BANK LOANS-SECURITY

Introduction:  Banks lend money to the public, for various purposes, like purchase or construction of a home, for purchase of  consumer goods like a TV, Music System, etc.   Banks also finance businesses, both manufacturing and services.   Apart from all these, they also extend personal loans to members of the public.

This service provided by Banks, namely, financing, or more commonly called lending, is fraught with several inherent risks.   Loan defaults may occur for more than one reason, including reasons beyond the control of the borrowers, like for example, in case of floods or a Tsunami, that may wipe out the assets of the borrower, apart from rendering him incapable of restarting his  business immediately.   The most serious risk to Banks in the lending process is the risk of non payment of the loan by the borower.   Imagine a situation where none of the borrowers of  Banks repay the loans availed of by them!   This could lead to a collapse of the  Banking industry!

The current spate of Bank failures in America and elsewhere, is, in good part, on account of borrower defaults.   Whereas, in an ideal situation, every borrower repays the loan availed by him, from the Bank, in real life, this does not happen.   Many a time, borrowers, both individuals and institutions, fail to keep up their repayment committments, affecting the well being of the lending Bank.   Sometimes, there are even genuine reasons why borrowers become defaulters.

This being the case, Banks invariably, have in place, norms and procedures that they follow before parting with money to a borrower.   Banks examine and evaluate credit proposals, as to their viability and feasibility, both technically and financially, before taking a decision to grant a loan.   Each loan is appraised individually to ascertain the soundness of the proposal and only then a decision to grant a loan is taken.   Among the various precautions observed by the Banks to safeguard their interests in the lending process, is the obtention of security for the loan extended by them.

Definition of Security:  Security, in relation to a loan extended by a Bank to a borrower, means, an asset, of any kind or description, having certain qualities, among them, monetary value, that can be possessed by the Bank, in the event of default, and applied toward repayment of the loan.

Having extended the loan to the borrower, Bank would naturally like to ensure that the loan is repaid with the interest thereon.   That is, Bank would want to secure the loan.   This is done by way of creating a charge against the asset financed by the Bank.   The type of charge created depends on the nature of loan, and the security.

Basically, there are two types of securities availabe to Banks to secure a loan.    They are Primary security and Collateral security.

Primary Security refers to the asset directly created out of Bank finance.   For example, where a Bank finances the purchase of a home, the home is the primary security.   In the same way, a car purchased with the help of a Bank loan, is the primary security for that loan.   Bank creates a charge against this primary security, to secure its loan.   This charge give the Bank the legal authority to dispose off the asset, and apply the proceeds therefrom, to the loan amount in default.

Collateral Security refers to certain additional security obtained by the Bank to secure the loan, in addition to the primary security.   For example, say, a Bank has financed the purchase of machinery by a Pharmaceutical manufacturing company.   This machinery would be the primary security for this loan.   In addition, the Bank may obtrain collateral security in the form of the factory building and land owned by the company, as an additional security.   This will secure the Bank further and safeguard its interests in the event of the primary security not having sufficient value to liquidate the loan.   Many a time, it so happens, that on account of adverse market conditions, the value of the primary security gets eroded, exposing the Bank to a higher level of risk han it had originally bargained for.

In addition to the above discussed securities, there is also the scope of securing the loan with the help of personal security of the borrower.   Obtaining personal security of the borrower enables the  Bank to proceed against the borrower and his personal estate, in order to recover the loan.

Qualities of a Security:  In order that a security may provide a real means of liquidation of a loan in part or in full, the concerned asset must have the following important qualities, among others:

1.  Valuable Security:  A security obtained as a cover against default, of the borrower,  in repayment of the loan, must have some monetary value that can be realised and adjusted toward the loan.   Intrinsic value alone would not be helpful to the Bank in mitigating the problem arising out of a default.

2.  Marketable Security:  Even though a security may have a monetary value, it may not be  possible to encash the value as and when needed by the Bank, because it may not be easily marketable.   That is, it may not be easy or even impossible to dispose off the security and realise its proceeds, for various reasons.  

For instance, the asset obtained as a security for a loan, may not be in demand, at the time it is required to be encashed or realized and credited to the loan amount in default.

3.  Stable Security:  Stability of security here means the stability of the value of security.   Certain securities have widely fluctuating values, depending on market and other conditions.   As a rule, Banks prefer securities that are not prone to market gyrations, and offer a reasonable chance to the Bank to have it adjusted to repay a good part of the loan in default,  if not the  entire loan.

