deposits and duration
In exception to time deposits, other deposits are not tied to fixed durations.
A savings account customer is allowed to add on his/her deposit anytime
he/she wants, similarly for withdrawals. For certain products, however,
withdrawals are restricted to a certain number of times or amount within a
specified period.
For time deposits, the amount and duration are fixed at customers’ choice.
Any changes to be made can only be made by cancellation or premature
withdrawal of deposits.
Deposits with longer duration are highly preferable by banks as it

contributes toward a steady deposits pool. Nevertheless, deposits with
shorter duration are also favourable since it carries lower interest payout
of even zero interest.
In managing the pool of deposits, care must be taken to ensure the various
types of deposits which have different durations are always replenished by
new deposits, preferably on longer duration. It is critical to ensure
duration-based loans extended are always supplemented by sufficient
deposits at all times.
3.1.2 Categories Of Deposits

i. Deposits category
Deposits can be classified into two main categories, i.e.;
a. Transaction (payment) deposit
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Transaction deposits are maintained with the banks in effect to
make payments to third party. The recipient of the withdrawn fund
shall be nominated by the customer, where the bank shall honour
the withdrawals as per instruction made. Instructions can be made
using cheques issued to the deposits accounts. There are several
other modes of payment such as electronic fund transfer using
Automated Teller Machines (ATMs), Inter-bank Giro transfer and
Internet banking.
Transaction deposit is also known as demand or current account.

Based on the nature of the account, it is largely maintained by
government, organisations and business entities. Individuals use
current account mainly to facilitate their personal transactions.
Normally current account is a non-interest bearing deposit. This is

due to the flexibility of withdrawals and fluctuations of deposit
amount maintained at any time. Yet, the managing and payment
processing costs for the accounts are absorbed by the banks.
b. Non transaction deposit
Non transaction deposits are maintained with banks for several

purposes, i.e. for savings, investments and as trusts.
Savings deposits are designed to attract funds from customers, who

want to put aside money with the banks for future consumption or
financial emergencies.
Investment deposits or known as time deposits are committed

deposits by depositors which in return received the promised
interest payout upon maturity of its durations.
Trust accounts are set-up for management of funds for the benefit
of the third party, e.g. a minor, which is unable to execute contract
on his/her own behalf.
3.2 TYPES OF DEPOSITS

3.2.1 Current account
Current account is an account maintained mainly by organisations to

handle its outgoing payments and to accept payments from third party. An
introducer is required for opening of a current account, from the bank’s
existing accountholders, generally to avoid bad cheque offenders.
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Accountholders will be issued cheques, i.e. valid bill of exchanges to
permit the accountholders to make payments through withdrawals of their
accounts. Recipients of the withdrawn fund should be nominated on the
cheques, or the cheques can be drawn as cash (for cash cheques).
Monthly statement of the account is given to the account-holder showing

the detail transactions done throughout that particular month.
For customers who are allowed or given overdraft facility, the

disbursement is made using the current account. Disbursement is
automatically made once the accountholder drawn money exceeding his
available balance.
3.2.2 Savings account
Savings account is kept by thrift depositors, mostly by individuals, where

the deposits and withdrawals are made normally in small amounts, at any
time.
The depositor is given a passbook to record the deposits and withdrawals

made. Alternatively, customers can choose for monthly statements or e-
statement (internet statement).
Savings account is a low-rate interest-bearing deposit, because it is

considered as volatile deposits. Interest is paid monthly based on the
average daily balance.
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3.2.3 Time deposits
Time deposits, also known as fixed deposits, are investment-purpose

accounts that pay higher interest compared to savings accounts.
The investment periods are fixed by the banks, ranging from 1 month to 5
years. The normal deposit tenures are 1-month, 3-month, 6-month, 9-
month, 12-month, 15-month, 18-month, 24-month, 36-month, 48-month
and 60-month.
The interest payout is also different based on the periods. Interest rates are
higher for longer periods to encourage long-term deposits. The rates
offered frequently changed based on the current investment scenario.
The minimum amount is also fixed, and once a fixed deposit (FD) is made
the whole amount can’t be withdrawn until maturity date. Some banks
allowed premature withdrawal with or without a penalty on the interest
payout. The common penalty is to pay interest for completed months
based on the nearest interest rate with the corresponding period. For
example, a 24-month FD has been drawn after 14 months of investment.
Interest shall be calculated based on the nearest rate which is the interest
rate for 12-month FD.
The calculation shall be as follows;

FD amount x 12-month interest rate x 14/12 (months completed).
Upon maturity of the fixed deposits, customer has the options to “roll-
over” the investments, i.e. reinvest the principal and interest received for
similar period or reinvest only the principal amount.
3.3 THE RISK AND REWARDS

Deposits placed with conventional banks are considered low-risk and low-return
investments. Perhaps, the risks to depositors are almost zero considering that the
return is guaranteed and the banks shall absorb any unexpected loss derived from
investments or lending activities. In actual fact, the risks on those activities are
calculated risks and have been provided by banks in their balance sheet on an on-
going basis.
However, systemic risk, the risk of failure of the banking system or the bank itself,
due to unforeseen circumstances could lead the depositors vulnerable to losses of
their deposits due to the bank’s incapacity to refund the principal deposits. This could
happen when panic strike the bank’s depositors leading to a mass withdrawal of funds
which could not be supported by the liquidity reserves.
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However, for special corporate deposits which are tagged directly to specified
investments or syndicated loans, the risk exposure on return is higher since any loss
arising shall be absorbed equally between banks and depositors. Similarly, the return
is also higher if the activities run smoothly as expected.
3.4 THE MANAGEMENT AND PRACTICES
3.4.1 Types Of Account holders
a. Individual Account
It is an account opened by individuals legally eligible to enter into

contract, i.e. not a bankrupt, sane and not a minor.
Individuals are allowed to open current, savings and fixed deposits.
b. Joint Account
It is an account opened by two individuals or more, normally by members

of a family, .e.g. husband and wife, parents and children. All
accountholders must be legally eligible individuals.
For a joint account, accountholders must specify mandate of authority as

to withdrawals from the account. For example, the mandate of either;
- “both to sign”, meaning any withdrawal request must bear both
accountholders’ signatories, or
- “any one to sign”, meaning any withdrawal request can be done by
anyone or single signatory.
For joint account, banks normally specify that all account-holders are
“jointly and severally” responsible to the conduct of the account and any
claim thereto. It means, the accountholders are equally responsible on a
joint-basis and on individual basis.
Joint account is normally opened for savings and fixed deposits.
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c. Partnerships Account
A partnership is the relationship between two or more individuals sharing

a single business. Normally the partnership business is registered and
supplemented by a legally binding partnership contract.
For a partnership account, the account mandate must be specified similar

to joint account. The partners are also jointly and severally responsible to
the account.
Partnership account is normally opened for current account.
d. Sole Proprietorship Account
A sole proprietorship is a business owned by a single person. In law, the

owner and the sole proprietorship business is a single entity. Therefore,
the account is quite similar to individual account.
Sole proprietorship account is opened for current and fixed deposits only.
e. Company Account
Company account is opened for companies incorporated under the

Companies Act, 1965. A company is a legal entity owned by its
shareholders. It could be managed by its owner or by appointed managers.
The operation of a company account is delegated by a resolution made by

shareholders or board of directors of the company, endorsed by the
company’s secretary. The resolution provides mandate for the company’s
account. In addition to the signatory mandate, sometimes there are limits
onto the signatories based on amount to be withdrawn.
Company account is opened for current and fixed deposits only.
f. Minor Account
A minor is defined as a person below the age of 18 years old, based on the
age of majority established under the law.
A minor lacks contractual capacity, therefore cannot open an account on

his/her own. An account can be opened by parent(s), for example Ali
Haron on behalf of Azam Ali. However, minors aged 12 and above, who
have identity cards are allowed to open on their own names.
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Minor account is opened for savings and fixed deposits only.
g. Societies, Clubs and Associations Accounts
Societies, clubs and associations are unincorporated bodies, normally

registered under Registrar of Society. They are managed by appointed
officials.
The operation of account is based on the resolution made by the meetings

of its official. The resolution provides the necessary mandate governing
the account’s operation.
Societies, clubs and association accounts are normally opened for current
and fixed deposits.
h. Trustees Account
A trust is defined when a legal title to asset is transferred to another party

(trustee) who is undertaken to use or manage the asset for the benefit of a
third person. An example is a trust account opened by lawyers on behalf of
its clients.
The trustee is fully responsible on the operations of the account.
Trustees Account is opened for savings, current and fixed deposits.
3.4.2 Account Features
a. Types of accountholders
The following table shows the general types of account-holders for the
different types of account;
Type of Account Type of Accountholders

Savings account • Individuals
• Joint individuals
• Minor
• Clubs, societies and association
Current account • Individuals
• Partnership
• Sole proprietorship
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• Trustee
Type of Account Type of Accountholders
Fixed deposit • Individuals
• Minor
• Partnership
• Sole proprietorship
• Trustee
b. Initial deposit
For opening of accounts, depositors need to comply with the initial

amount set by the banks. The amount varies according to account types
and banks.
Sometimes minimum balances are set for certain accounts, where at any
given time the deposit amount must not go below than the limit.
For fixed deposits, the initial amount set is the principal amount of FD.
c. Limits on withdrawals
Some banks limit the number of withdrawals or the amount that can be
withdrawn within a specified period such as within a month. The purpose
is to ensure the fluctuations of deposits is minimised. Normally, the
withdrawal limits are imposed only for savings account.
However, currently most banks allow unlimited withdrawals. Though,

limits are still set for transactions done electronically using Automated
Teller Machines and Internet banking. It was done for security purposes
from unauthorised transactions.
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d. Documentation
Documentation is critical to establish a valid contract between bank and

accountholders. It also spells out how the accounts to operated by the
banks.
These are the documentations generally required during the opening of

account;
i. identification documents
e.g. identification card for individuals, registration documents for
companies, partnership and societies.
ii. resolution or minute of meeting,
which spells out the mandate of the accounts.
iii. Other documents,
e.g. trust deed for trustees, memorandum of association, article of
association.
The bank also prepared several documents that need to be

complied with and fill-up during opening of accounts.
- Account rules and regulations, outlining the terms, conditions
and general practices governing the account’s operations.
- Signature specimen form; to record the signatory(ies) of the
account onto passbook or specimen card.
- Customer information form; to record detail information about
the accountholder.
- Passbook; to record the transactions of the account for savings.
- Fixed deposit certificate; to record the deposits made including
the maturity date.
- Account statement; only issued at every month-end for current
account.
e. Rules and regulations governing the accounts.
Account rules and regulations document is important because it specifies

the general features of an account type, the depositors’ responsibilities, the
bank’s responsibility, disclaimer clauses, code of conduct governing the
account, etc.
An adequate and comprehensive document shall protect the bank and

minimise impact from legal over-exposures or negligence liability.
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3.4.3 Demand Deposits (Checking Account)
a. Cheque technicality
Cheque has unique features which are quite standard among banks. Upon
issuing cheque, reasonable care must be observed to ensure it is valid and
technically correct.
These are the general features of a cheque;
Features Narration
Bank’s logo Shows the cheque issuing bank’s logo
together with account’s branch name.
Cheque crossing Standard crossing “A/c Payee Only” at
the top of the cheque, meaning that the
account can only be paid into the
nominated payee’s account.
The crossing can be cancelled to
convert the cheque as cash cheque, by
signing onto the crossing.
Cheque date The cheque date is normally equivalent
to the cheque issuance date.
If the date is a future date, it becomes a
post-dated cheque which can be
presented to the bank only beyond that
date.
If the date is a past date, it becomes a
valid cheque. However it must not past
beyond six-month period of which it
automatically becomes a stale cheque
and invalid.
Cheque payee The payee is the recipient of the
withdrawn fund. Any error in spelling
and amendments to the payee’s name
render the cheque invalid.
Amount The amount payable by the cheque
must be written correctly in text and in
numbers. Any mismatch renders the
cheque invalid.
Signature area The valid signature(s) of the account
based on the mandate and specimen
provided.
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The bank has the right to reject the
cheque if it found the signature(s)
differ(s) from the specimen or does not
comply with the account’s mandate.
Company stamp area The registered company stamp as
provided in the specimen.
Features Narration
MICR coding MICR encoded cheque number, issuing
bank & branch code and account
number. These codes can be read by
MICR reader for faster scanning of
cheque information.
The bank, upon receiving the cheque presentation by payee, must exercise
necessary checks to ensure all technicalities are correct and it is not a
forged cheque. Negligence could lead the bank liable for any losses
incurred by the accountholder.
Should there is any technical error onto the cheque presented; the drawing
bank has the rights to reject the payment request and charge penalty fee to
accountholders.
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b. Bad cheque offences
A bad cheque is the cheque that has been returned by the drawing bank
due to insufficient fund within the account. It is called a bad cheque
incident, due to inability of the accountholder to ensure the cheque issued
is sufficiently funded.
A warning letter must be sent out by banks acknowledging accountholder

the offence made. If bad cheque incidents have been implicated three
times within a span of twelve months, the accountholder shall be referred
to Biro Maklumat Cek (BMC), a central information unit for bad cheque
offenders.
c. Biro Maklumat Cek
Biro Maklumat Cek (BMC), stationed at Bank Negara Malaysia, is a one-

stop centre for information on bad cheque offenders at banks in Malaysia.
Offenders registered under BMC are not allowed to open another current
account at any banks until the expiry of the penalised period.
d. Fees and charges
Under the account rules and regulations, bank clarifies any fees and
charges chargeable to the accountholder based on transactions performed,
service request or periodical fee. Certain fees or charges are collected for
the third party, e.g. stamp duty on cheques issued to current accounts,
collected for Inland Revenue Department.
An example of charges on transactions performed is ATM fee for

withdrawals made on MEPS (Malaysian Electronic Payment System)
network, i.e. other bank’s ATM machine.
An example of charges on service request is charge for ad-hoc account

statement.
An example of periodical fee is annual maintenance fee for current

account.
e. Negotiable Certificate of Deposits
Negotiable certificate of deposits (NCD) are certificate-based deposits

which have big-value denominations, i.e. in multiples of RM50,000 up to
RM10 million per certificate.
NCD certificate issued to depositor is tradable in the secondary market,

providing opportunity for liquidity and interest realisation at any stage.
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3.4.4 Related Banking Services;
To enhance the level of services to depositors, several banking services

have been introduced to provide more convenience to perform the related
transactions onto the deposits accounts.
Among the services areas follows;
a. ATM
Automated Teller Machines (ATM) are the earliest form of

electronic banking introduced to allow depositors to perform
transactions using their bank’s ATM machines anytime even at
off-banking hour. Then, the services is extended by allowing
transactions performed at selected other banks’ ATM machines
using MEPS (Malaysian Electronic Payment System) network
established by a pool of banks.
Nowadays, ATM machines are placed anywhere such as in petrol

stations, shopping complexes, colleges and factories. The
transactions that can be performed at ATM machines are
withdrawals, fund transfer, balance enquiry and other enquiries.
b. Electronic banking
Electronic banking refers to the provisions of several machines that

is self manned and accessible to depositors 24 hours a day. These
machines accept most of routine transactions performed for deposit
accounts.
Among the machines available are;

- Cash deposit machine; accepts cash deposit and cash payment
for loan.
- Cheque deposit machine; accepts cheque deposit.
- Statement request machine; allows depositors print ad-hoc
statement of accounts.
- ATM machines; allows withdrawals, fund transfer, enquiry,
etc.
- Passbook update machine; allows immediate update for
savings passbook.
c. Internet banking
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Internet technology and high security features allow banks to
introduce internet banking services to their customers especially
for tech-savvy youngsters and middle-aged professionals. Internet
banking provides mobility convenient and time freedom for
accountholders to perform related transactions anytime anywhere.
Among the transactions that can be performed are fund transfer,

balance enquiry, other enquiries, bills payment, loan and credit
card payment, ad-hoc statement printing and cheque book request.
Through internet banking, depositors can communicate with their
bankers using emails from anywhere.
d. Mobile banking
Mobile banking uses the mobile phones as medium to perform

limited transactions and enquiries onto depositors’ accounts.
balance enquiry, other enquiries and loan payment.
e. Corporate desktop
Corporate desktop is provided for subscribed corporate customers

only. Desktop computer(s) and dedicated computer line are
provided within customers’ office to assigned officers to allow
them to perform related transactions with the bank.

balance enquiry, other enquiries, FD placement request, bills
payment, loan payment and cheque book request.
3.4.5 Roles of deposits
In general, deposit as a financial instrument benefits both the banks and

depositors on a multitude basis;
a. Deposits as main source of funds for banks
Deposits are the cheapest mode of funding compared to other financial

components. Yet, it is flexible to depositors to choose the amount and
period which they want to invest with the banks. And for banks, the
deposits as their capital are easily replaceable by new deposits should any
existing depositors make withdrawals.
b. Deposits as liquidity components
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Deposits are accounted on cash-basis, therefore it is liquid. Adequate
liquidity reserves are critical as a sign of bank’s healthiness and capability
to deliver to their depositors.
c. Deposits as investment products to customers
Deposits with banks are considered as low-risk investments and secured

return for depositors compared to other investments like unit trusts and
stock market. Using the banks’ management expertise, depositors
nevertheless have indirect access to high-level investments with adequate
risk management practised by the banks.
d. Deposits as payment transaction accounts
Current deposits allow depositors to manage their payments efficiently.

Using cheques, payments are easy to make and more secured compared to
carrying a lot of cash for payments.
3.4.6 Bank’s rights and duties to depositors
Under the contract established in deposits acceptance by a bank, it implies the

bank’s right and duties to depositors;
a. To charge fee and commission
Bank has the right to impose fees and charges onto the deposits based on
the notifications made to customers from time to time. Among the fees
charged are current account annual fee, passbook replacement fee and
ATM fee. Charges are normally made onto certain transactions or as
penalty, such as charges on cheque cashing and penalty charges on
returned cheque due to insufficient fund.
b. To receive money for the customer’s account
The bank is obliged to accept deposits on behalf of customers and duly

credited into customers’ account.
c. To honour the customer’s cheque and payment instruction
The bank is obliged to honour and pay accordingly the customers’ cheques
or any other payment instructions that have been made in accordance to
mandate given to banks.
d. To maintain confidentiality of customer’s information
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The bank must protect the customers’ information as strictly private and
confidential. Certain particular information can only be given to
authorised body upon formal request made or on judicial cases.
e. To render a statement of account
The bank shall issued monthly statements to customers as a record on

transactions performed onto the accounts for that particular period.
f. To abide by any mandate given by customers
The operations of the accounts must be made according to the rules and
regulations governing the account and the mandate given by customers.
Failure to comply with customers’ mandate shall expose the banks to
breach of contract or negligence.
3.4.7 Depositors’ rights and duties to the bank
a. To draw cheques
The depositors have the rights to draw cheques based on the amount
available in the accounts. The cheques must be drawn according to the
mandate given to the banks. Any change to the mandate details or cheque
signatories must be notified and duly updated with the banks before its
execution.
b. To give payment instructions
The depositors are entitled to provide precise and definite payment

instructions to the banks at their choice. For example, a post-dated cheque
issued can only be accepted by the drawing bank upon the stated date.
Depositors are also allowed to request the bank to execute other kind of
payment transactions such as funds transfer and interbank GIRO.
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c. To exercise reasonable care in drawing cheques
Cheques are valid bill of exchanges when they’ve been issued accordingly
and deemed correct. Therefore, current accountholders are responsible to
ensure unused cheques are kept under lock and key.
The accountholders are also responsible to exercise due care when

drawing them in accordance to the mandate and with sufficient funds.
Failure to do so, the banks shall be rejecting the payment requests and
penalise accountholders with related charges and/or list the accountholders
with Biro Maklumat Cek.
3.4.8 Cost on deposits
As discussed earlier, deposit received by banks is a cost to the bank. Therefore,

banks must put in place proper deposits strategy (liability management) to ensure
it tallies with banks’ overall Asset Liability Management (ALM). ALM manages
the costs within a bank to match the corresponding income received, to achieve
the targeted interest margin.
The following are the costs related to deposits;
a. Deposits maintenance cost
Deposits maintenance cost in general refers to the cost of manpower and

facilities provided by banks to facilitate all transactions performed on deposits
accounts, including the direct promotional activities and deposit retention
programmes. These costs are classified under bank’s overhead costs. The cost
includes security and insurance coverage on hard-cash.
b. Interest payout
Savings and fixed deposits accounts are interest-bearing accounts. Therefore,

for every dollar received under these accounts banks must pay the interest rate
upon maturity or periodical basis based on the promised interest rate.
3.4.9 Relationships between deposits, investments and financing
Deposits have indirect relationships to the lending activities and the investments
made by the banks. Normally, the various deposits types are combined into a pool
and treated as a single fund. Under this concept, any deposits regardless of
amount and period, provides a low-entry point into fixed duration and high
denomination investments and loans.
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However, some banks offer special deposits to corporate customers, which are
tagged directly to certain investments or syndicated loans. These deposits are
normally made on special arrangements and offered only to selected customers.
3.5 COMPARATIVE ANALYSIS BETWEEN ISLAMIC AND

CONVENTIONAL DEPOSITS
3.5.1 Differences between conventional and Islamic deposits
There are distinctive differences for deposits received under conventional banking
and Islamic banking system. The main criteria is the avoidance of interest or
“usury” by Islamic banks throughout its activities.
Although usually the deposit operations and facilities are very similar, the
differences lie in several underlying principles, such as follows:-
3.5.1.1 Deposit contract
The deposits received under conventional banks are based on borrowing

contract, i.e. banks borrow the money (deposit) from depositors for a
stipulated period of time, payable upon maturity with the promised
interest.
Meanwhile, under Islamic banks, deposits are received under either one of
these two contracts;
a Wadiah contract
Wadiah, literally means “safeguarding of assets”, where banks received

the depositors’ money for safekeeping until withdrawal request is made.
Although under this contract the banks are allowed to use the deposits for
investment activities, they not obliged to give return to depositors. Yet
they are allowed to give it on a voluntary basis or known as “hibah”.
b. Mudharabah contract
Mudharabah deposits, are deposits made purportedly for investments with

the bank based on an agreed profit-sharing percentage. The bank acting as
investment manager, invests the money into permitted investments and
Islamic financing activities, realise profits and share the outcomes with
depositors based on the ratio agreed. Therefore, for depositors the actual
return on deposits is known only upon maturity (or upon periodical
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payment of profit, e.g. monthly). The return varies according to the actual
outcome of investments, though some of them are relatively preditable.
3.5.1.2 Return on deposits
Under conventional banking, the return or interest on deposits is fixed and

guaranteed regardless of the actual outcome on investments.
Under Islamic banking, the return or profit to depositors is subject to the actual
investment outcomes. The profit on investments is shared based on the agreed
profit-sharing ratio, say 70:30 for depositors and banks respectively.
Therefore, under Islamic banking, depositors and banks are equal partners who
would definitely share any windfalls or losses, if any, derived from the
investments.
3.5.1.3 Risk-sharing
Under Islamic banking, the parties to Mudharabah contracts are entitled to

equal risk sharing. Therefore, the risk is higher for depositors under Islamic
banking as compared to conventional banking, and yet providing opportunity
for higher rewards should the investments yields higher profit.
3.6 SUMMARY
In summary, the deposits under conventional banking has matured and evolved quite
significantly especially in terms of its operations and facilities in pace with the
technology and Internet developments.
Compared to other investment avenues; e.g. unit trusts, capital market, commodity
market; deposits are still attractive due to its liquidity, low-risk and payment facilities.
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STUDY MATERIALS
TOPIC 4: DEPOSITS MOBILIZATION BY ISLAMIC

BANKS
LEARNING OUTCOMES
e. Explain the types of deposit in Islamic banking

f. Shariah principles governing
g. Deposits facility practices
4.1 INTRODUCTION
Similar to conventional banking regime, customer deposits are also liability products of
Islamic Banks. As sources of funds of Islamic banks, the main uses of deposit funds are
to be utilized to finance various financing and investment activities requested by the
customers i.e. the purchase of assets such as houses, vehicles, land, and building. There
are various types of deposits products offered by Islamic banks where each of the deposit
has its own unique characteristics.
Though the above similarity sounds convincing but the underlying concepts and
principles of deposits products under the Islamic banks, however, actually different from
the non-Islamic Banks. The approaches of Islamic banking towards management of
deposit funds are notably different from that of interest-based commercial banking or
non-Islamic banking. Factors such as philosophical, moral, legal and economic will
eventually differentiated the management of deposit in Islamic banking against non-
Islamic banking.
Besides the shareholders funds, the depositors’ funds also act as a major source of funds
for Islamic banks. As for non-Islamic banks, deposit facilities cater for the motives to
hold money. Liquidity preference theory, which is known as ‘Keynesian approach’,
highlighted the reasons why people need money for the purposes of transaction,
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precaution and investment. Hence, deposit facilities such as demand deposits, savings
accounts, and investment deposits are considered suitable to fulfil the needs.
4.2 TYPES OF DEPOSIT
Islamic banks operate, among others, the following types of deposit accounts:
a. Demand Deposits
b. Savings Accounts
c. Investment Deposits
d. Negotiable Instruments of Deposits
4.2.1 Demand Deposits
4.2.1.1 Purpose of the facility
A demand deposit facility entitles the account holders to receive his or her
funds on demand. Besides that, the account holders can also issue cheques
on the account to transfer the legal ownership of funds to others i.e. payee.
The demand deposit account is also known also as current account, offered
for those who need money for transaction purposes i.e. issuance of cheque
for payment of monthly financing commitment, business commitments
etc.
4.2.1.2 Common Features Of Demand Deposits
Among the common features of demand deposit facilities offered by

Islamic banks are as follows:
a. Available to customers who have the capacity to enter into a contract

i.e. 18 years old and above, even though the maturity age according to
the majority of Muslims jurists is 12 years old.
b. For business entities, clubs, societies, and associations, certificates of
registration and documents such as memorandum and articles of
association, minutes of meetings relating to the opening of an account
must be presented to the bank as documentary evidence of the
establishment.
c. The Islamic banks use its own discretion to determine the minimum
balance required during the opening of the demand deposit account.
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d. Cheque book will be supplied by the Islamic banks to the demand
deposit account holders.
e. Withdrawal from the demand deposit account may be made on
demand with the issuance of cheques or any other banking related
written instructions given by the account holders.
f. The cheques issued by demand deposit account holders will be
honoured by the Islamic banks but is subjected to the availability of
the funds of the account holders in the demand deposit account. If not,
a penalty will be imposed by the Islamic banks for any cheque
returned due to an insufficient balance in the demand deposit account.
g. Islamic banks may impose a service charge to demand deposit account
holders being servicing and maintaining the demand deposit account.
h. Account holders can request for the termination of the relationship
between the Islamic banks and account holders. However, due notice
of such intention must be given by the account holders.
In the case of death or bankruptcy of the account holder, the demand deposit
account will be suspended.
4.2.2 Savings Accounts
4.2.2.1 Purpose of the facility
The saving account facility is offered to account holders that looking for
safe custody of their funds, wish to save money as well as to earn an
income from that saving. Hence, the precautionary motives as well as the
investment motives are among the main reasons why depositors hold
money under this account.
4.2.2.2 Operational Requirements of the Facility
a. Primary Features Of Savings Account
i. Application must be made by the account holders personally.

ii. Deposits and withdrawals from the saving accounts are allowed
using the standard form furnished by the Islamic banks except
for Automated-Teller Machine (ATM) related transactions.
ii. The saving account facility has no profit sharing characteristic
except for contract under the concept of Al-Mudharabah.
b. Rules and Regulations
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i. Islamic Bank entitled to have its own rules and regulations
governing Savings Account.
ii. Breach of contract by either the Islamic banks or saving
account holders may lead to the closing of account.
iii. The relevant Islamic concept/contract i.e. Al-Wadiah must be
spell-out clearly to the account holders.
iv. Islamic banks must obtain prior consent from the account
holders to utilize their funds in the savings accounts.
c. Opening Of Accounts
1) Among the types of savings accounts available to the account

holders are as follows:
i. Individuals Accounts
ii. Trust accounts
iii. Joint Individuals
iv. Societies
v. Associations and Clubs
2) Capacity to enter into a contract (Baligh)
i. As per Shafi’i and Hambali schools of Islamic

Jurisprudence, the ‘BaIigh’ age for both boys and girls is
15 years old.
ii. As for minors below the age of 15 years old, the savings
account must be under the name of their guardian (trust
account).
iii. Blind/deaf/mute person are recognised by Shariah as
having the capacity of operating an account.
3) Identification of account holders
Under section 16 of Anti-Money Laundering Act 200 (AMLA), a

reporting institution including Islamic banks:
i. must maintain accounts in the name of the account holder

ii. must not open, operate or maintain any anonymous account
or any account which is in a fictitious, false or incorrect
name.
Besides the above, when establishing or conducting business

relations particularly during the opening of new accounts, Islamic
Banks must verify, by reliable means, the following information:
a. the identity of the customer
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b. representative capacity,
c. domicile,
d. legal capacity,
e. occupation or business purpose of any person,
f. other identifying information on that person, whether he is
an occasional or usual client,
The verification above can be performed from the use of following

identification documents:
a. Identity card
b. Passport
c. Birth certificate
d. Driver’s License
e. Constituent document, or any other official or private
document i.e. certificate of company’s registration,
companies’ minutes of meeting, board of directors’
resolutions.
Reasonable measures must also be taken by the Islamic banks to obtain

and record information about the true identity of the account holders for
the following transaction:
a) during the opening of the account or
b) a transaction is conducted if there are any doubts that any person is not
acting on his own behalf, particularly in the case of a person who is
not conducting any commercial, financial, or industrial operations in
the foreign State where it has its headquarters or domicile.
4.2.2.3 Record–keeping
Under the section 13 of AMLA, Islamic banks must keep a record of any
transaction involving the domestic currency or any foreign currency
exceeding such amount as the competent authority may specify.
The record must include the following information for each transaction:
a. the identity and address of the person in whose name the transaction is
conducted.
b. the identity and address of the beneficiary or the person on whose
behalf the transaction is conducted, where applicable
c. the identity of the accounts affected by the transaction, if any.
d. the type of transaction involved such as:
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i. deposit,
ii. withdrawal,
iii. exchange of currency,
iv. cheque cashing,
v. payment or transfer by, through, or to such reporting institution
e. the identity of the reporting institution where the transaction occurred

f. the date, time and amount of the transaction
g. Other information as the competent authority (Bank Negara Malaysia)
may specify in writing.
Note:
Person includes any person who is a nominee, agent, beneficiary or
principal in relation to a transaction
4.2.2.4 Application Form
i. Customers must fill in his/her personal details in the

application form. The personal details include customer name,
identity card number, date of birth, occupation, addresses and
any other relevant details.
ii. Concept/Contract used to accept the deposit i.e. ‘Al-Wadiah’
must be clearly stated in the application form.
iii. Consent from customers agree to allow to utilize their deposits
must be stated in the application form.
iv. Customer must sign the application form indicating the
agreement on the rules and regulations governing the facility.
4.2.2.5 Savings Account Transaction
a. Deposit transactions include the following:
i. In the form of cash, cheques, bank drafts, money orders, postal

orders, dividend warrants etc.
ii. Cheques/other bills of exchange must be payable to the account
holder before allowed to be deposited into the account.
iii. Deposits will only be credited when the funds have been
received by the Islamic banks.
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b. Withdrawal transactions from the saving accounts are allowed using
the standard form furnished by the Islamic banks or using the
Automated-Teller Machine (ATM), which require no standard form.
c. Inter-branch deposits and withdrawals can be performed at any branch

of the Islamic banks.
4.2.2.6 Investment Deposit or Investment Accounts
4.2.2.6.1 Purpose of facility
The investment deposits/accounts facility caters for customers who

intend to keep money for investment motives which normally
prefer to place their money in the time (fixed) deposit facilities.
The investment deposits offered by the Islamic banks are normally
governed under the principle of Mudharabah where the Islamic
bank acts as an entrepreneur or manager of the funds and
investment depositor acts as an investor.
Under the principle of Mudharabah, the Islamic banks provide no

guarantee or no fixed return on the amount deposited but to share
the profits or losses made with the investment depositor based on
the profit and loss sharing ratio agreed earlier.
The agreement on profit and loss sharing ratio between the Islamic
bank and the investment depositor is made at the beginning of the
deposit and cannot be amended during the tenure of the deposits
unless with the consent of both Islamic bank and the investment
depositor.
4.2.2.6.2 Types of Investment Deposit
Under the investment deposits, there are few alternatives made

available to the investment depositors that are as follows:
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i. Deposits based on duration
Under this arrangement, depositors are free to choose the
period that they want to place their funds with the bank .i.e.
1 month, 3 months, 6 months, 9 months, one year or more.
ii. Deposits based on notice

This investment deposit facility requires the depositors to
submit a written notice to Islamic Banks prior to
withdrawal of funds.
iii. Deposit for a specific project or purpose

The depositor agrees to invest in a particular project
selected by him/her. The profit from that project is
distributed between the Islamic bank and the depositor
according to predetermined profit sharing ratios and
mutually pre-agreed terms and conditions.
4.2.2.6.3 Common Features of Investment Deposits
Among the common features of the Investment Deposits are as

follows
i. minimum amount of deposit

ii. types of customers who can operate an investment account
iii. withdrawal and renewal process
iv. distribution of profits
An example on how to calculate dividend earned by Investment

depositor under the Investment Deposit Account
Question:
Using the following information, calculate the total amount of

dividend earned by the Investment Depositor of Islamic Bank if
he/she deposits his money of RM50,000 on 17th July 200X for the
next three (3) months:
Date of Profit Being Actual Profit Profit Sharing Ratio

Declared Declared by (Customer: Bank)
Islamic Bank
16th June 200X 8.0% 80:20
16th July 200X 7.5% 80:20
16th August 200X 8.5% 80:20
16th Sept. 200X 8.5% 80:20
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16th October 200X 9.0% 80:20
Note: Answer to the above is provided in Appendix 1.
4.2.2.6.4 Negotiable Instruments of Deposits
Applicable Concept
The Islamic Negotiable Instruments of Deposits are based on two
(2) types of concepts:
i. Bai’ Bithaman Ajil (BBA) – Negotiable Islamic Debt

Certificate (NIDC)
a. BBA refers to the sale of goods on a deferred payment

basis.
b. The Islamic bank sells the identified asset to a customer
and subsequently buys the asset from the customer at an
agreed price (the sale price), which includes the
customer’s mark-up (profit).
c. Or it refers to a sum of money deposited with the
Banking Institutions (BIs) and repayable to the bearer
on a specified future date at the nominal value of the
NIDC’
ii. Al-Mudharabah – ‘Islamic Negotiable Instruments of

Deposits (INID).
Al-Mudharabah refers to an agreement between two (2)

parties that is:
a. the provider of the funds (customer) – which provides

100% capital for the financing, and
b. the entrepreneur (Islamic bank) – who manage the
project using his entrepreneur skills
- or it refers to a sum of money deposited with the BIs
and repayable to the bearer on a specified future
date at the nominal value of NIDC plus declared
dividend
- Profits arising from the project are distributed
according to pre-determined profit sharing ratio
(PSR)
- Any losses accruing are borne solely by the
provider of the funds.
4.2.2.6.5 General specifications
The general specifications are:
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It certifies that a sum in Ringgit has been deposited
with the Issuer (Islamic bank) whereby it is repayable
to the bearer, upon presentation of the certificate to the
Issuer through an Authorised Depository (AD) on a
specified future date (i.e. maturity date) at a nominal
value.
4.2.2.6.6 Specified future date (i.e. maturity date)
a. Not earlier than 90 days and not later than 60 months from the
date of issue or
b. Not less than the following:

i. 12 calendar months if the profit sharing ratio (PSR) is
determined every 3 months ( ≥ 1 year), or
ii. 24 calendar months if the PSR is determined every 6
months ( ≥ 2 years).
4.2.2.6.7 Nominal value
Nominal value, which is in an amount of the following:

i. Not less than RM50,000 (minimum)
ii. In multiples of RM50,000 up to a maximum of RM10
million.
4.3 SHARIAH PRINCIPLES GOVERNING DEPOSIT FACILITIES
Among the Shariah principles that governing the deposit facilities are as follows:
4.3.1 Al-Wadiah
The Bank accepts deposits for Savings Account under the Islamic principle
of Al-Wadiah.
4.3.1.1 Definition
It is a contract between two parties i.e. the owner of goods and
the custodian of the goods to ensure the safe custody of the
goods from being stolen, lost, destroyed etc.
4.3.1.2 Types of Goods

The ‘goods’ can be referred to anything that is of value such as:
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a. Fixed assets
b. Money
c. Jewels
d. Certificates
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4.3.1.3 Tenets (Rukun)
There are 4 tenets of Al-Wadiah, namely:
i. The goods under the custody
ii. Owner of the goods
iii. Custodian of the goods
iv. Contract : Offer and acceptance (Ijab and Qabul)
4.3.1.4 Types of Al-Wadiah

There are two (2) types of Al-Wadiah:
a) Al-Wadiah Yad Amanah (Trust)
b) Al-Wadiah Yad Dhamanah (Guarantee)
Type of Al-Wadiah Details

Al-Wadiah Yad Islamic bank acts as a trustee to the
Amanah (Trust) fund. If the money under the
custody is accidentally lost or
destroyed, the custodian is not
obligate to replace or compensate
it.
Al-Wadiah Yad The Islamic bank’s responsibility
Dhamanah will however change from Al-
(Guarantee) Wadiah Yad Amanah to Al-
Wadiah Yad Dhamanah if the
deposit scheme has any one of the
following features:
i. Funds pooled together and
not segregated according to
the accounts.
ii. Funds deposited by
customers are utilized by
the Islamic bank in its
investment or financing
projects.
iii. Islamic bank imposed
service charges on the
deposits.
By pooling and utilizing the fund,
the Islamic bank’s responsibility is
in the form of guarantee and
therefore it is compulsory for the
Islamic bank to return the fund as
and when requested by the
customer.
4.3.1.5 Discretionary Reward