4.  Transferable Security:  The security offered by the borrower to secure the loan, must have the quality of transferability.   That is , the ownership, or the interest in the security, must be capable of being transferred to the lender, without too much effort and expemses.

As can be seen from the above, securing the loan extended by the Bank is of vital importance and also necessity to the Bank, as otherwise, it may jeopardise the interests, or even the survival of the Bank.   That apart, securing a loan with an asset of the borrower increases the stake of the borrower, who would have more reasons to make his venture a success by doing his best.

This home truth has been forcefully brought forth in the current economic crisis, in which many Banks have realized their folly in not properly securing their loans.

COMMERCIAL BANKING: CERTIFICATE OF DEPOSIT (CD)

Introduction:  Commercial Banks, anywhere in the world, provide two basic services to their customers.   Deposits, and Advances, or loans.   A commercial Bank accepts deposits from members of the public, and extends loans to them, on certain terms and conditions.

Apart from the above basic services, Banks offer several others, of course.   This article, however,  is restricted to the brief study of deposits, in particular, the Certificate of Deposit or CD.

Deposits:   A deposit may be defined as a sum of money, placed by the customer, with the Bank, for the purpose of safety, liquidity, and returns, as the case may be.   It is also a loan from the customer to the Banker that the Banker has to repay, with or without interest.

There are different types of deposit accounts, divisible into two main groups-those that are repayable on demand, and those that are not.   Those deposits that are repayable on demand are called demand deposits, and those that are not, are called time deposits,or also fixed deposits,  which are kept with the Bank,  for a certain specific period of time.   And the Bank normally pays interest on such deposits, as per terms applicable to them.   One such type of deposit is the Certificate of Deposit(CD).

Certificate of Deposit(CD):  A Certificate of Deposit, is simply a deposit for a large amount of money that earns a special rate of interest, by virtue of its size.   The interest offered on such deposits may be either fixed or floating.   And such deposits are subject to certain special conditions, which conventional deposits may not be subject to.

Some of the important features of the Certificate of Deposit are discussed below:

Amount:   Normally a CD is issued by Banks, for an amount, that is considerably larger than the minimum amount, for which conventional or regular deposits are issued.   However, there may not be a specific incremental percentage applicable to such deposits, compared to regular deposits.   It depends on the individual Bank to fix the minimum amount of CD it is willing to issue.   For example, a Bank that may accept USD:1,000.00 for issue of a regular or conventional deposit, may require a minimum amount of, say, USD:100,000.00 for issuing a CD.

This type of deposit is issued by Banks in order to attract large amounts of deposits, or bulk deposits, to meet their requirements.   In order to attract such large amounts, they are happy, and sometimes compelled, to offer, attractive rates of interest, on them.

Rate of Interest:  Banks offer a attractive, that is, higher rate of interest on CDs, compared to other deposits of comparable maturities, because of the large size of the deposit, and the necessity of these deposits for their operational requirements.

For example, say, a customer places a sum of USD:100,000.00 with a Bank, in a regular deposit, for 90 days, and the Bank offers 2% rate of interest on the deposit.   On the other hand, if he places an amount of USD:1000,000.00, in a CD, for the same period of 90 days, the Bank may pay him 3% rate of interest on this deposit.

Further, Banks may offer a fixed or a floating rate of interest for different maturities, as stated above.   Sometimes, the depositor may have the option of either of the rates, and sometimes he may be compelled to accept a fixed or floating rate offered by the Bank.   It depends on the market conditions, and how badly the Bank  needs such deposits, at present, and also in future.   The Bank will take a view of the issue, having regard to all the relevant factors, and come up with a proposition that is attractive to the depositor, and at the same time viable for itself.

As an illustration, supposing a Bank issues two CDs of USD:1 Million each, both for a period of  90 days, on the 15th of March, 2009, and due on the 13th of June, 2009.   Let us assume that both the CDs are issued at a rate of interest of 2%, the first on a fixed rate basis, and the second on a floating rate basis.   Now, let us assume that on the 15th of May, 2009, the applicable rate of interest on the deposits of the above maturity, are reduced to 1.75% from 2%.   What happens then?   Whereas the deposit with the fixed rate will continue to get 2% rate of interest, the other deposit with the floating rate will be paid partly at 2%, and partly at 1.75%.   The amount of interest payable on the above two deposits would be as under.