Under the principle of Al-Wadiah,
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i. The custodian i.e. the Islamic bank is not allowed to mention
or to promise any rewards or return.
ii. The customers/depositors, on the other hand, are also not
allowed to demand any rewards or return on their savings.
iii. Any promised rewards given under the contract of Al-Wadiah
is considered as ‘riba’ which is strictly prohibited.
iv. Rewards do not only referring to monetary items. It includes
also other forms of incentives such as coin boxes, clothes etc.
v. Rewards cannot be promised earlier but as and when the
Islamic bank wants to reward his customers, the bank can
always do it on its own discretion.
4.3.1.6 Returns On Savings Account

a. Concept of Returns/Profit
i. Islamic bank is not obliged to give return/profit to

customers
ii. Returns/profit is merely on the discretion of the Islamic
bank.
iii. All eligible depositors must get equal percentage of
returns
iv. Profit given to customers in the past can be declared by
Islamic bank as percentage of returns per annum.
b. Calculation Of Profit
i. The profit distributed can be based on the average daily

balance of the account
ii. Calculation of profit
* Cumulative daily balance for the month 1

= X rate X
(No. of days in the month) 12
* Assuming that profit is distributed monthly.
4.3.1.7 Al-Mudharabah
The Islamic bank accepts deposits for Investment Deposits Account
under the Islamic principle of Al-Mudharabah.
4.3.1.7.1 Definition
Al-Mudharabah is a contract between two parties, i.e.,

the owner of capital and the entrepreneur of the
proposed project where both agree to share the profits
based on the agreed ratio while the losses, if occurs, is
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to be borne by the owner of the capital.
4.3.1.7.2 Modus Operandi
i. Investment depositors (the owner of capital) place a

specified sum of money at the Islamic bank (the
entrepreneur) for a stipulated period of time with an
agreed predetermined ratio of profit sharing.
ii. The Islamic bank is entrusted to utilise the deposits
in its financing activities and investment projects
without any intervention from the Investment
depositors (owner of capital).
iii. Profit earned on the investment will be distributed
between the two parties (Islamic bank and
Investment depositors) according to the profit
distribution ratio determined at the point of ‘akad’ or
contract.
iv. Loss, if any, will be borne totally by the Investment
depositors (owner of capital).
4.3.1.7.3 Tenets (Rukun)

There are six tenets of Al-Mudharabah:-
i. Owner of the fund
ii. Entrepreneur of the project
iii. Capital
iv. Project (Utilisation of the Fund)

a. Project must be a Shariah-approved project
b. Islamic bank must not enter into another Al-
Mudharabah Investment without the specific
consent from the owner of capital.
v. Profit sharing ratio

a. The profit sharing must be agreed according to
ratio, not according to the amount.
b. The profit sharing ratio (PSR) is determined at
the point of contract.
c. Loss, if any, will be borne by the owner of
capital.
d. If the loss is proven to be due to the
mismanagement or negligence of the
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entrepreneur (Islamic bank), the Islamic bank is
responsible to bear the loss.
vi. Contract of Offer and Acceptance (Ijab and Qabul)

Prior to the offer and acceptance of the contract,
both parties involved must determine and agreed the
following:
a. The amount of investment i.e. RM5,000
b. The period of investment i.e. 1 month, 3 months,
6 months, 9 months, etc.
c. The profit sharing ratio i.e. 50:50, 60:40, 70:30.
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4.3.1.7.4 Opening Of Accounts
i. Customer is required to open an account on the initial

investment made. For subsequent investment, different
certificates will be issued under the same account.
ii. The Investment Deposits Accounts are opened to all,

Muslims and non-Muslims.
iii. The accounts can be classified as the following:

a. individuals,
b. joint individuals,
c. firms and corporations,
d. Societies, associations and clubs.
iv. According to Shafi’s School of Thought, a person must

be ‘baligh’ in order to enter into a contract: i.e., reach
the age of 15 years old (Hijrah birth date).
v. Minor is allowed to open a trust account under the name

of respective parents/guardian.
vi. The Islamic bank must state in the application form or

signature specimen card or any relevant documents of
opening of account that the investment deposit is under
the Islamic principle of Al-Mudharabah.
4.3.1.7.5 Profit From Investment Account
i. In terms of profit sharing, it will be distributed between the

owner of the capital (investment depositor) and the
entrepreneur (Islamic bank) in an agreed predetermined
profit sharing ratio (PSR) i.e. 70:30 (Depositor: Islamic
Bank)
ii. The profit sharing ratio must be agreed and stated in the
contract, i.e. in the investment certificate
iii. The Islamic bank can always give a higher return to the
depositors than the agreed PSR.
iv. Returns to the depositors can be based on gross or net
profit subject to the agreement between both parties
involved.
v. Calculation of profit
Formula:
= Principal X Profit Rate X Period of Investment
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(in months)
12
vi. Interim profit

a. For deposits placed for a long period, such as 24
months, interim profit may be paid every 6 months.
b. The calculation of interim profit may be based on 6
months rate for the particular month.
c. Profit Due Upon = Total Profit - Total Interim Profit
Paid Maturity.
d. If the total interim profit paid out is greater than the
actual profit, the difference in the amount is a ‘Profit
Refund’. The principal amount paid on the day of
withdrawal will be less by that amount.
vii. Profit on Premature Investment

a. According to Shariah Principles, once the
Bank has utilized the deposits, profit gained
must be shared with depositors even though
the investment is withdrawn prematurely.
b. For convenience purposes, the Bank can
impose the following conditions:-
i. For amount RM5000 and ab3ve, profit
will only be distributed if the investment
is made for at least 1 month.
ii. For amount lesser than RM5000,
minimum RM500, profit will only be
distributed if the investment is made for
at least 3 months.
4.3.1.7.6 Deposit Into Account
a. Deposit into account can be made in the form of cash, cheques

or funds transferred from savings/current or through inter-
bank transfer.
b. If customer deposits a cheque, the investment certificate can

only be issued when the cheque is cleared.
4.3.1.7.7 Maturity of Investment Deposit
a. On maturity of the Investment Deposit, customers may have

several options:-
i. Renew the principal amount together with the profit
earned
ii. Renew the principal sum without the profit earned
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iii. Withdraw both the principal amount and profit earned
b. The Islamic bank may remind the depositors 2 weeks before

the maturity date of their investment certificate of the above
option. If the certificate is not presented on the maturity date,
the Islamic bank may automatically renew the deposit
together with the profit earned by the depositors.
c. Auto renewal must be based on the original terms conditions.
4.3.1.7.8 Stopping Of Account

a. An account can be stopped or freeze in the event of death,
bankruptcy or insanity of the account holder.
b. In the event of death, the Mudharabah account will be freeze
unless upon the receipt of letter of administration or a grant of
probate from the beneficiary.
4.3.1.7.9 Lost of Certificate / Closing of Account

a. Customer is required to notify the Islamic bank in writing on
the lost of the Investment Certificate by completing the
Indemnity form to the Bank.
b. A new certificate will then be issued to the Investment
Depositor.
4.3.1.7.10 Unclaimed Monies Account
a. Automatic renewal is allowed for a period of 7 years from the

original maturity date.
b. If there is no claim within the stipulated period, the
investment will be transferred to the Unclaimed Monies
Account as required under the Unclaimed Monies Act 1965.
c. The transfer of the Investment Account to Registrar of
Unclaimed Monies is not against the principle of Shariah. The
ownership of the fund is still retained with the account holder.
The account holder can always claim the balance with the
relevant authority that is responsible to the management of
unclaimed monies.
4.4 DEPOSITS FACILITY PRACTICES IN VARIOUS COUNTRIES
4.4.1 JORDAN
a) Demand Deposit Facility Known as Trust Account Facility

The demand deposit facility offered by Jordan Islamic Bank is known
as the ‘trust account facility’. The trust accounts are further dividend
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into two types:
i. Current account - with cheque book facilities
ii. Demand Deposit – deposits and withdrawals are made upon the
presentation of the pass-book of the account holders. The
features are of similar to the current account facility except
without the cheque book facilities.
Under the requirement of the Jordan Islamic Bank for Finance and
Investment Law No.13 of 1978, its stated that ‘Trust accounts are cash
deposits received by the Bank where the Bank is authorised to use the
deposits at its own risk and responsibility in respect of profit or loss,
and which are not subject to any conditions for withdrawals or
depositing’.
4.4.2 TURKEY
a) Current Account Facility
The current account facility offered in Turkey can be opened in local

currency (Turkish Lira) or in foreign currency. The additional features
of the facility, among others, include the following:
i. Payable partially or totally on demand

ii. Open to various customers i.e. individuals, joint individuals,
business organization (sole-proprietorship, partnership and
companies, and other legal -clubs, societies, and associations)
iii. Account holder receives no interest, profit or other proceeds
iv. The funds do not fall within the scope of the Savings Accounts
Insurance Fund.
v. Current accounts are booked and operated independently of
Institution accounts and participation accounts
vi. Institution accounts transfers the accumulated profit and the loss
incurred from the current account to its own accounts
vii. Current accounts are booked and operated individually as
Turkish lira accounts.
viii. Current account holders are the first-priority creditors of the
Islamic Bank assets including the capital and the reserve of the
Institution for the total amount that they have deposited
ix. The maximum amount that the current account holders allowed
to deposit is determined by the Central Bank of Turkey (the
Central Bank).
The above rules and regulations are imposed by the Turkey’s

Undersecretariat of Treasury and Foreign Trade of the Prime Ministry
under its article 15 and 16.
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b) Requirement on the Utilization of the Funds
Among the requirements imposed on the utilization of the funds of

Current Accounts include:
i. A minimum of 10% of the funds accumulated in the current
accounts must be kept in cash or deposits in commercial banks
including Islamic Banks.
ii. An additional 10% must be kept in the Islamic bank either in
cash or as liquid assets that is to be specified by the Central
Bank and the percentages can be changed by the Central Bank.
iii. The remainder of the funds can be utilised to finance the
commercial activities of real or legal persons, 50% of which
have a term of longer than one year.
iv. 80% of funds utilised shall be collected in cash when due and
20% at the most can be participated to the profit and loss of the
real or legal persons using the fund in accordance with the
covenants of the Contract for Profit and Loss Participation.
v. The share portion the Institution receives from profit and loss,
and, if necessary, the securities the Institution takes must clearly
expressed in the Contract for Profit and Loss Participation
investment.
vi. The amount of a fund which can be associated with a single,
real or legal person from these amounts shall be determined by
the Central Bank.
vii. Foreign exchange accumulated in these accounts can also be
utilised in other Turkish banks or in the international monetary
and commercial markets.
4.4.3 BANGLADESH
a) Procedures on PLS-Savings Account adopted by Islamic Bank

Bangladesh
The following procedures are adopted by Islamic Bank Bangladesh:
a. Any individual singly or jointly and any socio-economic

institution can open this account by tendering an initial deposit
of Tk. 100 (Taka one hundred) only.
b. Withdrawal is ordinarily allowed 4 (four) times in a calendar
month up to 25 per cent of the balance or Tk. 15,000 (Taka
fifteen thousand) whichever is less in a single transaction.
c. For withdrawal of amount exceeding the above limit, 7 (seven)
days prior notice is required, otherwise no profit is allowed that
month.
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d. For the purpose of calculation of profit, the lowest balance
standing in the account from 6th to the last day of that month
taken into consideration. Profit is credited to accounts
provisionally in June and December every year. Final rates of
profit are declared after closing of accounts in December and
auditing of the same by the Statutory Auditors. The amount of
provisional profit credited in June and December is adjusted on
basis of the final rate.
e. The PLS-Savings account can be operated by cheque.
f. Collection of bills, cheques and other negotiable instrument
undertaken on a limited scale.
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4.4.4 UNITED ARAB EMIRATES
a) Calculation of returns to depositors by Dubai Islamic Bank

The Dubai Islamic Bank adopts the following approach to calculate the
returns to depositors:
“The profit in the savings account is calculated on the minimum

balance during the month. The account holder is given profit according
to the common percentage of profits. The profits are distributed at the
end of every financial year after the approval of the Bank’s balance
sheet by the General Association. The depositor in the Savings
Investment Account participates in the profit of the Savings Investment
w.e.f. the beginning of the following month after the month during
which the deposit took place. The profits are not calculated w.e.f. the
beginning of any month during which the money is withdrawn from the
account. The minimum balance for considering the profit is Dh. 1000
(Dirham one thousand).”
4.4.5 MALAYSIA
a) Standard Formula to Calculate Rewards For Savings Account

Holders
Formula:
CBD for the month 1

MP = X R X
(No. of days in the month) 2
where,
MP : Profit for the month
CDB : Cumulative daily balance in the savings account
R : Rate of profit given at the end of month.
The above formula is used with the assumption that profit is distributed
on a monthly basis.
b) Minimum Deposit under Investment Deposits Account

The minimum deposit of RM5,000 is required to open an investment
account for a period of one a month.
4.4.6 KUWAIT
a) Types of Investment Deposit Facilities
Kuwait Finance House (KFH) has two types of investment deposit
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facilities:
i. Investment deposit for limited

ii. Investment deposit for unlimited periods.
Except for the maturity period and renewal process, similar

procedures are applied for both deposit facilities. Both facilities
require a minimum deposit amount of KDI,000 (Kuwaiti Dinars one
thousand).
The returns (profit) for these deposits are payable at the end of the
fiscal year and according to the realised profit and the percentage
determined by the bank.
b) Operational Procedures of The Kuwait Finance House (KFH)
Investment Deposit Facility
a. KFH will issue a deposit certificate in the name of the depositor
for the deposited amount.
b. The depositor or the beneficiary or whoever has the right to
withdraw, cannot withdraw any part of the deposit before the
due date.
c. The investment of the deposit is carried out on the basis of
absolute speculation and KFH have a free hand to invest it in
the way seen proper for realising mutual advantage.
d. The depositor or beneficiary or whoever is authorised to
withdraw the deposited amount, can withdraw the deposit on
the due date against presentation of the deposit certificate to
KFH and after signing the final settlement.
e. The beneficiary may abdicate or negotiate the deposit
certificate to another party on the same conditions agreed upon
with the KFH provided that he turns up at KFH premises and
presents the deposit certificate to record the abdication in the
KFH registers and in replacement of the old certificate KFH
will issue a new certificate in the name of the new beneficiary.
f. In case the certificate happens to be damaged or lost KFH must
be notified forthwith to take necessary precautions at the
client’s expense and to re-issue a substitute certificate
exempting KFH from any responsibility whatsoever.
g. The return (profit) of the deposit will be paid periodically as
determined by the administration of KFH.
h. The certificate should be stamped by KFH bearing two
signatures of two officials authorised to sign in this respect.
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Summaries of Shariah Principle Used Under the Savings Accounts Facilities, Demand
Deposits Facilities and Investment Deposits Facilities Offered by various countries can
be crossed referred at Appendix 2, Appendix 3 and Appendix 4 respectively.
Appendix 1
Calculation of dividend earned by Investment depositor under the Investment

Deposit Account
Answer
Actual Profit Profit Sharing Ratio Dividend Earned
Date of Declared Profit Earned in (RM)
Profit (in %) Depositor Bank By Customer [5 = RM50k X 4]
Declared [1] [2] [3] [4 = 1 * 2] 12
16th July 7.5% 80 20 6.00% -
16th Aug 8.5% 80 20 6.80% 283.33
16th Sept 8.5% 80 20 6.80% 283.33
16th Oct 9.0% 80 20 7.20% 300.00
Total Dividend Earned by Investment Depositors = RM866.66
Appendix 2
Summary of Shariah Principle Used Under the Savings Accounts Facilities Offered
by Various Countries
Source: Sudin Haron and Bala S. (2001). Islamic Banking System – Concepts & Applications. Pelanduk
Publications. 91- 108
Type of Deposit Shariah Principle Used Reward Given

Facility / Country to Account
Wadiah Mudha-
Qard Holder?
Wadiah Yad- rabah
Hassan
Dhamanah
Savings Accounts
a) Iran √ √
(Cash and non-
cash)
b) Bahrain – Faysal √ No reward
Islamic Bank of
Bahrain
c) Sudan √ No reward
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– Faysal Islamic
Bank of Sudan
d) Malaysia √ √
e) Kuwait -Kuwait √ √ √
Finance House
f) United Arab √ √
Emirates
- Dubai Islamic
Bank
g) Bangladesh – √ √
Islamic Bank
Bangladesh
Appendix 3
Summary of Shariah Principle Used Under the Demand Deposits Facilities Offered
Shariah Principle Used

Type of Deposit Wadiah
Country Qard
Facility Wadiah Yad-
Hassan
Dhamanah
Demand Deposit Iran √
(Current Accounts) - as per Law of Usury-
Free Banking 1983 of
Iran
United Arab Emirates √

- Dubai Islamic Bank
Kuwait √
- Kuwait Finance
House
Bangladesh √
Jordan √
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Malaysia √ √
Bahrain √
– Faysal Islamic Bank
of Bahrain
Appendix 4
Summary of Shariah Principle Used Under Investment Deposits Facilities Offered

Type of Deposit Basis of Investment Deposits

Facility / Country
Duration Notice Specific Period of
project or Investment
purpose Deposits
Investment Deposits
a) Malaysia √ Quarterly basis
b) Kuwait -Kuwait √ Yearly basis only
Finance House (minimum = one
year)
Options:
a) limited period
that valid for one
year and
renewable
b) Unlimited
period;
withdrawal after
one year; requires
3 months written
notice, if not,
auto-renewable.
c) Bangladesh – √ Quarterly basis
Islamic Bank
- not
Bangladesh
allowed
to
withdraw
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unless
with
written
notice (7
days)
d) Jordan - Jordan √ √ Yearly basis only
Islamic Bank
- not (minimum = one
allowed year)
to
withdraw
unless
with
prior
written
notice
(90 days)
- 106
REFERENCES
Sudin Haron and Bala S. (2001). Islamic Banking System – Concepts & Applications.
Pelanduk Publications. 91
Rose, P. (2006). Money and Capital Markets. (9th Ed.). USA: Irwin –McGraw-Hill
BIRT (1997). Unpublished seminar paper.
Bank Negara Malaysia’s guidelines on ‘Islamic Negotiable Instruments of Deposits

(NID)’.
- 107
STUDY MATERIALS
TOPIC 5: THE COST OF DEPOSIT
LEARNING OUTCOMES
a. Understand the importance of cost of deposit to a bank.

b. Understand the essence of cost of deposit.
c. Understand the components of cost of deposit.
d. Analyze relationships between cost of deposits and loan pricing.
e. Understand the cost of deposits in Islamic banking
f. Understand the Islamic financing pricing mechanism.
5.1 INTRODUCTION
To a bank, deposits are the ultimate “business capital” to be used for their lending
and investment activities. The bank’s shareholders fund or company capital is
used mainly to finance their establishments, i.e. the bank’s set-up, premises set-
up, logistics and system infrastructure, staff salaries, general expenses,
advertisements costs and perhaps bits of investments for surplus capital. In some
banks, shareholders’ fund is used for restricted lending activities, for e.g. staff
loan, subsidiary company’s loan, etc, which provide minimal return.
Therefore, since the shareholders’ fund is mainly used for pure cost activities or
non-income generated activities, the bank is relying on customer deposits as the
capital for the bank to generate income.
And the deposits are not free. It’s either in exchange to services to be enjoyed by
the depositors or with interest payout onto the deposits amount. Thus, the deposits
itself has it cost of deposits, which should be carefully managed by the bank to
ensure whatever revenue generated from its lending and investment activities is
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more than the cost of deposits. The net revenue for the bank is basically the
bank’s profit for the banking business.
5.2 COST OF FUND

5.2.1 The importance of cost of fund
The banks’ awareness on the cost of deposits or cost of funds at all times
is basically to continuously identify the cost of doing business. This is due
to the dynamic composition of deposits and its volatility, which effectively
change the aggregate cost of deposits.
In comparison to a normal company set-up where the capital is normally

fixed, the cost of capital or return on equity is highly predictable and
dividends is paid on yearly basis; the banks’ deposits pose different
challenges to its management.
In early days, banks offer only a few products and many operated as
single-branch banks. Added by regulations on the deposit rate ceiling, the
banks management are quite straightforward. However, nowadays banks
become major establishments with branches nationwide and overseas
offering a variety of products and services to their customers. And the
banks are aggressively competing to maintain existing depositors and
attract new clients. Normally, banks resort to offering better services and
higher interest rates which effectively increase the cost of deposits.
On the other side, the banks’ shareholders demand higher profit and better
dividend payout. The banks’ profit margin is projected and the
management is given the tasks to achieve the goals.
Literally, to satisfy both the higher interest rate to depositors and higher
dividend payout to shareholders, banks need to price the loan relatively
high and invest in high-return investment products. But, this cannot be
true considering that the banks also struggle to compete for loan customers
especially for high net worth corporate customers and high-return
investment products are quite limited in the market.
In summary, the cost of deposits is the key factor that determines the loan
pricing and targeted investment income, which consequently provides the
bank’s profit. Without a prudent cost of deposits management, the bank
could lose its competitiveness.
5.2.2 Liquidity reserves impact
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Liquidity reserves comprise of statutory reserve and float reserve. The
statutory reserve is set by the central bank, normally around 10% of total
deposits. The float reserve is based by the bank’s policy on additional
liquidity as a buffer to statutory reserve, for e.g. 5% of total deposits. The
level of float reserve can be based on the composition of deposits currently
maintained by the bank, i.e the percentage of volatile deposits (e.g. current
account deposits) against total deposits. Higher percentage of volatile
deposits could mean higher liquidity reserves required by the bank to meet
expected withdrawals.
Therefore, for every dollar received on deposits, a portion must be set

aside for liquidity reserves, as explained by the following equation;
Net investable deposit = Principal deposit – liquidity reserves
For example, the liquidity reserves are set at 15%.
Net investable deposit = RM1 – (RM1x15%)

= RM1 – RM0.15
= RM0.85.
Based on the above example, the net investable deposit for every RM1
received is actually RM0.85. The net investable deposit refers to the
deposits available to the bank for loan and investment activities, i.e. after
deduction of liquidity reserves. Although the deposit that can be used is
RM0.85 for every RM received, the interest payout onto the deposits is
based on full amount received that is RM1. The liquidity reserves
(RM0.15) are idle cash which contribute to the cost of deposits.
The level of liquidity reserves is manageable by managing the float

reserves. It should be consistent the bank’s Liability Management, i.e.
managing the deposits components and its percentage in the overall
deposits. As discussed earlier, current account requires higher float
reserves while fixed deposit in contrast requires smaller float reserves.
Therefore an ideal combination of these deposits could result an ideal
percentage of liquidity reserves as projected by the bank.
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5.2.3 Types of deposits and its contribution to cost of deposits
In general, there are two types of deposits, i.e.;
5.2.3.1 Non-interest bearing deposits
Non-interest bearing deposits are normally transaction deposits,

such as, current account and savings account. These deposits are
maintained with the bank primarily to facilitate services such as
checking and payment services and for safekeeping. For current
account, there is no interest payable to the deposits, however the
servicing costs are quite high for its high-volume transactions.
For savings account which incur moderate-volume transactions,
interest is offered at a low rate.
Collectively, non-interest bearing deposits accrue minimal

interest expense for the bank but high servicing costs for the
services delivery.
5.2.3.2 Interest bearing deposits
Interest bearing deposits such as fixed deposits, is maintained by

the depositors for the interest returns promised by the banks.
This category of depositors is quite sensitive to any changes in
the interest rates either in the their bank or other banks. They
would always be looking for good bargains among several banks
in order to maximise their earnings from the deposits. Thus,
banks are always reviewing their interest rates to match the
expectation of the depositors based on the economic scenario
and its competitors.
The interest expense is substantially high for this category of

deposits, however, the servicing cost is relatively low since the
deposit is static with a lump-sum withdrawal upon maturity. The
cash-flow for this category of deposits are also highly
predictable and easy to manage.
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5.2.3.3 Deposits acquisition cost
In the banking environment today where customers are offered

with various products and options by different banks with
different kind of services, the competition has become stiffer to
get new customers and new deposits.
Banks are going another extra length to grab new customers’

attention and to instil loyalty among the existing customers.
Among the strategies adopted are new product packaging,
customers get customers programme, loyalty reward
programme, association in charity drive, premier services and
brand advertisement. Some programmes are created specifically
for certain products such as deposits acquisition.
And the costs for these “promotions and advertisement

exercises” are very substantial nowadays, which is why it has
been tracked directly to every product performances.
Deposit acquisition cost refers the cost incurred to attract new

deposits from new customers or existing depositors. The cost is
calculated based on projections made by the banks as a result of
the promotion and advertisement embarked for this particular
product. For example, say the bank embarks on a programme
aimed to attract at least RM100 million of new deposits for the
month of January at a cost of RM100,000. Therefore the
acquisition costs for every RM1 is calculated as follows:-
Deposit acquisition cost = RM100,000 / RM100 million

Deposit acquisition cost = RM0.001
The above cost shall constitute part of the cost of deposits,

which banks normally prepare the projections on a full year
basis. Although the acquisition cost is directly related to new
deposits or additional deposits, it indirectly deals with the
existing deposits which are replenished by the new deposits.
Therefore, it can be said that deposit acquisition cost is the cost
needed to maintain the current or projected level of deposits due
to the projected withdrawals from the current deposits.
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5.2.3.4 Marginal cost of deposits
Marginal cost of deposits is the measurement of costs incurred

or payable to obtain additional unit of deposits, based on the net
investable deposits. Marginal deposits used current or estimated
data from the market or the bank’s own projections computed on
annual basis. However, since the market may change or actual
expenses varied throughout the corresponding year, the
computations need to be reviewed regularly to reflect the
changes.
The basic computation for marginal cost of deposits is as

follows:-
Cost of deposits = interest rate + servicing costs + acquisition costs

Net investable deposits
5.2.3.5 Interest rate
Interest rate refers to the average interest rate payable to all depositors on
a single dollar basis. This is calculated on a prorata basis based on the
composition of deposit types available within the banks.
For example, ABC Bank has the following composition of deposits with
the corresponding interest rate payable;
Exhibit 2(a)
Deposit Type Composition Interest Payable

Current account 30% 0%
Savings account 25% 2%
Fixed deposits 40% 4.5%
Interbank borrowings 5% 2%
Total deposits 100% -
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Therefore, the average interest rate is:
Interest rate = (0% x 30%) + (2% x 25%) + (4.5% x 40%) +

(2% x 5%)
= 0 + 0.005 + 0.018 + 0.001
= 0.024 = 2.4%
Now, let’s simulate a significant change in the deposit composition and
recalculate the average interest rate.
Exhibit 2(b)

Interest rate = (0% x 20%) + (2% x 20%) + (4.5% x 55%) +

(2% x 5%)
= 0 + 0.004 + 0.02475 + 0.001
= 0.02975 = 2.975%
The result shows that the average interest rate has increased due to
increased percentage of fixed deposits (high-interest deposits) within the
pool of deposits. This example proves that the Liability Management
approach taken by the bank contribute quite significantly to the cost of
deposits.
Secondly, let’s simulate a significant change in the interest rate payable to

depositors if the bank wants to follow the market rates and recalculate the
average interest rate.
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Exhibit 2(c)

Savings account 25% 2.5%
Interest rate = (0% x 30%) + (2.5% x 25%) + (5.5% x 40%) +

(2% x 5%)
= 0 + 0.00625 + 0.022 + 0.001
= 0.02925 = 2.925%
The result shows that the average interest rate will increased about 0.525%
should the bank follows the market trend, which eventually increased their
loan pricing.
The table shown above is a simplified deposits combination, where in a

real banking environment it breaks further into different products with
different interest rates such as fixed deposits which has different tenures
with different interest rates. Therefore, the above computation should in
further detail to obtain accurate average interest rate for the bank.
The average interest rate is derived from a single pool of funds, where all
deposits reside, assuming the bank is adopting this approach in its Asset
and Liability Management. If the bank keeps separate pool of funds for
different types of deposits, the cost of funds can be defined for each
deposit type.
5.3 ADMINISTRATIVE COSTS

Administrative cost or servicing costs refers to the costs incurred to handle the
deposits received by the bank. Among the broad classifications are;
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5.3.1 Direct maintenance cost
Among the direct expenses to deposits are cash in transit costs, insurance costs,
passbooks, check books and check clearing expenses. These expenses are directly
related to accounts and physical-cash handlings by the bank.
5.3.2 Administrative and general expenses
Administrative and general expenses (AGE) refer to the overhead expenses by the
bank incurred in the daily operations. An example is depreciation expenses.
5.3.3 Staff expenses
Among the staff related expenses are staff salaries, staff benefits and allowances,
training, etc.
5.3.4 IT infrastructure and system maintenance
IT infrastructure and system maintenance covers the computer hardware and

software expenses, network infrastructure, electronic banking machines, gadgets,
display tools, etc.
The total servicing costs can be based on the bank’s projections or historical
data divided by the total deposits within the bank.
Servicing costs (%) = Total servicing cost x 100%

Total deposits
For example,
Servicing costs (%) = RM25 million x 100%

RM2,000 million
= 1.25%
5.3.5 Deposit acquisition cost
The deposit acquisition costs are basically the promotion and advertisement costs
mainly for attracting deposits. It is calculated as follows;
Deposit acquisition cost (%) = Deposit acquisition cost x 100%

New deposits projected
For example,
Deposit acquisition cost (%) = RM15 million x 100%

1,000 million
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= 1.5%
5.3.6 Net investable deposits
The composition of deposits and the individual float reserve determines the net
investable deposits. An example below shows the computation of average float
reserves based on the given deposit combination.
Exhibit 2(d)
Deposit Type Composition Float

reserves
Fixed deposits 40% 2%
Therefore, the average float reserve:
= (30% x 10%) + (30% x 6%) + (40% x 2%)

= 0.03 + 0.018 + 0.008
= 0.056 = 5.6%
Therefore (when the statutory reserve is set at 10%);
Net investable deposit = RM1 – [RM1 x (10%+5.6%)]

= RM1 – RM0.156
= RM0.844
Let’s simulate changes to the deposit combination and recalculate the

average float reserves, which effectively change the net investable deposit.
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Exhibit 2(e)
Deposit Type Composition Float reserves

Fixed deposits 50% 2%
Therefore, the average float reserve:
= (25% x 10%) + (25% x 6%) + (50% x 2%)

= 0.025 + 0.015 + 0.01
= 0.05 = 5%
Therefore (when the statutory reserve is set at 10%);
Net investable deposit = RM1 – [RM1 x (10%+5%)]

= RM1 – RM0.15
= RM0.85
Based on the computations above, the marginal cost of deposits can be calculated
as follows:-
Cost of deposits = interest rate + servicing costs + acquisition costs

Net investable deposits
Cost of deposits = 2.4% + 1.25% + 1.5%

0.85
= 0.0606 = 6.06%
5.3.7 Historical cost of deposits
Historical cost of deposits used historical interest rate or historical cost of deposits
to be used as current or for future projections. The figure is normally taken as it is
or using averages of a specified period of time.
The historical cost of deposits provides no information on the future trend of

interest rates since it does not take into account current developments and future
anticipation of interest rates’ increase or decrease. Any substantial movements in
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rates may caught the bank absolutely off-guard in current loan pricing and
investment evaluations.
5.3.8 Loan Pricing
Once the bank has computed its cost of deposits, now the bank can start to price
their loan accordingly. There are two types of loan pricing, i.e.;
Fixed rate loan
Fixed rate loan is naturally for short term financing such as vehicle loan and
personal loan, where the interest rate charged is fixed until maturity. Banks should
be very careful in devising fixed rate price to ensure it always exceed the cost of
deposits throughout the financing period, and yet attractive to customers.
Floating rate loan
Floating rate loan is used for long-term financing such as housing loan and
overdraft facilities. The long-term commitments expose the bank to interest rate
risk, i.e. the risk of adverse changes in interest rates which reduces the bank’s
profit margin or even create losses.
The floating mechanism used is Based Lending Rates (BLR) which sets the
minimum rate charged at any given of time.
5.4 OTHER RELATED COST
Cost of deposits in Islamic banking
The deposits in Islamic banking system are free of interest or “usury”. In Islam,
any borrowings must be paid exactly in the same principal amount, nothing more
or less, except the token is given willingly by borrower or the loan amount or a
portion of it is waived willingly by lender. However, none of the token or waiver
can be promised during inception of that loan.
Therefore, Islamic banking used two principles in deposits acceptance which

avoided interest-based practices and yet benefits both depositors and bank.
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5.4.1 Wadiah deposits
Wadiah deposits aimed for safeguarding of assets (deposits) with the bank,
normally used as underlying principles in savings account and current
account. Rather than for investments, the accounts are used to facilitate
payments and for safekeeping purposes.
The return to Wadiah deposits, except for current account, is in the form
of “hibah” or token paid on a regular basis.
5.4.2 Mudharabah deposits
Mudharabah deposits are deposits received for the purpose of investments

with the bank, normally used for Mudharabah savings account and Islamic
investment accounts (equivalent to conventional fixed deposits).
According to the agreement between depositors and the bank, the profit
derived from the usage of Mudharabah deposits for Islamic financing and
investments activities shall be apportioned according to agreed “profit-
sharing ratio” (PSR) agreed upon inception and payable upon maturity
date or on a periodical basis.
Based on the Mudharabah contract, the depositors and bank shall share
accordingly the actual profit received from the investment of the deposits.
Therefore, the bank will only pay depositors based on what it has received,
nothing more.
This is the main difference between conventional banking and Islamic

banking. In conventional banking, bank decides upfront how much they
are willing to pay depositors for their borrowing regardless of how much
the bank receives on its investments. While in Islamic banking, the bank
shares the profit received from its investments, or loss if any.
The risk to the bank is when the profit derived is low, the depositors will
receive the corresponding low return and may withdraw their deposits.
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The profit distribution is done at gross level, as shown in the following diagram.
Profit from Financing & Investments

minus
Direct investment costs
Depositors’ share of profit Bank’s share of profit

minus
Servicjng cost
Acquisition cost
Other costs
Bank’s net profit
5.4.3 Profit sharing distribution
Profit sharing distribution or computation of profit to depositors and bank

is done on interval basis, normally every month using a profit distribution
table. One profit distribution table is used for one pool of deposits, if the
bank segregates between different deposit types.
The following exhibit shows an example of profit distribution table.
Exhibit 6(a) – Table A
Deposit types Amount Weightage Weighted amount

Current account 20,000 1.0 20,000
Savings account 20,000 1.0 20,000
Investment account – 1 mth 5,000 1.1 5,500
Total 75,000 - 83,500
Based the profit received of RM8,500, the profit is distributed according to

weighted amount.
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Table B – Apportionment of profit based on weighted amount and ratio for
depositors
Deposit types Weighted Profit PSR Profit to

Amount (RM) Ratio depositors
Current account 20,000 2,036 0% 0.00
Savings account 20,000 2,036 50% 1,018.00
Investment account – 1 mth 5,500 560 70% 392.00
Investment account – 3 mth 12,000 1,222 70% 855.40
Investment account – 6 mth 26,000 2,646 70% 1,852.20
Total 83,500 8,500 4,117.60
Table C – Apportionment of profit based on weighted amount and profit sharing

ratio for the bank.
Deposit types Weighted Profit PSR Profit to

Amount (RM) Ratio depositors
Current account 20,000 2,036 0% 2,036.00
Savings account 20,000 2,036 50% 1,018.00
Investment account – 1 mth 5,500 560 30% 168.00
Total 83,500 8,500 4,382.4
Table D – Calculation of effective rates to depositors
Deposit types Deposit Profit to Effective

Amount depositors rate of
return
Current account 20,000 0.00 0%
Savings account 20,000 1,018.00 5.1%
Investment account – 1 mth 5,000 392.00 7.84%
Investment account – 3 mth 10,000 855.40 8.55%
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Investment account – 6 mth 20,000 1,852.20 9.26%
Total 75,000 4,117.60 -
The above tables can be combined into a single spreadsheet table. Table D
shows the effective rates of return to depositors to individual deposit types
based on actual gross profit of RM8,500 received for this pool of deposits
and the agreed profit sharing ratio.
The profit is distributed based on weighted deposits using weightages set

by the bank based on priority and risk profile. Higher weightages normally
refers to more favourable types of deposits by the bank.
5.4.4 Moving Average Profit Rate
Since Islamic banking system used actual gross profit (realised using Cash
or Accrual accounting revenue recognition system), the profit amount may
fluctuates significantly if the investments or financing have different terms
of maturity or profit realisation compared to monthly profit distribution.
Examples are profits on investments that are realised every 3 months, loan
instalments payable every 6 month, investment papers that are sold upon
full-year completion.
In those particular periods of profit realisation, the profit may surge

substantially thus encouraging depositors to have the similar maturity
period once they recognise the trend.
Therefore, banks use moving average profit rate (MAPR) as effective rate
of returns to depositors to stabilise the profit realisation over a span of
several months or a year. The MAPR used could be 12-month MAPR or
shorter 3-month MAPR, where the latest rates produced using profit
distribution table combined with previous months’ rates is averaged over
the number of months selected. Using this method the income is spread
evenly and effective rates of return to depositors become stable.
The problem with MAPR is the historical rates used in the calculation, which may
differs with the current changes in the market rates. The elasticity of MAPR to
reflect the current changes in profit scenarios depends on the period used, shorter
period means more elastic and vice versa. On the other hand, the less elastic
characteristics may be useful if current trend is on a decreasing move.
5.4.5 Financing Pricing
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Overall, Islamic banking use actual profit to calculate the costs of
deposits, which is historical at the time of calculation. Therefore, the usage
of the costs of deposits rates for pricing of financing must be done
carefully to ensure it anticipate the future trend of that costs.
Most financing products are fixed rate financing. The fixed rate locked
over a span of years may not risk the bank in terms lower profit or loss
arising to increased costs of funds, but, it may locked the depositors in
low-rate environment should the market trends increase.
In consequence, increasing withdrawals may risk the bank liquidity

problems and lack of depositors. And in effect to increased inflations and
operating costs, the bank could net smaller profit and lower dividend to its
shareholders.
5.5 RATE OF RETURN FRAMEWORK
On 16 October 2001, Bank Negara Malaysia issued the Framework of Rate of