The first Deposit, issued at a fixed rate of 2% , will fetch an interest amount of USD:5000.00, and the Second Deposit, issued at floating rate would fetch an interest amount of USD:4847.00.   Interest on this deposit is calculated at 2% for 60 days, upto 14th May, and thereafter, at 1.75% for 30 days upto 13th June.

Other Features of CDs:  The main feature, and consequently, the major attraction of CDs, as we have seen, for both the Depositor andthe Banker  is the large amount of the deposit, and the higher than the usual rate of interest offered on other deposits.

These deposits are issued for the maturity value, in advance, against payment of the Principle amount, less interest.   In the above example that we have seen, in the case of the first deposit with the fixed rate of interest, the face value of the deposit would be USD:1 Million minus the interest amount of USD:5000.00, that is, USD:995,000.00.   And in the case of the second deposit, with the floating rate of interest, the face value of the deposit would be USD:1 Million minus the interest amount of USD:4847.00, that is, USD:995,153.00.

Other features of this deposit relate to the eligibility norms applicable, both to the issuing Bank, as well as the participating parties, both individuals, and institutions.   And also those relating to issues like repayments, transfers etc, having a bearing on the interests of both the depositors and the Bank.

Restrictions:  While CDs may offer attractive rates of return on the customer’s investment, they may not be suitable to everyone.  For instance, depositors who are not sure of keeping the deposit with the Bank, till the completion of the contracted period of the deposit.

These type of deposits are subject to certain restrictions.   Often these relate to the payment of the deposit before maturity, which is normally not permitted.   Also, Banks do not normally entertain loan proposals against such deposits, though they may be  freely transferable, unlike conventional deposits.   Overall, Banks do strive to make these deposits attractive to the public, to serve the interests of both themselves, and the depositors.

Note:  It is to be noted that the practices, rules and regulations etc., relating to the issue and conduct  of CDs, may differ from country to country, and between different Banks in the same country.

COMMERCIAL BANKING: DOCUMENTARY CREDITS

Introduction:  Banks, as we know, lend money to the public, for various purposes.   Like purchase of a home, a car, or other consumer durables etc.   They also extend loans to Industries that manufacture various goods, and machineries, and also to service industries that provide various services, like  a salon, internet kiosk, etc., to the community.

Banks play a vital role in the development process of any nation, by providing finance for different activities related to trade and commerce.   This includes both domestic and international trade and commerce.

One of the ways in which commercial banks facilitate international trade and commerce, is by way of extending a non funded financing facility or mechanism called the Documentary Credit(DC),  or the Letter of Credit(LC).

This mechanism to facilitate international trade was developed under the auspices of the International Chamber of Commerce, Paris.  The rules and regulations etc., governing the Documentary Credits, and the transactions thereunder,are contained in what is known as the Uniform Customs and Practices for Documentary Credits.

Definition: A  Documentary Credit (DC), or Letter of Credit (LC), (they are one and the same), is a legally binding undertaking given by a Bank on behalf of its customer, in favor of a third party, to make payment to him (the third party), the stated sum of money against submission of the required documents, as per the terms of the DC.  

A simple example of a DC transaction goes thus:  English Oriental Bank, a commercial Bank, based in London, U.K., establishes a DC on account of one of its clients, M/s. Hudson Industries, favoring a Software Company in Bombay, India,  by name, Zed Software Co.   Details of this Documentary Credit and how it works is discussed below.

The underlying contract of this DC is as follows:  Zed Software Co (ZSC) has a contract to supply to Hudson Industries, technical software, related to the maintenance of a gas turbine, under contract, by Hudson Industries.   The value of the contract is Pound Sterling 500,000.00.   The typical problems and issues that can arise from a business proposition like this, may relate to the different rules and regulations of trade, in the respective countries;  the different currencies, and the differing exchange rates applicable to them;  the different customs and practices prevailing in the two countries, that can pose communication and other problems between the buyer and seller etc.   That apart, the buyer and seller, in this case, the Hudson Industries, and Zed Software may not know each other, and may not be  sure as to how far they can trust each other. 

Each of them may confront questions for which they have no answers.   Like, Zed S0ftware may find more comfort in receiving advance payment from Hudson Industries, before supplying them the software.   On the other hans, Hudson Industries is not sure of receiving the contracted for software, if it makes advance payment.   Or the software may not be of the same quality etc, that they had sought and paid for.   So they would like to receive the software in advance, so they could check the same and satisfy themselves.   Hence, there would be a stalemate here, with neither of the parties budging from their respective positions.