Return as part of the effort to standardise the method on the calculation of rate of
return for the Islamic banking industry. The objectives of introducing the
framework are to:
i. Set the minimum standard in calculating the rate of return;

ii. Provide level playing field and term of reference for the Islamic banking
players in deriving the rate of return; and
iii. Provide Bank Negara Malaysia with better means of assessing the
efficiency of the Islamic banking institutions (IBis) as well as their
profitability, prudent management and fairness.
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5.5.1 The need for the framework arises from the contractual relationship in
Islamic banking, particularly the mudharabah (profit-sharing) contract between
the depositors and the bank. Under the mudharabah contract, a depositor that
deposits his funds with the bank also assumes the role as capital provider. The
bank assumes the role as the entrepreneur where it will invest the depositor's
funds. Profits accrued from investment and financing are shared between the
depositor and the bank based on pre-agreed profit sharing ratio. Losses, if any,
will be borne by the depositor, except in cases where there is evidence of
negligence by the bank in managing the depositor's funds.
5.5.2 Given this unique relationship where the depositors would have a direct
financial interest in the bank, a standard calculation of the rate of return is
imperative to ensure that depositors will receive their portion of the investment
profits in a fair and equitable manner. It will also address the information
asymmetry between the bank and its depositors by enhancing the level of
transparency of Islamic banking operations.
5.5.3 The broad concept of the framework is based on the return on assets (ROA)
approach. which calculates the income of the balance sheet assets. The framework
prescribes the methodology in calculating income generated from the balance
sheet assets. including other income such as trading income. It also incorporates
the type of expenses to be deducted from the total income such as impairment
loss. income-in-suspense and profit distributable to other related parties i.e.
specific investment deposit holders. bank capital and interbank placements.
5.5.4 While the framework is meant for calculating and distributing profit to the
depositors. it also serves as a tool for the IBis to assess and monitor their business
strategies and financial performance.
5.5.5 Following feedbacks from the industry on the pilot implementation of the
framework. Bank Negara Malaysia has made a revision to the framework.
particularly to address the implementation and operational issues. While the
fundamental objectives of the framework remained unchanged. the revised
framework aims to promote a higher level of capacity and efficiency of the IBis in
managing their Islamic banking operations. This would enable the IBis to benefit
from the flexibilities introduced in the framework.
5.5.6 The underlying principle of the framework is that all deposits accepted by
the IBis shall only be utilised in the provision of finance (financing. advances and
loans). investment in securities, interbank placements and other business
prescribed by Bank Negara Malaysia that complies with Shariah. In other words.
the deposits cannot be used or utili sed in other than these activities such as
acquisition of fixed assets and investment in subsidiary or associate companies.
5.6 SUMMARY
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In summary, the calculations of costs of deposits in conventional banking system
must be done using reliable and fresh data to ensure it anticipates the future trend
to maintain its market competitiveness and maximise the profit margin for the
bank. Frequent review of cost of deposits may ensure the projections made by the
bank’s stakeholders are achievable.
In Islamic banking, although costs of deposits are derived using historical data,
the bank can factor in anticipated market rate increase in the financing pricing.
However, in an environment of fixed rate financing, the effective profit would
have a slower impact since the fresh financing needs adequate momentum to
exceed the existing financing level.
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STUDY MATERIALS
TOPIC 6: SAVINGS DETERMINANTS
LEARNING OUTCOMES
The candidate should be able to:
a. discuss the basic theories and concepts related to saving

b. explain the major determinants of saving, i.e. internal and external
determinants
c. identify the variables that constitute the internal and external determinants of
saving
d. determine the strength of relationship between savings and its dependent
variables.
6.1 INTRODUCTION
Saving is an issue of fundamental importance to academicians, economists and policy
makers alike. While, for household, saving is essentially a way to move resources over
time, for the economy at large, the supply of saving represents an important source for
the financing of investment. The economic literature has distinctively highlighted the
importance of savings mobilisation in the economic development of any country.
Economic theory advocates that high level of savings are translated to higher investment,
with financial institutions playing the intermediation role of mobilising and allocating
financial resources from savers to investors. The soundness of financial institutions
determines the magnitude of savings and the efficiency of its allocation. Thus, at the
national level, savings are crucially important because they allow for investment which,
in turn, creates jobs and enhances production. This leads to an increase in income, which
permits additional savings and investments. Commercial banks are dependent on
depositor’s money as a source of funds. To this end, bank deposits constitute an
important source of private savings. Banks play an important intermediary role of
channelling funds from the surplus sector (household) to the deficit sector (firm) such
that all savings are injected back into the economy as investments.
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Although bankers are now focusing more efforts into off-balance-sheet activities,
traditional banking business of supplying funds to the economy is still of great
importance. For example, most business organisations especially in developing countries
are highly dependent on bank loans as a source of capital. Thus, the ability of banks in
giving out loans depends very much on their ability of attracting deposits. Unlike those
days where banking was among the most heavily regulated industry, now policies such as
the maximum interest rates could be paid on deposits, minimum capital-to-asset ratios,
statutory reserve requirements, lending direction, range of products and services offered
are no longer strictly imposed by the monetary authority. The process of financial
liberalisation had also created a more competitive environment in the banking industry.
This forces commercial banks to compete aggressively for deposits and such competition
takes many forms. First, banks are unconstrained in terms of deposit facilities they can
offer. Thus, the range of products is much broader than what was previously available.
Therefore, customers are free to negotiate any minimum denomination, rates of return
and maturity period prior to placing their deposits with a particular financial institution.
Second, deposit facilities are now also available at other non-financial institutions. In
light of these changes, to remain ahead of its competitors, commercial banks have to be
more sensitive on pricing, products offering, and quality of service offered to their
customers. Since the role of commercial banks as the most important financial
intermediary will persevere, studies in savings management will continue to become a
topic of interest for many researchers. In light of the growing competition between
Islamic banks and conventional banks for deposits, it becomes an imperative strategy for
Islamic banks to recognize the determinants of saving behaviour. In line with this,
effective research should be pursued to investigate the behaviour of depositors especially
at the micro level. The objective of this topic is to review the determinants of savings in
explaining depositors’ behaviour and is organised into 6 sections. Section 6.2 discusses
the theories related to savings both from the western perspective as well as the Islamic
point of view. Section 6.3 describes the internal determinants of savings. Section 6.4
reviews the variables that make up the external determinants of saving. Section 6.5
presents a brief overview of the statistical models used in evaluating the determinants of
savings. Finally, the summary of the topic is given in section 6.6.
6.1.1 Theories On Savings
This section highlights the conventional theories on savings as well as the Islamic
perspective on the theory of savings.
a. Conventional Theories on Savings
The conventional theories on savings originated from the works of Keynes who
introduced the theory of demand for money. According to Keynes, savings behaviour can
be explained by the motives for holding money. From the depositor’s perspective there
are three main theories relating to savings behaviour: the traditional models of the life-
cycle hypothesis, the permanent-income hypothesis; and the more recent buffer-stock
theory of savings behaviour.
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b. Keynesian theory on demand for money
The demand for money refers to the desire to hold money. According to the Keynesian
theory of demand for money, people hold money for three main motives: transactions
motive, precautionary motive and investment motive. Given that the primary use of
money is for transactions, people hold money as cash and in bank deposits in order to
facilitate the purchase of goods and services. The cost of holding money for transaction
purposes is the opportunity cost of not earning interest or profits on alternative
investments. The transactions motive for holding money can be looked at from the point
of view of consumers or businessmen. Consumers need cash to meet their household
expenditure. Thus, a certain amount of ready money is kept in hand to make these current
payments. Likewise, businessmen need cash in order to meet current business expenses.
The transactions motive assumed regular income and a smooth flow of expenses.
However, there can be significant uncertainty as to when income will be received or
expenses incurred. Hence, the precautionary demand for money arises because people are
uncertain about their ability to cover unexpected expenses. Precautionary motive for
holding money refers to the desire of people to hold cash for unforeseen contingencies.
Household often hold some additional money as a precaution against unforeseen
circumstances such as a car breakdown or health problems. Businesses too keep
precautionary balances due to uncertainties regarding the timing of their receipts and
payments. The demand for money for precautionary purposes may increase during
recessions whereby greater uncertainty over future income may lead households to
increase precautionary money balances. The final motive for holding money is for
investment or speculative purposes. Under this motive, individuals or businessmen hold
idle money balances in order to make speculative gains by dealing in financial assets such
as bonds, stocks or other securities whose prices are known to fluctuate. Hence, money is
held in order to speculate on the probable changes in the rate of interest or in stock prices
with a view of making profits. Money is also used as a means of storing wealth either by
keeping it in current account or in some interest-bearing time deposit account; or through
the purchase of physical assets.
c. Life-cycle hypothesis
The life-cycle hypothesis of savings behaviour predicts that individuals should smooth
consumption across their stages of life. This implies that people save in order to smooth
consumption over time. According to Modigliani and Brumberg (1954), the life-cycle
hypothesis predicts that consumption function depends upon consumer’s lifetime income
whereby consumers borrow prior to labour market entry, accumulate wealth during their
working life and start to dissave during retirement. Since income tends to fluctuate
systematically over the course of a person’s life, saving behaviour is determined by one’s
stage in the life-cycle. Hence, the cornerstone of the life-cycle hypothesis is age-related
consumer heterogeneity and the prediction that savings follow a hump-shaped pattern,
which is high at middle age and low at young and old ages. The life-cycle hypothesis also
postulates that the accumulation for retirement is the prime motive for saving. This
hypothesis also links the net saving of the people to the growth rate of the population,
their age structure, the rate of increase in income and the amount they wish to leave to
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their heirs. The life-cycle hypothesis also implies that the aggregate private saving rate
will also be influenced by income growth. Modigliani (1966, 1970) argues that a higher
growth rate increase total income of the working population relative to that of retires and
dependent persons, hence raising the aggregate saving rate. Sarantis and Stewart (2001),
on the other hand, argued that with higher income growth, each generation’s future
income expectations rise. Therefore, each generation will increase their saving rate in
order to expand the accumulation of their wealth, and thus their consumption during
retirement.
d. Permanent-income hypothesis
The permanent-income hypothesis predicts that higher future income reduces current
saving. In contrast to the life-cycle hypothesis, the permanent-income hypothesis focuses
attention on the income of consumer earned in recent past as well as expected future
earnings. The permanent-income hypothesis was put forward by Milton Friedman in
1957, which draws a distinction between permanent income and temporary income.
Friedman defined permanent income as the average income that a person expects to
receive over his lifetime. People normally estimate their average income by looking at
their current wages and what they expect to earn in the future. Based on this estimation,
they will plan their spending. Permanent income changes do not justify current saving
since more can be consumed now and in the future. Temporary income is the unexpected
income received. People do not normally base their consumption or spending on
temporary income. Temporary income changes are met by consumption smoothing
whereby part of today’s income windfall is saved to sustain higher spending tomorrow.
e. Buffer-stock theory of savings behaviour
The buffer-stock theory was pioneered by Deaton (1991) and Carroll (1990). According
to the buffer-stock theory of saving, consumers hold assets mainly so that they can shield
their consumption against unpredictable fluctuations in income. The buffer-stock
behaviour arises because when consumers face important income uncertainty, they are
both impatient and prudence. Impatience means that if income were certain, consumers
would like to borrow against future income to finance current consumption and prudence
in the sense that they have precautionary motive. Carroll (1992) showed that under
plausible circumstances this tension would imply the existence of a target wealth stock.
Whenever wealth is below the target, fear or prudence will dominate impatience and
consumers will try to save. Meanwhile, if wealth is above the target, impatience will have
a stronger role and consumers will plan to dissave. Buffer-stock behaviour emerges if
consumers with important income uncertainty are sufficiently impatient. In the traditional
model, consumption growth is determined solely by tastes; in contrast, buffer-stock
consumers set average consumption growth equal to average labour income growth,
regardless of tastes.
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6.1.2 Islamic Savings Theories
The term ‘Islamic banking’ means conduct of banking operations in consonance with
Islamic teaching. In view of this definition, Islamic banks are expected not to have
philosophies and objectives adopted by the conventional banks; but must be in line with
the teachings of Islam. Islamic business entities are required to engage themselves in
legitimate and lawful business, and to fulfil all obligations and responsibilities. All
transactions are based on the concept of honesty, justice and equity. Similarly, the status
of the relationship between the Islamic banks and its suppliers of funds is dependent on
the principles of Shariah used in creating that relationship. Theoretically, this relationship
is bounded by three general principles which dominate the economic behaviour of
Muslims, namely, belief in the Day of Judgment and life in the hereafter, Islamic concept
of riches, and Islamic concept of success (Khaf and Ahmad, 1980). All these principles
are expected not only to have a significant impact on the decision-making process of
Muslims, but also to have an influence on their perceptions towards Islamic banks. In
light of these three principles, we expect Islamic bank customers not to be guided by
profit motive. Instead, the reason for placing their monies with the Islamic banks is more
towards getting blessings from Allah and this action is considered the best way in
administering the resources given by Allah. Since it is the belief of every Muslim that all
properties belong to Allah, returns on their deposits are also considered a gift from Allah
irrespective of amount. Similarly, in the case of losses, it is also from Allah.
a. Belief in the Judgement Day and the hereafter
The first principle has an impact on the depositor's behaviour and their decision making
process. The choice of action is not only based on the immediate returns but also in the
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hereafter. Therefore, the decision to have a banking relationship with Islamic banks is not
because of profit motive but rather to gain the blessings of Allah. One of the ways to gain
blessings is to support any program that will improve the Muslim community. Verse 20
of Chapter 9 of the Qur'an states:
"Those who believe, and suffer Exile and strive with might and main, in
Allah's cause, With their goods and their persons, have the highest rank In
the sight of Allah: They are the people Who will achieve (salvation)."
The word fthad or 'strive in the cause of Allah' as indicated by the above verse refers to a
form of self-sacrifice. Ali (1989) believed that the essence of self-sacrifice consists of (i)
true and sincere faith, and (ii) earnest and ceaseless activity, involving the sacrifice (if
need be) of life, person, or property, in the service of Allah. Since Islamic banks operate
on an interest-free basis and their establishment is to improve Muslim communities, their
existence therefore is in the service of Allah. In the case of the second principle, Islam
has given a clear guideline that wealth is a bounty from Allah and is a tool that may be
used for good or for evil. Poverty is, in some instances, associated with disbelief and
riches are considered a gift from Allah (Khaf, 1980). Wealth itself is considered as an
important means by which man can pave the way for the attainment of his ultimate
objective. All persons are exhorted to work to earn a living and to accumulate wealth.
Accumulating wealth is considered among the highest blessing bestowed on man and
everyone is encouraged to strive for wealth. Verse 10 of Chapter 62 of the Qur'an states:
"And when the Prayer Is finished, then may ye Disperse through the land,
And seek of the Bounty Of Allah: and celebrate The Praises of Allah Often
(and without stint): That ye may prosper."
The above verse suggests that Muslims must work and acquire wealth upon completion
of prayer. The Shariah defines the methods of earning, possessing, and disposing of
wealth. The best method in accumulating wealth as defined by Shariah is by striving on
one's own and not from the income generated by other people's efforts. Striving for your
own food is in line with many Hadiths in which the Prophet (pbuh) had given his advice
to Muslims followers to work for their own food. For example, the Prophet (pbuh) is
reported to have said (Sahih Al-Bukhari, Vol 3, pp. 162-3):
"Nobody has ever eaten a better meal than that which one has
earned by working with one's own hands. The Prophet
of Allah, David, used to eat from the earnings of his
manual labour."
Therefore, the practice of treating or expecting the returns given by the Islamic bank as
one of the main sources of income to support living is inappropriate from the Islamic
perspective. The rewards should only be considered as a complimentary income and
should have no significant influence on one's financial position. Thus, according to this
first principle, the choice of action is based not only on the immediate financial returns
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but also on those returns in the hereafter. Based on this, the decision to place deposits
with Islamic banks should not be due to profit motives but rather to gain the blessings of
Allah and one of the ways to achieve this is for Muslims to support any programs that
serve to improve the welfare of Muslim communities. Since Islamic banks operate on an
interest-free basis and their establishment is designed to enrich the Muslim communities,
Muslims who support these banks are therefore considered people who achieve salvation
as indicated by Verse 20 of Al Tawbah.
b. Islamic concept of riches
The Islamic concept of riches also serves as an important factor which influences
Muslims' perceptions toward the existence of Islamic banks. The following Hadiths give
the meaning of richness from the Islamic perspective:
"Abu Hurairah reported Allah's Messenger (pbuh) as saying: Verily Allah

does not look to Yourface and 'your wealth but He looks to your heart and
to your deeds." -(Sahih Muslim, Vol 4, p. 1362)
"Abu Hurairah reported that Messenger of Allah (pbuh) said: Richness

does not lie in the abundance of (worldly) goods but richness is the
richness of the soul (heart, self. " - (Sahih Muslim, Vol 2, p.501)
In the case of the second principle that involves wealth, Islam has given a clear guideline
to be followed by Muslims. In Islam, wealth is a bounty from Allah and is a tool that may
be used for good or evil. Poverty is, in some instances, associated with disbelief and
riches are considered a gift from Allah. Wealth itself is considered as an important means
by which man can pave the way for the attainment of his ultimate objective. All persons
are exhorted to work to earn a living and to accumulate wealth. Accumulating wealth is
considered among the highest blessings bestowed on man and everyone is encouraged to
strive for wealth (Verse 10 of Al Jumu’ah). The methods of earning, possessing, and
disposing of wealth, however, must be in line with Shariah. The best method of
accumulating wealth as defined by Shariah is by striving to succeed on one’s own and
not from the income generated from other peoples’ efforts. This is in line with many
Hadiths in which the Prophet (pbuh) had given his advice to Muslims to work for their
own food. Based on these Hadiths, Muslims should not regard rewards to be given by
Islamic banks as a source of income.
c. Islamic concept of success
As indicated by the above Hadiths, Islam defines success as the level of obedience to
Allah and not as the accumulation of wealth. Service and obedience may be rendered by
the positive use of capabilities and resources given by Allah. According to Islamic
teachings, if a man really wants to serve Allah, the utilisation of the natural and human
resources made available to him is not only a privilege but also a duty and obligation
prescribed by Allah. This is in line with Verse 27 of Chapter 8 of the Qur'an which
commands Muslims not to betray the trust given by Allah and His Apostle. Applying this
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principle to a banker-customer relationship would mean that the depositors should not be
discouraged by low profit returns or the overall success of the bank.
6.2 INTERNAL DETERMINANTS

Both theoretical and empirical works on savings have consistently outlined the major
potential determinants of savings. This section highlights the internal determinants of
savings. Internal determinants of saving include variables that are within the control of
the bank. In other words, these are the variables that the bank management can use to
directly influence the amount of deposits or savings. This section will only highlights the
main internal determinants such as interest rate or rewards on deposits, service quality,
number of branches, and size of banks. Other internal factors that are expected to
influence saving behaviour of depositors are also included in the discussion such as
location, service charges, number of products and services, friendliness of bank staff,
reputation and bank efficiency. These factors, however, have yet to be developed as one
of the determinants of savings in the literature. Understanding the magnitude of influence
that these variables have on customers’ choice of selecting their banks is useful to
bankers because the information could be used to help banks enlarge their customer base
and consequently increase their deposits level. Furthermore, knowledge on the selection
attributes of customer will allow banks to formulate appropriate marketing strategies to
attract customers.
6.2.1 Interest rates
Interest rates on deposits have always been featured as one of the important
considerations in explaining the savings behaviour of individuals. Interest rate can either
be an internal or external variable. This section discusses interest rate as the return on
deposits given by banks, and thus, regarded as an internal variable. Savings, according to
classical economists, is a function of the rate of interest. The higher the rate of interest,
the more money will be saved, since at higher interest rates people will be more willing
to forgo present consumption. Based on utility maximization, the rate of interest is also at
the centre of modern theories of consumer behaviour, given the present value of lifetime
resources. In other words, customers are guided by the profit maximisation theory.
However, the results of a change in the rate of return, is theoretically ambiguous because
of potential offsetting substitution and income effects. The effect of real interest rate on
the level of savings can be distinguished between an income effect and a substitution
effect. Household may reduce their savings in the presence of higher real interest rate
because less investment is now required to support future level of consumption. Under
the substitution effect, higher interest rate increases the present price of consumption
relative to the future price, and thus provides an incentive to increase saving. If household
is a net lender, the interest rate rise will have the effect of raising consumption and
decreasing the amount of saving (income effect). Thus, saving responds positively to
rises in the interest rate only if the substitution effect is stronger than the income effect.
Hence, the effect of interest rate on savings is ambiguous theoretically, being subject to
potentially offsetting income and substitution effects. There may also be a wealth effect
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associated with changes in the interest rate. To the extent that a rise in interest rate
implies that the present value of securities have declined, household may act to increase
their level of savings in order to restore at least some portion of the declined in the net
worth induced by the increase in interest rate. Interest rate variable is also often used by
researchers to validate the existence of smoothing consumption theory and life-cycle
model where individual will keep their monies during working years for usage during
their retirement period.
For bank depositors, a rise in the interest rate is good news since interest on deposits is
regarded as a reward for saving. In this context, conventional deposits such as savings
and fixed deposits are expected to be sensitive to changes in interest rate. Hence, under
the conventional theory of economic behaviour, interest of deposit accounts have a strong
relationship with the amount of deposits or saving. Conventional bankers have long
learned that deposit pricing is important because it can be used to shape the type of
customer base that banks can best serve. Changes in the price of deposit not only affect
spread between bank loan rates and deposit interest rates but also customer balances and
deposit mix decisions. These factors in turn influence both bank growth and profit margin
(Edmister, 1982). The success of any new deposit plan depends very much on customers
who already hold deposit accounts with the bank. Even existing customers will be willing
to pay higher prices for deposit services. Bank customers will pay no more for a deposit
than the sum total of its benefits to them and will go elsewhere when the value of those
benefits falls below the deposit’s price or if a competitor offers a significantly better
package of services. The crucial element that emerges from this observation is that those
who are willing to part with their monies must be rewarded. Since depositors are
motivated by returns, then it becomes imperative for bank management to understand the
extent that deposit rates or rates of returns on deposits influence customers’ decision to
deposit or save. This also holds true to Islamic bank management given that they also
have non-Muslim customers who are not bound by Islamic doctrines or teachings. For
Muslims customers, if they truly uphold Islamic teachings then, conceptually, they should
not be guided by profit motive and thus, any changes in the rates of profit on deposits
should not have any significant impact on the amount of deposits or savings. Seeing as
Islamic banks do not operate on an interest basis, they are not exposed to interest rate
movements. Nonetheless, it is common for Islamic banks to use a benchmark rate in
pricing their financial instruments. The benchmark rate that is commonly used by Islamic
banks is the London Inter-bank Offered Rate or LIBOR. In Malaysia, the benchmark rate
is the Kuala Lumpur Inter-bank Offered Rate (KLIBOR). For example, the mark-up price
in fixed income contracts such as in murabahah and ijarah are determined by adding a
risk premium to the benchmark rate. Since the contracts are tied up to a certain mark-up
rate, this indirectly exposes them to risk whenever there are movements in the market
interest rate or LIBOR. In this sense, changes in LIBOR are expected to affect market
interest rates and therefore the demand for loans.
A number of studies have confirmed a connection between interest rate developments and
savings behaviour. Studies by Kauffman (1988), Sherman (1999), Hussain and Brookins
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(2001) and Milleki (2002) confirmed a connection between interest rate developments
and saving behaviour. Athukorala and Sen (2003) reported that interest rate on bank
deposits has a significant positive impact, but the magnitude of the impact is rather
modest. Mason et al. (1998) found that interest rate have positive but less robust effects
on savings than predicted by economic theory. Loayza and Shankar (2000) used
cointegration approach in measuring the relationship between savings in India and factors
such as real interest rate, per capita income, the dependency ratio, financial development,
the government saving rate, and the share of agriculture in gross domestic product
(GDP). Their results revealed that real interest rate, per capita income and the share of
agriculture in GDP had a positive relationship with savings. Another study that used India
as a sample was conducted by Athukorala and Sen (2003) and they ascertained that
except for the changes in the external trade, factors such as rate of growth, real interest
rate on bank deposits, spread of banking facilities and inflation had significant positive
relationship with savings. Cohn and Kolluri (2003) also used highly developed nations in
their study. They examined the long run relationship between per capita households
saving and the real rate of interest, government savings and social security contributions.
Their results indicated that interest rate was positively related to savings, while negative
between government saving and social security contributions. Qin (2003) examined the
savings behaviour of Mainland Chinese and found that expected savings potential was the
chief determinant of bank deposits. Similarly, just like their Taiwanese counterparts,
interest rate seems to be important to Mainland Chinese in making deposits.
Precautionary was also one of the important factors that motivated them to save. The
most recent literature on savings behaviour is a study by Hondroyiannies (2004). He
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applied cointegration techniques to estimate the savings behaviour of Greece households
and found that in the long-run, savings function is sensitive to real interest rate.
6.2.2 Service Quality
Service quality is generally referred to as a critical pre-requisite for establishing and

sustaining satisfying relationships with valued customers. Towards this end, the
relationship between service quality and customer satisfaction has emerged as a topic of
significant and strategic concern (Oliver, 1993). Previous studies that have investigated
this relationship suggest that service quality is a critical indicator of customer
satisfaction. Customer satisfaction can be defined as the feeling or attitude of a customer
toward a product or service after it has been used (Solomon, 1996; Wells and Prensky,
1996). In the banking industry, the level of customer satisfaction has become so
important that some banks have now considered it as a dominant aspect of their
marketing strategies. This is because there is a tendency for satisfied customers to repeat
their banking business with that particular bank whilst dissatisfied customers are prone to
switch to another bank. Furthermore, satisfied customers are likely to pass on positive
messages about it to others. On the contrary, their dissatisfaction will generally be
reflected in a negative word of mouth that can have a detrimental effect on the business
of the bank. In the service industries, quality depends on the customer’s experience with
delivery because services are experienced while they are produced. Studies in the service
literature emphasises the importance of quality perceptions and the relationship between
service satisfaction and quality. These studies presented evidence to suggest that service
quality leads to customer satisfaction, particularly in the banking industry. Customer
satisfaction is now central to a bank’s competitiveness because a satisfied customer will
repurchase from the bank and convey positive message about his experience to others. A
dissatisfied customer, on the other hand, will do the opposite. Hence, maximising
customer satisfaction helps to secure their retention. The issue of customer retention is a
major concern of many banks. For example, in the UK, Lloyds Bank conducted a
research to examine and identify customer satisfaction and dissatisfaction. Based on the
output of this research, Lloyds designed and implemented a new customer retention
practice. In the US, the National Bank of Middlebury developed a quality service
program based on customer retention through service quality. Some banks have become
very innovative in satisfying their customers. Telemarketing for instance, is found to have
a significant impact on customer satisfaction. Technology has aided banks to offer self-
service banking products such as automatic teller machines (ATMs) and e-banking
services. This recent development in the banking technology is the main impetus for
customer services improvement. Therefore, service quality practices of most banks are
geared towards customer satisfaction and retention.
Service quality is considered as a critical success factor that affects the financial
institutions’ competitiveness and regarded as an essential determinant that allows
institution to differentiate itself from the competition and thus, gain sustainable
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competitive advantage. Islamic banks are of no exception to this rule. Islamic banks need
to implement a well designed and viable service quality programs in order to create a
perception of uniqueness in the mind of the customer so as to ultimately gain a
comparative advantage in the marketplace. Failure to understand customers’ needs and
satisfaction will inevitably lead to serious difficulties in retaining current customers and
attracting new ones. In addition, since banks are competing in the marketplace with
generally undifferentiated products, service quality becomes a primary competitive
weapon. Banks that excel in quality service will find themselves having a distinct
marketing edge since improved service quality has been proven by researches to be
positively related with profit, increased market share, return on investment, customers’
retention and the levels of customer satisfaction (Christopher et al, 1991). Researches
conducted by Kwon and Lee (1994) and Wong and Perry (1991) concluded that service
quality is now widely regarded as a driver of corporate marketing and financial
performance in banking. It is essential for Islamic banks to adopt service quality in their
banking businesses as studies have proven the apparent relationship of service quality to
costs, profitability, customer satisfaction, and customer retention (Crosby, 1979; Rust and
Zahorik, 1993; Bolton and Drew, 1991; Reichheld and Sasser, 1990). For these reasons,
service quality is viewed as an important issue in the financial service industry. Cronin
and Taylor (1992) opined that there is little evidence to support the notion of the
expectation-performance gap as a basis for measuring service quality as suggested by
Parasuraman et al. (1988). Based on a review of literature on service quality and
customer satisfaction, Cronin and Taylor concluded that it is the current performance that
best reflects customer’s perception and that expectation is not relevant to service quality
measurement. Thus, the author equates service quality to performance. Baggs and Kleiner
(1996) argued that customer satisfaction includes the entire package that an organization
presents to the public such as image, quality, convenience, price etc. If the organization
excels in many areas, the resulting effect will be a larger market share. Therefore,
performance can be linked with an organization profits through its market share. Based
on this explanation, market share can be used as a proxy for service quality.
6.2.3 Number of branches
Another consideration in investigating the behaviour of depositors relates to the role of

banks in promoting savings. A notable development in the banking system following the
financial deregulation has been the rapid expansion of bank branches (Sen and Vaidya,
1997). As the number of branches increases, this would have contributed to increase in
the saving rate. Hence, it has the effect of encouraging financial saving due to
improvement in the accessibility to banking facilities and reduction in the costs of
banking transaction through reduced transport cost in this context. As Lewis (1955) has
put it, “if they (savings institutions) are pushed right under the individual’s nose . . .
people save more than if the nearest savings institutions is some distance away.” Based
on these arguments, a positive relationship can be assumed between the number of
branches and financial saving or deposits. Convenient location or location being near
home or office was found to be important by Anderson et al. (1976), Kaynak (1986),
Laroche et al. (1986) and Javalgi et al. (1989). For example, Riggall (1980) surveyed 250
customers who had just opened accounts six months before and found that location was
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cited as the key factor in selecting a bank. In a recent study by Athukorala and Sen
(2003), the authors reported that the expansion of banking facilities (increase in the
number of branches) seems to have contributed significantly to improvements in saving
propensity in the economy by encouraging financial saving. Their finding suggests that
the increase in the number of bank branches had resulted in the decline of the population
per bank branch (bank density), thus increase in financial savings in the form of bank
deposit.
6.2.4 Size of Banks
The size of a bank is considered an internal determinant on the assumption that

management of the bank is responsible for expanding their organisation by acquiring
additional assets and liabilities. The size of a bank is also associated with the concept of
economies of scale. Economic theory suggests that if an industry is subject to economies
of scale, larger institutions would be more efficient and could provide services at a lower
cost, ceteris paribus. Since larger banks are assumed to enjoy economies of scale, they
are able to produce their outputs or services more cheaply and efficiently than can smaller
banks. As a result, large banks have greater capacity and ability to attract more depositors
than smaller banks. Thus, bank size is positively related to savings rate. Empirical studies
that measures the existence of the economies of scale in banking was pioneered by
Alhadeff (1954). Since then, researchers in banking not only compared the existing
economies of scale between various types of banks but also banks within various
localities. Among these are studies by Benston (1965), Benston (1972), Clark (1984),
Smirlock (1985), Nelson (1985), Noulas et al. (1990) and Zardkoohi and Kolari (1994).
In the banking literature, total assets are used as a proxy for size (see Vernon, 1971;
Kwast and Rose, 1982 and Smirlock, 1985).
6.2.5 Capital Structure
Similar to conventional banks, the capital structure of Islamic banks comprises of paid-up
capital, reserves and retained profits. The paid-up capital consists primarily of the par or
stated value of all outstanding shares subscribed and paid by members (usually in the
form of ordinary shares). The surplus account usually derives from premiums over par
value at which common shares were sold to the public. The reserve accounts comprise
various funds which are established by the bank to either fulfil the requirements of a
monetary authority or for specific purposes such as those required by its by-laws or by
the management of the bank. Retained profits or retained earnings are the net profits
carried forward from previous years. The amount of capital maintained by a bank serves
two primary purposes. First, it represents the owners’ stake in the business and it is
assumed that bank management will undertake a careful policy not only to safeguard this
stake, but to ensure sufficient returns for the investment made by these owners. Second, it
serves as a buffer to protect depositors. In the case of loss or liquidation, the claims of
depositors are satisfied before those of the shareholders. Thus, the higher the amount of
capital injected by the owners, the more confident customers will be and the more
deposits will be placed at the bank. Following the works by Modigliani and Miller (1958)
involving a firm’s capital structure, other researchers in banking studies have included
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capital structure as their independent variables (Bourke, 1989; Bhala, 1992; Berger et al.,
1995 and Haron, 2004).
6.2.6 Other Factors
Many studies have investigated bank selection criteria or the reasons as to why customers
choose to bank with a specific bank (see for example Anderson et al., 1976; Erol and El-
Bdour, 1980, Erol, et al., 1990, Kaynak et al., 1991; Haron et al., 1994; Hegazy, 1995;
Naser et al., 1999). These studies have identified a number of factors that are found to be
critical in influencing the choice of a bank by customers. Amongst the criteria used by
customers to select a particular bank include convenience (i.e. location), service charges,
a wide range of services offered, friendliness of bank staff, bank name or reputation, and
bank efficiency. However, the relative importance of each of those attributes differs from
one market to another depending on the type of institutions (Islamic bank or conventional
bank), customers’ level of education, age, income and occupation. It is envisaged that
high service charges would result in less savings. Fee and commission is expected to
influence the process of saving mobilisation. Since all these factors are expected to
influence customers’ decision to deposit their money with the bank, they will thus have
an impact on the level of deposits. Hegazy (1995) investigated bank selection criteria for
both Islamic and conventional banks and concluded that the selection attributes for both
banks are different. Factors that were found to play an important role in the selection of
Islamic banks are convenience of location, friendliness of personnel, timeliness and
efficiency. Erol and El-Bdour (1989) and Erol et al. (1990) have specifically looked into
the bank selection criteria used by customers in deciding whether to bank with Islamic
bank or conventional bank. These studies reported that customers who only banked with
the Islamic banks chose to do so because of three main factors: provision of a fast and
efficient service; the bank’s reputation and image; and confidentiality of the bank.
Similarly, the study of Naser et al. (1999) supported this evidence. Convenient location
and service charges were reported to be critical factors influencing the choice of bank by
customers by Anderson et al. (1976), Riggall (1980), Laroche and Taylor (1988) and
Javalgi et al. (1989). Haron et al. (1994) investigated the bank patronage factors of
Muslim and Non-Muslim customers in Malaysia. Based on their findings, they suggested
that banks should place appropriate emphasis on bank efficiency. Their results showed
that both Muslims and Non-Muslims customers value their time highly and expect their
banking transactions to be completed as quickly as possible. Even though all the internal
factors discussed here are considered as important criteria that have a strong influence on
bank patronage behaviour of customers, these factors have yet to be developed in the
current literature as one of the determinants of savings or bank deposits.
6.3 EXTERNAL DETERMINANTS