It is here that Banks come into the picture, alongwith their tools to facilitate transactions like these, between buyer and seller, based in different countries.   Now, in a case such as this, Hudson Industries would approach their Bankers, the EOB, to open a DC in favor of their Indian supplier, Zed Software, for the supply of the software, in the value of Pound Sterling 500,000.00.  

Let us assume that EOB accede to the request of their customer, and establish a DC for the amount of Pound Sterling 500,000.00, favoring Zed Software Co,  subject to terms and conditions as per their credit policies.   EOB then advises this DC to Zed Software, through their Correspondents in India, say,  Indian Future Bank (IFB), who, in turn, would advise the DC to Zed Software.   Let us assume that Zed Software is a client of IFB.   Upon receipt of the DC, the company would know they kind of product or service it is expected to supply to Hudson Industries, and other details relevant to the contract.

According to the terms of the DC, ZSC is required to submit documents as per DC terms, in relation to the contract for the supply of the software to Hudson Industries,  and claim payment from their own Bank, the IFB.  Some of the most important documents to be submitted under this transaction includes, the commercial invoice, the bill of exchange, the certificate of origin, the transport document like the airway bill, etc.    The IFB, upon receipt of the documents, from ZSC,  scrutinize the same, and if they are in consonance with the terms of the DC, make necessary payment to their customer, and in turn, claim reimbursement from EOB, the Bank that established the DC.   EOB, in turn, scrutinize the documents submitted by the IFB, and if found in order, reimburse IFB for the amount claimed by them.   Thereupon, the EOB present the documents to their customer, Hudson Industries, and recover the money paid by them to the IFB.

This is a simple example of how a DC works.   This example pertains to one particular type of DC, of which there are many.   It is also assumed in this case, that there are no complications throughout the transaction, and it ends peacefully, with all the parties concerned happy about the outcome.

In real life situations, of course, many a problem arises, either in respect of the documents submitted by the beneficiary, or the manner in which the two Banks, or the parties handle the transaction, or any other reason related to the transaction.

Conclusion:   Banks, as facilitators of international trade and commerce have been served well by the mechanism of the Documentary Credit.   The beauty of these credits is that they provide appropriate protection, as required, by the seller, buyer, the seller’s Bank, and the buyer’s Bank, while extracting their share of responsibility under the transaction.

The DCs have acted as a sort of bridge bertween buyers and sellers of goods and services, based in different countries, bringing them together, through the agency of the Banks.  

Since they came into being in 1933, DCs have no doubt played a significatnt role in cross border trade, overcoming the barriers of language, customs and practices, currencies, etc.   And last, but not the least, they are an important source of business and revenues to the Commercial Banks, and are expected to grow even more in importance, in the coming years.

COMMERCIAL BANKING: GUARANTEES

Introduction:  Commercial Banks extend various types of credit facilities to their constituents, to enable them carry out their business activities.   These facilities may be broadly divided into two categories-Funded and Non Funded facilities.

Funded facilities are those, where Banks actually part with money.   For example, a Bank sanctions a Term Loan to a Paper Manufacturing Company, for purchase of machinery.   The Bank would normally make payment to the supplier of this machinery, on behalf of its borrower.   In turn, the supplier delivers the machinery to the Paper Manufacturer.   Similarly, the Bank may grant working capital to its borrower, to meet the day to day expenses of running the business.

Non funded facilities, on the other hand, are those where the Bank does not actually part with money, but promises to do so, contingent upon the occurance of certain events.   Which means, unless the said event eccurs, the Bank will not be called upon to part with money.   The most common non funded facilities offered by Banks are Letters of  Guarantee and Letters of Credit.

Definition of Guarantee:  A Guarantee is a contract, a legally binding agreement, given by one person, on behalf of another, to carry out or perform the task of the latter, in case of his default.   In the same fashion, it may also relate to the promise of discharging the liability of one person, by the other in case of the former’s default.

Types of Guarantees:  There are two types of Guarantees, taken up for discussion in this article, namely, Financial and Performance Guarantees.  Apart from these, there is athird type of Guarantee called the Deferred Payment Guarantee, which will be discussed at a later date.

Performance Guarantee:  This guarantee, as can be seen, relates to performance.   In this type of guarantee, the Bank undertakes to either ensure the performance of the contract by its customer, on whose behalf it has issued the guarantee, or to make good, the loss suffered by the third party, or the beneficiary under the guarantee,  on account of the non performance by the Bank customer.