External determinants of savings are those variables that are outside the control of bank
management. Variables such as gross domestic product, Base Lending Rate, inflation,
regulation, demographic factors and competition are considered external to the bank.
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6.3.1 Gross Domestic Product
Gross domestic product or GDP is normally used as a proxy for income. The relationship
between savings and income as well as growth has been a major subject of discussion in
the growth literature. Subsistence-consumption theories suggest that countries with
higher income levels tend to have a higher saving rate. Empirical evidence strongly
supports this conclusion (see for instance Dayal-Ghulati and Thimann, 1997; Loayza et
al., 2000 and Ozcan, 2000). Similarly, Doshi (1994), Carrol and Wei (1994) and Edwards
(1996) found statistical evidence supporting a positive relationship between income and
saving behaviour. Regarding income growth, most empirical literature has shown an
ambiguous relationship between savings and growth. Similarly, the direction of causality
between these variables is still under much debate. The simple permanent-income theory
postulates that higher growth reduces current savings because of higher anticipated future
income. Thus, urging people to dissave against future earnings. On the other hand, the
life-cycle hypothesis implies that the aggregate private saving rate will also be influenced
by income growth. Modigliani (1966, 1970) argues that a higher growth rate increases the
total income of the working population relative to that of the retired and dependent
persons, thus rising the aggregate saving rate. But in the life-cycle model, growth has an
ambiguous effect on savings, depending on which age cohorts benefit the most from the
growth, how steep their earning profile are, and the extent to which borrowing constraints
apply. Studies by Miles and Patel (1996) and Sarantis and Stewart (2001) found that
income growth exerted a positive impact on savings. Loayza et al. (2000) investigated the
effects of policy and non-policy variables on savings and reported that positive saving
rates with the level and growth rate of real per capita income and the influence of income
is larger in developing than in developed countries. Similarly, Athukorala and Sen (2003)
reported that saving rate rises with both the level and the rate of growth of income. The
relationship between saving and growth in seven Asian countries (South Korea, Taiwan,
Singapore, Malaysia, Thailand, Indonesia, and India) was investigated by Agrawal
(2001). The author reported that high rate of growth of income per capita contributed to
the high rate of saving in these countries. Empirical evidence reported by Ozcan (2000)
suggested that real per capita income level has a positive coefficient and has a statistically
significant impact on the saving rate. Their results indicate that consumers tend to save a
higher fraction of their GDP. The authors also found that real per capita growth is
positively related to savings, which supports the hypothesis that there is a virtuous circle
that goes from faster growth to increased saving to even higher growth. Other studies,
however, found mixed evidence for income growth (see for instance Callen and Thimann,
1997; Masson et al., 1998). In interpreting this evidence, it is worth bearing in mind that
the life-cycle model leads to a positive impact only if income growth accrues between
cohorts rather than within them where in the latter case, a negative relationship between
income growth and savings would emerge.
6.3.2 Base Lending Rate
Base lending rate represents the lowest interest rate charged for bank loans. Changes in
the rate will have a direct relationship with credit available to customers. Increase in the
rate means higher cost of borrowing to customers and also serves as an indicator whether
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they can easily obtain financing for their needs as well as their capacity to pay back the
loans. On the other hand, lower base lending rate simply means lower lending rates.
When people are refrained from extensive borrowings due to high base lending rate, they
are induced to save in anticipation of future consumption needs that cannot be financed
through credit. Therefore, base lending rate is expected to have a positive relationship
with savings. In the event of an increase in the base lending rate, borrowers are now faced
with higher financial burden because they would have to pay more now for the loan that
have taken. Under the conventional banking system, an increase in base lending rate is
expected to reduce the demand for borrowing and thus, increase the amount of savings.
As it is expensive to buy houses due to high interest rates on loans, rational customers
will postpone their purchase and save more now until the rate falls to a more normal or
acceptable level. On the other hand, a low base lending rate will serve as an incentive for
customers to borrow more at present and save less in order to finance their increase in
consumption.
In a parallel banking system where conventional and Islamic banks operate side by side,
bank customers can take advantage of the system by switching products. For example,
high level of base lending rate will induce rational customers to switch from conventional
financing to Islamic modes of financing such as al-bai-bithaman ajil (BBA) financing.
The financial burden that is evident in the conventional financing in the case of rising
base lending rate is absent in BBA financing. BBA financing is a credit sale contract with
payments made on fixed instalments. As such, changes in the base lending rate do not
allow Islamic banks to adjust their profit rates. Hence, as base lending rate increases, the
demand for BBA financing will increase simply because profit rate remains the same. In
this case, changes in base lending rate do not have an effect on savings as customers
simply switch their financing modes. Understanding such behaviour is nonetheless
imperative for Islamic banks as they need this information to make crucial decisions on
deposit mobilisation. The increase in the demand for BBA financing requires greater
amount of deposits to finance customer purchases. In light of rising interest rates, the
biggest challenge facing Islamic banks is how to attract more deposits, bearing in mind
that Islamic banks operate on a non-interest basis. Muslim bank customers are expected
to make choices based on faith or imam. In this sense, even when Islamic banking
products are relatively more expensive, they should not be deterred from using these
products. This is because the choice should be made on the basis of faith with financial
benefits coming in second. As pointed out in section 6.2.2.1, the choice of action of
Muslims should be based on the returns in the hereafter. This can only be achieved
through gaining the blessings from Allah and one of the ways to achieve this is to support
any programs that help improve the welfare of Muslim communities as a whole. If
Muslims truly uphold Islamic teachings, increase in the base lending rate should not have
any effect on the savings rate. However, Islamic banks must be mindful that customer
whose loyalty is driven by faith is also rational. This means that customers do not act on
blind faith but instead on Islamic rational behaviour.
6.3.3 Inflation
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In the empirical literature on saving, inflation has often been used as a proxy for
uncertainty. The variable inflation captures the effects of uncertainty about the future
bear on saving primarily via its impact on precautionary savings. In the literature,
Consumer Price Index (CPI) is normally used as a proxy for inflation. Inflation may
influence savings through several channels. First, theory postulates that greater
uncertainty should raise savings since risk-averse consumers set resources aside as a
precaution against possible adverse changes in income and other factors. Since inflation
brings about uncertainty in future income, higher inflation leads to higher saving on
precautionary grounds. In the period of high inflation, consumers prefer to save a larger
fraction of their income for precautionary motives. Hence, inflation may increase
precautionary savings by individuals. This precautionary motive for saving in light of
high inflation is supported by the findings of Loayza et al. (2000). Second, inflation can
influence saving through its impact on real wealth. If consumers attempt to maintain
target level of wealth or liquid assets relative to income, saving will rise with inflation.
Athukorala and Sen (2003) found that inflation rate has a positive effect on the saving
rate over and above its effect on operating through real return to saving. This provides
support for the hypothesis that when faced with inflation, consumers attempt to maintain
a target real wealth relative to income by reducing consumption and thus, increasing
saving. Finally, savings may rise in inflationary period if consumers mistake an increase
in the general price level for an increase in some relative prices and refrain from buying
(Deaton, 1977). Based on the work of Ozcan (2000), the precautionary motive for saving
is supported by the findings that inflation captures the degree of macroeconomics
volatility and has a positive impact on savings.
6.3.4 Regulation
The banking industry is among the most heavily regulated industries. There are important
reasons why regulations have been imposed on the banking industry. Firstly, regulation is
designed to maintain bank soundness. Public confidence in the strength of a particular
bank and the soundness of the overall banking system is believed to be critical to the
economy. Secondly, it is to achieve an efficient intermediation process, and finally to
provide desired levels of specific bank products and services. To achieve these goals,
regulations are imposed on both bank management and the banking system. Direct
regulations on bank management basically cover the lending policy, deposit policy,
interest rate and liquidity requirements. Regulations on the banking system include the
condition of entry, establishment of new ventures, mergers and acquisitions. However,
the banking system is now being deregulated in order to enhance competition between
banks. The effect of financial deregulation and financial liberalisation on saving
behaviour can operate through two channels. First, financial development may provide
outlets for financial saving; thereby raising saving rates (McKinnon and Shaw, 1973).
Financial liberalisation appears to have produced a positive effect on savings across
empirical studies (Dayal-Gulhati and Thimann, 1997 and Oczan, 2000, Ozcan et al.,
2003). However, De Gregorio and Guidotti (1994) argued that financial liberalisation
only affects the form that savings takes place, and need not raise the level of saving. The
second aspect involves the liberalisation of consumer access to bank credit. Regulatory
changes have allowed banks to lend more freely to individuals, and this may at least
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initially, lead to a significant decline in saving. Empirical evidence supports this effect in
countries that have liberalised the access to consumer credit (Jappelli and Pagano, 1989;
Bayoumi, 1993; Ostry and Levy, 1995 and Masson et al., 1998). Loayza et al (2000),
Serven (2000), Bandiera et al. (2000) and Sarantis and Stewart (2001) found that the flow
of private domestic credit relative to income carries a negative and significant coefficient,
suggesting that the relaxation of credit constraints leads to a decrease in the private
saving rate. Borrowing constraint prevents people from borrowing and thereby possibly
inducing them to save for contingencies and for the purchase of assets such as houses or
cars. Hence, one would expect that a relaxation of borrowing constraint to have a
negative impact on savings. This implies that financial liberalization exert a negative
effect on savings. Thus, enhanced credit availability reduces the private saving rate. The
negative relationship is consistent with the notion that financial development allows
households and small firms to use collateral more widely to reduce down payments on
loans for housing and consumer durables. Financial depth is normally proxy by the
M2/GNP ratio. Others have used the volume of consumer credit as a proxy for financial
liberalisation and private credit flow relative to income to capture consumers’ access to
borrowing
Many researchers have stressed the importance of liquidity constraints on savings

behaviour. The presence of binding liquidity constraints that prevent households from
borrowing are likely to decrease current consumption and therefore increase savings.
Even when they are not binding, there is the possibility that liquidity constraint will affect
current consumption in an important way. It has been shown that the presence of liquidity
constraints induces behaviour similar to that related to precautionary saving. A study
conducted by Jappelli and Pagano (1994), for instance, analyse the role of liquidity
constraint in aggregate private saving behaviour. The authors showed that saving rate will
be higher in an economy with liquidity constraint than in an economy with perfect capital
markets and concluded that liquidity constraint has a significant impact on net national
saving. They proposed that when capital markets are perfect, consumers can set up their
plan by maximising a utility function subject to a budget constraint. If, however, capital
markets are imperfect, agents also face a liquidity constraint. Thus, the young can only
borrow a proportion of the income required to finance their desired level of consumption
in the first period. Sarantis and Stewart (2001) suggested, based on their analysis, that
greater financial liberalisation will lead, through the easing of liquidity constraint, to
lower private saving rates.
6.3.5 Demographic factors
The set of variables compiled under the heading “demographic factors” include
urbanization ratio, the age distribution of the population and life expectancy. These
variables are termed life-cycle variables, as they operate under the predictions of the life-
cycle and precautionary saving theories. The life-cycle hypothesis highlights the
importance of the age structure of the population. The age structure of the population is
an important factor for savings because people who seek out to smooth consumption over
their lifetime will tend to save when they expect future income to be low and dissave
when they anticipate it to be high. Hence, if high proportion of the population is of
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working age then the economy should have a high rate of private saving, as workers
provide for their retirement. Conversely, when this cohort reaches retirement age and
dissave, then savings should decline. In view of this reasoning, young people dissave
against future earnings while old people dissave against previously accumulated savings.
The highest saving rates are observed in people who are at or around the peak of their
earnings. These findings have been captured in the empirical works by employing the
dependency ratio variable. For example, the work by Masson et al. (1995) showed that
saving rate is dependent on the aging of the population, declining birth rates and
increasing life expectancy. An increase in life expectancy increases the expected
retirement period and provides incentives to increase financial savings. Doshi (1994)
reported that a positive relation exists between life expectancy and saving. Another
demographic variable is the urbanization ratio which is defined as the percentage of the
population living in urban areas. This variable is also expected to have a negative
relationship with savings. This is because increased urbanization actually reduces the
need for precautionary saving. The need for precautionary saving is normally high with
rural societies which have greater volatility in income. In the current literature, there is an
extensive work that has been written which attempt to link demographic variables to
saving behaviour. Works by Leff (1969), Modigliani (1970), Modigliani and Sterling
(1983), Graham (1987), and Masson and Tryon (1990) pointed to the evidence that
higher proportions of the young and elderly in relation to persons of working age, i.e.
dependency ratios, are associated with lower saving rates. Cardenas and Ecsobar (1998)
studied the savings behaviour in Colombia and found that urbanization and age
dependency had negative effect on savings. In this regard, it is important for bank
managers to understand the changes in the age structure of the population so as the
appropriate marketing strategy can be implemented or appropriate saving schemes can be
introduced to suit the demographics of customers.
6.3.6 Competition
Traditional economic theory suggests that a new entrant will increase rivalry in the bank
market. Although competition is considered as on the external determinants of deposit or
saving level, this area is not yet developed in the literature. The impact of competition is
normally discussed by researchers from the angle of regulation or market structure.
Philips (1964) believed that public regulation, private organisation and institutional
market characteristics made the performance of the industry insensitive to differences in
market structure and made competition difficult to observe. Heggestad and Mingo (1976)
believed that market structure influenced the bank’s desire to compete for customers.
When the degree of monopoly in a market is greater, they believed that bank prices will
be higher and fewer facilities will be provided by the bank. They tested the relationship
between concentration and eleven performance measures including facilities available to
customers and charges for using those facilities. Their findings suggested that the greater
the market share is, the greater will be its control over its prices and thus the services it
offers. This will have a bearing on the attractiveness of the bank from the depositor’s
point of view. Hence, competition is envisaged to be inversely related to the deposit level
of a bank. Competition can be measured by using entry to the market as a proxy (Emery,
1971 and Haron, 2004). Islamic banks in a monopolistic market are protected by law or
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other forms of government intervention which prohibit other Islamic banks from
operating. In the case of competitive markets, the existence of more than one Islamic
bank in operation serves as an indicator that there is little or no entry barrier for the
establishment of other Islamic banks. It is suggested that a dummy variable is to be used
as a proxy for competition (Haron, 1996; 2004).
6.4 STATISTICAL MODELS USED IN EVALUATING

DETERMINANTS
Various statistical models have been employed in the literature to investigate the
determinants of savings. This ranges from simple regression model, to the extension of
the multiple regression models, vector autoregression (VAR) model and recently more
advanced time series analyses such as cointegration analysis and error correction model
have been applied to examine the long- and short-run determinants. Whilst the dynamic
of the model can be determine using impulse response analysis. This section gives a brief
description of the models being used in the current literature to evaluate saving
determinants. The most widely used and popular models are the multiple regression
analysis and the cointegration analysis. Other researchers have applied fixed effect and
random effect estimation in their models in order to estimate the determinants of savings.
This section presents the statistical models that are used in the current literature which
includes multiple regression analysis, VAR, cointegration analysis, error correction
model, fixed and random effects estimation and the impulse response analysis.
6.4.1 Multiple Regression Analysis
Regression analysis is the procedure by which an algebraic equation is formulated to

estimate the value of a continuous random variable, given the value of another
quantitative variable. The variable for which the value is estimated by the regression
equation is called the dependent variable whereas the variable used as the basis for the
estimate is called the independent variable. Multiple regression analysis is an extension
of the simple regression analysis in which two or more independent variables serve as the
basis for estimating the value of the dependent variable. The principal objective
associated with multiple regression analysis is to estimate the value of the dependent
variable and to determine the extent of the statistical errors associated with the estimates.
Hence, the general purpose of multiple regressions is to learn more about the relationship
between several independent or predictor variables and a dependent or criterion variable.
To these ends, the multiple regression equation is determined based on the method of
least squares and the standard error of estimate associated with the use of this equation is
calculated. The principal assumptions for multiple regression analysis are: (1) the
relationship between independent variables and the dependent variable can be represented
by a linear model; (2) the dependent variable is a continuous random variable; (3) the
variances of the conditional distributions of the dependent variable are all equal
(homoscedasticity); (4) successive observed value of the dependent variable are
uncorrelated; and (5) the conditional distributions of the dependent variable are all
normal distributions. In this analysis, each regression coefficient included in the
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regression equation is called partial regression coefficient because the value of the
coefficient is determined in the context of the other independent variables also included
in the equation. The overall significance of the regression effect can be determined by the
use of the variance analysis.
In line with the potential savings determinants outlined in the previous sections, the
general saving equation including all relevant variables can be constructed as follows:
D = β + X1δ (1) + X2δ (2) + υ

(1)
where D is the total deposit, X1δ (1) represents internal variables and X2δ (2) is the external
variables. The random error term, υ, is added to make the model probabilistic rather than
deterministic and this term represents the residual value. The value of the coefficient δ
(known as the regression coefficient) determines the contribution of the independent
variable X given that the other X variables are held constant. Meanwhile β stand for the
intercept. Equation or model (1) above represents the complete model and is considered
the most appropriate model to examine the determinants of savings because the effects of
the selected determinants of savings or deposits level are measured simultaneously.
Based on using the least squares criterion, methods of calculus are used to determine the
normal equations, which then must be solved to determine each of the values of δ.
Since we have divided our determinants into internal and external, we can examine
whether each group of variables can stand on its own as determinants. In order to do this,
we have to formulate two equations to represents both determinants. For example, from
our complete model, the model can be re-written as follows:
Internal variable model:
D = β + X1δ (1) + υ
(2)
External variable model:
D = β+ X2δ (2) + υ
(3)
The applicability of equation or model (2) and (3) can be examined using the F-test
formula:
F=
[RSS ( H 0 ) − RSS ( H 1 ) / M ]
RSS ( H 1 ) /( N − K − 1)
Where,
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RSS (H0) = sum of squares of a constrained model
RSS (H1) = sum of squares of an unconstrained model
M = number of constraint
(N-K-1) = degree of freedom of a constrained model
The test for the applicability of the internal variable model, i.e. to test model (2) against
model (1) involves the following hypothesis:
H0 : Internal variable model can stand on its own (δ2 = 0)

H1 : Internal variable model can not stand on its own (δ2 ≠ 0)
Rejection of H0 means the internal variable model is inadequate and can not stand on its
own as a saving determinant model.
The test for the applicability of the internal variable model, i.e. to test model (3) against
model (1) involves the following hypothesis:
H0 : External variable model can stand on its own (δ1 = 0)

H1 : External variable model can not stand on its own (δ1 ≠ 0)
If H0 is rejected, the external variable model can not stand on its own as a saving
determinant model.
6.4.2 Vector Autoregression Model (VAR)
Insights into the interdependence structure of variables in a system can be obtained via
the vector autoregression (VAR) analysis. The application of VAR into empirical
economics was first introduced by Sims (1980). VAR is a form of non-structural
econometric modelling where the data, rather than theory, identifies the dynamics of a
model. Thus, VAR provides a flexible framework for analysing financial and economic
time series. Under traditional econometric models, economic theory is used as a basis for
selecting the appropriate variables to be included in the models. Furthermore, exclusion
restrictions are normally imposed with not much attention being paid to the underlying
economic structure. Hence, under these structural models, specific relationships between
variables are based either formally or informally on economic theory. Unfortunately,
economic theory is sometimes feeble or inadequate in determining the right specification.
For instance, economic theory may be too complicated that it becomes impossible to
derive a precise specification from its principles, and thus an approximation is necessary.
Even if the theory is consistent with several alternative lag structures, the dynamic
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behaviour of each model as determined by these lag structures can differ considerably.
Finally, there can be disagreement about what is the right theory. As a result, there are
times when the dynamic structure of a model should be specified by the data rather than
the theory. Thus, Sims (1980) suggested formulating non-structural VAR models. He
noted that since all variables in a VAR model are treated as endogenous, this avoids
infecting the model with spurious or false identifying restrictions.
In a VAR model, each variable is explained by its own lagged values and the lagged
values of all other variables in the system. A vector autoregressive process of order k or
VAR(k) for a system of ‘m’ variables can be written in the following matrix form:
k
Yt = δ + ∑A Y
j =1
j t− j + υt
(4)
where
⎡ Y1t ⎤ ⎡ β 10 ⎤ ⎡ β 11 j β 12 j L β 1mj ⎤ ⎡υ1t ⎤
⎢Y ⎥ ⎢β ⎥ ⎢β β 22 j L β 2 mj ⎥⎥ ⎢υ ⎥
Yt = ⎢ 2t ⎥ δ = ⎢ 20 ⎥ Aj = ⎢ υt = ⎢ ⎥
21 j 2t
⎢ M ⎥ ⎢ M ⎥ ⎢ M M M M ⎥ ⎢ M ⎥
⎢ ⎥ ⎢ ⎥ ⎢ ⎥ ⎢ ⎥
⎣Ymt ⎦ ⎣β m0 ⎦ ⎢⎣ β m1 j β m2 j L β mmj ⎥⎦ ⎣υ mt ⎦
The term autoregressive is due to the appearance of the lagged value of the dependent
variable and the term vector is due to the fact that we are dealing with a vector of two or
more variables. There are no exogenous variables in the model. In a VAR model, several
endogenous variables are considered and each endogenous variable is explained by its
lagged and the lagged values of all other endogenous variables in the model. In general, a
VAR model expresses current values of the endogenous variables solely as a function of
lagged values of all endogenous variables in the system. In equation (4), the vector δ
contains m intercept terms and each matrix Aj contains m2 coefficients. Hence, m + km2
terms need to be estimated. It should be noted that the right hand side of equation (4)
consists of predetermined variables only and the error terms are assumed to be serially
uncorrelated with constant variance. Therefore, VAR models can be estimated using
ordinary least squares (OLS). The VAR model has the advantage of not relying on any
underlying theory for its empirical specification and does not need any assumptions about
the values of the exogeneous variables in the forecasting period (Metin and Muradoglu,
2001). Therefore, these properties make a VAR model highly useful for forecasting
purposes.
However, certain issues must be taken into consideration when applying a VAR model.
Sims (1980) recommended against differencing the variables when employing this model
even if they contain a unit root, i.e. the variables are non-stationary. Differencing would
throw away information concerning the comovements in the data such as the possibility
of cointegrating relationships (Enders, 1995). One of the assumptions made when
estimating VAR equations is that the order or the lag length of the VAR is known. In
cases where the order of the VAR is not known, it has to be selected. The appropriate
number of lags to be included in a VAR model can be determined by the likelihood ratio
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(LR) test statistics, the Akaike Information Citerion (AIC) or the Schwartz Bayesian
criterion (SBC).
The LR statistics as recommended by Sims (1980) is as follows:
LR = (T – c) (log | Σr | – log | Σu | )
(5)
where T = number of usable observations

c = number of variables in each unrestricted equation in the system
Σr and Σu = the variance/covariance matrices of the restricted and unrestricted
systems
The LR has the asymptotic χ2 distribution with degrees of freedom equal to the number
of restrictions in the system.
If the calculated value of the statistic is less than χ2 at a prespecified significance level,
the null hypotheses cannot be rejected. However, the LR test is based on asymptotic
theory which may not be very useful in small samples. Furthermore, the test is only
applicable when one model is a restricted version of the other (Enders, 1995).
Alternative test to determine the optimum numbers of lags are the AIC and SBC as
follows:
AIC = T log | Σ | + 2 N
(6)
SBC = T log | Σ | + N log (T)
(7)
where | Σ | = determinant of the variance/covariance matrix of the residuals

N = total number of parameters estimated in all equations
The order of the VAR is selected by choosing the lowest AIC and SBC value, as
suggested by Johansen and Juselius (1990). Since VAR contains variables, which are
lagged dependent, it is prone to autocorrelation of the disturbance term. Hence, Charemza
and Deadman (1992) caution that extra care should be taken in choosing the maximum
lag length. On the other hand, choosing too long lags result in the problem of over-
parameterisation. In the case of a system with four variables where each variable contains
six lags, 24 parameters would have to be estimated for each equation. Hence, the entire
system would have 96 parameters to be estimated. This over-parameterisation increases
the likelihood of obtaining a large number of parameters with high standard errors and is
one of the major problems with VAR models.
6.4.3 Cointegration Analysis and Error Correction Model
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Although the previous studies in the literature have furnished insights with regard to the
relationship between saving and its determinants, the conceptual and methodological
approaches utilised in these studies present a number of concerns. Among the most
important concern relates to the use of ordinary least square regression models to
examine this relationship. This is because studies that employed OLS regression analysis
did so without first examining the time series properties (unit roots) of the independent
and dependent variables. In order to overcome this weakness, researchers have employed
cointegration techniques. Amongst the studies that have applied cointegration analysis to
investigate the long-run and short-run determinants of savings includes works by Loayza
and Shankar, 2000; Sarantis and Stewart, 2001; Cohn and Kolluri, 2003; Hondroyiannis,
2004). The first empirical research that examines the determinants of deposit levels of
both Islamic and conventional banks using cointegration technique is the work of Haron
and Wan Azmi (2005).
The first step of the cointegration analysis is to test for the presence of unit roots of the
variables in the system. This step is done to verify the order of integration of the variables
since cointegration tests are valid only if the variables have the same order of integration.
Standard tests for the presence of a unit root such as the Augmented Dickey-Fuller (ADF)
test, Phillips-Perron (PP) test and the KPSS test are used to investigate the degree of
integration between variables used in the empirical analysis. Under the ADF test, the null
hypothesis of a unit root, H0 : b1 = 0 (unit root), is tested using the following
specification:
p
∆Xt = b0 + b1 Xt-1 + ∑θ
j =1
j Δ Xt-j + εt
(8)
The original level data and the first-differenced level data are both tested for unit roots. If
the test statistics (t-ratio) is greater than the critical values given in Fuller (1976), the null
hypothesis is rejected and the data is said to be stationary. It should be noted that the t-
ratio used in the ADF test is not the usual Student t-distribution. The PP test is a
modification of the Dickey-Fuller test that takes into account the less restrictive nature of
the error process (Enders, 1995). The modification proposed by the PP test is non-
parametric in the sense that the test uses a non-parametric correction factor instead of
including lag terms to allow for serial correlation. This test employs the Z-statistics and
the critical values are the same as those of the ADF test.
Once the stationary condition is examined, the next step is to conduct a cointegration test.
The concept of cointegration was introduced by Granger (1983, 1986) and further
developed by Engle and Granger (1987). Cointegration in the variables simply reveals the
existence of a long run equilibrium relationship among them. Even if economic variables
individually follow a non-stationary process, a linear combination of these variables
might be stationary. If this is the case, they are said to be cointegrated. Cointegration
implies that the series do not drift too much apart and are tied together by some long run
equilibrium relationship. When the series are cointegrated, there is no need to difference
the variables. Contrary, other techniques require differencing the variables in order to
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achieve stationarity which involves a loss of potential information about long-run
relationships among the levels of variables. Hence, cointegration analysis is able to
capture this relationship which are otherwise lost when other techniques are used.
Furthermore, evidence of cointegration rules out the possibility that the estimated
relationship is spurious. There are several ways to test for cointegration. Amongst them
are the Engle-Granger (1987) methodology, Engle-Yoo approach, Johansen (1988)
method and Stock-Watson (1988) methodology. However, the two main procedures
currently used to test for cointegration are the residual-based ADF approach proposed by
Engle and Granger (1987) and the Johansen’s (1988) maximum likelihood approach.
However, the most popular method in testing for cointegration is the multivariate test for
cointegration developed by Johansen (1988) and Johansen and Juselius (1990). Studies
by Cheung and Lai (1993), Gonzalo (1994) and Johansen (1995) provided evidence to
support that performance of the JJ maximum likelihood approach test is superior to other
methods. They found that the results arrived from JJ statistics are more robust and
considerably more efficient. Furthermore, Zhou (2001) argued that this approach can
handle the endogeneity problem of the regressors, better model the interactions between
variables and fully capture the underlying time series properties of the variables in the
system.
The Johansen-Juselius (JJ) procedure of cointegration test is based on the maximum

likelihood estimation of the vector autoregression (VAR) model. The test can be carried
out through a VAR system such as follows:
Dt = β1Dt-1 + β2 Dt-2 + . . . + βk Dt-k + α + υt , t = 1, . . . , T

(9)
where Dt is a (n × 1) vector of I(1) variables; βi are (n × n) matrices of parameters; α is a

(n × 1) vector of constant; υt is a vector of normal log distributed error with zero mean
and constant variance; and k is the maximum number of lag length processing the white
noise. Differencing equation (1), the system can be rewritten as:
∆Dt = Г1∆Dt-1 + . . . + Гk ∆Dt-k + П Dt-1 + μ + єt ,

(10)
П defines the impact matrix, which relates the change, ∆Dt, to the levels, Dt-k, of k
periods earlier. The rank of П determines the number of distinct cointegrating vector, r. If
the rank of П is zero, then there are no combinations of the variables which are stationary,
i.e. there are no cointegrating vectors. Hence, equation (10) is reduced to a standard VAR
model of the first difference. If П is of full rank, then all variables are stationary. If the
rank П is r such that (0 < r < n), then there is cointegration between the variables with r
cointegrating vectors. The trace and maximum eigenvalue statistics are calculated to test
for the presence of r cointegrating vectors. The trace statistics (λtrace) tests the null
hypothesis that there are at most r cointegrating vectors against the alternative of r or
more cointegrating vectors. The λtrace for the null hypothesis of at most r cointegrating
vectors is
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n
λtrace ( r ) = – T ∑ ln(1 − λˆ
j = r +1
j )
(11)
The maximum eigenvalue statistic (λmax) for the null hypothesis of r cointegrating vectors
against the alternative of r + 1 cointegrating vectors is
λmax ( r , r + 1) = –T ln(1 – λ̂ r + 1)
(12)
where λ̂ j = the estimated values of the characteristics roots obtained from the П matrix
T = the number of usable observations
The critical values of the λtrace and λmax statistics are given in Johansen and Juselius
(1990, Table A3, p. 209).
If cointegration is found, a vector error correction model (VECM) is constructed.

However, if no cointegration is found, the analyses will be based on the regression of the
first differences of the variables using a standard VAR model. Engle and Granger (1987)
showed that cointegration implies, and is implied by, the existence of an error correction
term. This means that changes in the dependent variable are a function of the level of
disequilibrium in the cointegrating relationship (captured by the error correction term) as
well as changes in other explanatory variables. Once the variables are found to be
cointegrated, a vector correction model (VECM) will be used to investigate the dynamic
interactions among them in the system. The Granger representation states that for two
cointegrated variables, an ECM can be found in the following form:
∆Yt = β0 + β1∆Xt + β2єt-1 + υt

(13)
where єt-1 represents the error correction term which captures the adjustment toward the
long-run equilibrium and β2 is the short-run adjustment coefficient. A principal feature
of cointegrated variables is that their time paths are influenced by the extent of any
deviation from long-run equilibrium. Hendry and Richard (1983) argued that ECM
captures the dynamics of the system whilst incorporating the equilibrium suggested by
economic theory. The appeal of the ECM formulation is that it combines flexibility in
dynamic specification with desirable long-run properties (Dolado et al., 1990). The
advantage of ECM framework lies in its strength of capturing both the short-run
dynamics and long-run equilibrium relation between the two series.
6.4.4 Fixed and Random Effect Estimation
If the researcher is using a panel data set that combines time series with cross sectional
data, then the fixed and random effect estimation is recommended to be used so as to
obtain a more robust result. Both the fixed effects and random effects are forms of linear
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regression. Random effects estimation is the generalised least square procedure in the
context of panel data. In a fixed effects regression specification there is a binary variable
(also called dummy) marking cross section units and/or time periods. If there is a
constant in the regression, one cross section unit must not have its own binary variable
marking it. Suppose that you wish to estimate the following model:
k
Yit = β 1it + ∑ β kit X kit + a i + eit
2
(14)
Where Yit is the dependent variable for country i at time t ; X it is the kth explanatory
variable for country i at time t; i = 1, N refers to a given country; t = 1, T refers to a given
year; ai captures all unobserved, time-constant factors in country i that affect Yit ; eit
represents unobserved factors that change over time and affect Yit . The fixed effect
estimation is based on the assumption that the unobserved effect ai is correlated with the
explanatory variables. In order to eliminate the fixed effect ai , for each i, we have to take
the average of equation (14) over time, then subtract the time averages from the
corresponding variable. The random effect estimation assumes that ai is uncorrelated
with each explanatory variable. In this case, equation (14) can be written as follows:
k
Yit = β 1it + ∑ β kit X kit + u it
2
(15)
where u it = ait + eit is the composite error term. If indeed ai is uncorrelated with all X it
the random effect model is more appropriate. But if ai is correlated with some of the
explanatory variables then fixed effect model should be used. The results of the random
effects model can be checked using the Hausman specification test.
6.4.5 Impulse Response Analysis
For each variable in the system, innovation accounting techniques can be used to
ascertain how each variable respond over time to a shock in itself and in another variable
in the system. This can be done through impulse response analysis. Therefore, in order to
examine how rapidly changes in the value of a variable are transmitted to the other
variables, the system is subjected to an impulse response analysis as proposed by
Lütkepohl (1991). An impulse response function essentially maps out the dynamic
response path of a variable to a change in one of the variable’s innovations. This function
shows the speed and length of time of the interaction between them; and it is obtained
from the moving average representation of the original VAR model.
Consider the following VAR model:
- 155
m
X t = A0 + ∑ A p X t − p + ε t
p =1
(16)
In order to examine the interactions between the variables in the system, equation (16) is
transformed to a vector moving average representation as equation (17) below,
∞
X t = μ + ∑ C i ε t −i
i =0
(17)
The coefficients of Ci can be used to generate the effects of each εt shocks on the entire
time paths of all the variables under investigation. These shocks can take the form of one
standard error of each variable. The structure of response of variable to such a unit shock
in another variable can be determined by constructing a moving average representation
with disturbance process that is orthogonal contemporaneously. This is done by making
the following transformation. Let εt = Fut, where F is an m × m lower triangular matrix
and ut is an orthogonalised innovations such that E[εtεt ] = FΣF–1. Then equation (17)
becomes:
∞
Xt = μ + ∑C i =0
i Fu t −i
∞
= μ + ∑D u
i =0
i t −i
(18)
where Di = CiF. This represents the Choleski decomposition of the ut vector. Note that
each component in Di represents the response of a variable to a one standard error shock
in another variable after the orthogonalising process, while ut-i contains orthogonalised
residuals. Equation (18) above is used to derive the orthogonalised impulse response
functions and provides a framework for tracing the dynamic responses to shocks in the
system. The (i, j)th component of Di now represents the impulse response of the ith
variable in the k periods after a shock of one standard deviation in the jth variable. The
issue of interest is to examine how long it takes for the impulse responses to decay
following the shock. Theoretically, the impulse responses should converge to zero since
the system is stationary
- 156
6.5 SUMMARY
Financial saving such as bank deposits is crucial to the economic growth of a country. In
addition, commercial banks are dependent on depositor’s money as a source of funds. In
view of the growing competition between banks for deposits, it is imperative for Islamic
banks to recognize the determinants of saving behaviour in order to attract depositors to
place money with them. In the conventional literature, four main theories related to
savings are identified. Keynesian theory of demand for money sets the modern savings
theories. Based on the three motives of holding money as proposed by Keynes, the life-
cycle model, permanent-income hypothesis and buffer-stock theory of savings behaviour
was advanced. With regards to the savings theories in Islamic perspective, three concepts
were advocated. These are belief in the Day of Judgment and life in the hereafter, Islamic
concept of riches, and Islamic concept of success. These principles are expected not to
have any significant impact on the decision-making process of Muslims. Thus, in
consideration of these principles, one would expect Islamic bank customers not to be
guided by profit motive. Theoretical and empirical works in the saving literature have
consistently outlined the major potential determinants of savings. This topic divides the
determinants of savings into internal and external determinants. Internal determinants of
saving include variables that the bank management can use to directly influence the
amount of deposits or savings. Amongst the internal variables that were introduced was
interest rate or rewards on deposits, service quality, number of branches, size of banks,
capital structure, service charges and number of products and services offered. External
determinants of savings, on the other hand, are defined as variables that are outside the
control of bank management. Variables that are considered external to the bank are gross
domestic product, Base Lending Rate, inflation, regulation, demographic factors and
competition. The last section highlights the various statistical models that have been
employed in the literature to investigate the determinants of savings. Models ranges from
simple multiple regression model, vector autoregression model, fixed and random effects
model, and recently more advanced time series analyses such as cointegration analysis,
error correction model and impulse response analysis.
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Deposits Mobilizationand Financing Management

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STUDY MATERIALS

TOPIC 1: THE FUNCTIONS OF DEPOSITS IN THE

Upon completion of this module, a student is expected to be able to:

In the philosophy of Islamic finance, money is required to be mobilized in productive

1.2 CONCEPT AND THEORIES ON DEPOSITS

1.2.1.1 Source of Funds

Traditionally, a bank “borrows” or utilizes a large proportion (approximately 80%) of its

A simplified version of a bank Balance Sheet in T-account is shown here to illustrate

Cash 10 Deposits 100

Total Assets 115 Total Liabilities and Equity 115

Similar to conventional banking, deposit of an Islamic bank is a liability. The concept of

Table 2: Deposit accounts and Principles Applied in Return Computation

Account Type Principles Applied

Current Account qard hasan or wadiah

Saving Account wadiah,mudharabah or qard hasan

Investment Account pre-determined share of profits

Islamic Negotiable Certificate of Deposit mudharabah or qard hasan

(Source: Sudin Haron, 2005)

1.2.2.1 Financial Intermediation Theory

The Theory of Financial Intermediation describes four economic functions of deposit-

1.2.2.2 Information Asymmetry

1.2.2.3 Diversification Theory

Diversification Theory postulates that a well-diversified portfolio can reduce risks.

1.2.2.4 Segmented Market Theory

1.2.2.5 Liquidity Premium Theory

1.2.2.6 Syariah Principles

Wadiah is quite similar to savings account in conventional banking where a depositor

1.2.2.7 Deposit Protection

1.3 DEPOSIT TYPES AND STRUCTURES

1.3.1. Types and Structures of Deposits in a Conventional Bank

Deposits are divided into 3 types:

1.3.1.1 Demand Deposits

1.3.1.2 Savings Deposits

1.3.1.3 Fixed Deposits

1.3.1.4 Negotiable instruments of deposits (NIDs)

1.3.1.1 Demand Deposits

A customer needs to have an introducer or referee t o open a current account. The

(a) Types of demand accounts

There are several categories of demands or current accounts available in a Malaysian

(b) Non-resident Account

A non-resident is allowed to operate a current account. However, banks are required to

1.3.1.2 Savings Deposits

Saving Deposits Account

Premium Deposit Account

(a) Calculation of interest on saving accounts

Interest =Principal (P) x Times (T) x rate p.a. (I)

(b) Withholding Tax

In Malaysia, interest received from saving accounts is subjected to a 5% withholding tax.

(c) Types of Saving Accounts

Savings account can be divided into 5 types. There are:

(i) Individual Saving Account

(ii) Joint Account

(iii) Club, societies and association

The bank will request for important documents such as

(iv) Trustee Account

1.3.1.3 Fixed Deposits or Times Deposits

Table 4: Maybank Rates as at February 2006.

Fixed Deposit Account

(a) Calculation of interest on fixed deposit accounts

Interest on fixed deposit is calculated based on simple interest computation as follows:

Interest (I) = Principal (P) x Time (T) x Rate quoted

Example 1: En. Ahmad places RM10,000 in a one-month deposit account from 24