As an illustration, say, M/s. A Wind Power(AWP) contracts with the State of Arizona to supply and set up 500 wind mills across the State for a consideration of USD:1 Million.   American Banking Corp.,(ABC) the Banker to M/s. A Wind Power, gives a guarantee, favoring the State of Arizona, on behalf of their client, that AWP would supply and set up the 500 wind mills in Arizona, as per the terms of the contract between AWP and the State of Arizona.   Further, in the event of AWP faililng to execute the contract, the American Banking Corp. would reimburse the State of Arizona, a sum of USD:1 Million in lieu of their client’s failure to execute the said contract.

In the above example, ABC, have issued a Performance Guarantee, on behalf of their client AWP, favoring the State of Arizona.   In this example, two scenarios may emerge.   One, the AWP executes the contract as per the terms, and gets paid by the State of Arizona and everything ends peacefully.   All the three parties to the Guarantee are happy.   The Bank has collected its commission/fees from the client, the State of Arizona have their wind mills in place, and the Bank client have received their payment from the State.

In the second scenario, however, the Bank client, i.e. AWP, on whose behalf the Bank had issued the guarantee, may either not perform the contracted work, or may not perform it according to the terms of the contract.   In that event, the State of Arizona may invoke the guarantee, and demand payment of the guaranteed amount of USD:1 Million.   And ABC would be obliged to make the payment, without demur.

Financial Guarantee:  This type of guarantee relates to money, as against performance.  Under this guarantee, the Bank undertakes to make good a payment, on behalf of its client, to a third party, upon default of its client, to do so.  

As an illustration, say, the World Bank floats a international Bid or Tender for the supply of 500 wind mills to be set up in the African State of Mali.   The value of the Bid is USD:1 Million.  According to the terms of the bid, the competing companies are expected to deposit a sum of USD:100,000.00 with the World Bank, as Earnest Money, to be eligible to participate in the Bid.   M/s. A Wind Power (AWP), a competing company, approaches its Bankers to issue a guarantee in favor of the World Bank, on its behalf, for the stated amount.   The Bank agrees to comply with the request of its client, subject to certain conditions, as per Bank policies.   This type of guarantee is called a Financial Guarantee.

In the above case, the Bank has issued a guarantee in lieu of a cash deposit that its client would have had to keep with the World Bank.   This enables the company to participate in the bid without having to shell out the USD:100,000.00, which might affect its liquidity adverserly.   This is just one example of a Financial Guarantee.   If AWP wins the bid, but refuses to accept the contract, then the World Bank would invoke the guarantee, and keep the Earnest Money deposit of USD:100,000.00.   Then the ABC would be left with the alternative of recovering the money from their client.

Both types of Guarantees, discussed above, lay down the respective rights, and responsibilities of the parties to the guarantee.   The amount of the guarantee is specified.  The validity of the Guarantee is specific.    So also the time time limit for invoking the guarantee.   Grace period, if any, is also specified in the Guarantee document.   Limitations, if any, are also laid down in precise terms to avoid confusion and conflict.

Conclusion:  Guarantees are one of the major financing options available to Banks, to assist their clients engaged in trade and commerce.   Banks do not extend this facility to all and sundry, but only to creditworthy clients.   Even though, this facility is a contingent liability to the Bank, that is, it crystallizes only upon the happening of a certain event, in this case, the default of the client, a prudent Bank assumes a default on part of its client, while considering granting of this facility.   

INVESTMENT BANKING, MADOFF STYLE!

“Misfortunes never come singly”!   Ask the Americans!   As if the economic crisis, and all the misery it entails for Americans were not enough, they have now to grapple with “the biggest investment fraud in Wall Street history”(reuters).  

Mr.Bernard Madoff, an investment banker and an ex Chair of the NASDAQ, has pleaded guilty to all the eleven criminal counts of financial fraud and related offences, leveled against him.   His sentencing is due on the 16th of June this year.

What is Mr.Bernard Madoff guilty of, and how did he carry out the frauds he is accused to have, and to which he has pleaded guilty?

This story is, perhaps, as old as the human race.   Because it has to do with the human psyche.   It has to do with human nature.   It has to do with human weakness.   It has to do with GREED.   Madoff wanted to become rich, and fast.   And so did his clients.   And in the end, greed did both the parties in.   As usual.

There are innumerable cases similar to the Madoff scam, insofar as the underlying modus operandi is concerned.   Where it differs, may be in the scope and the sheer size of it, although it involves a relatively smaller number of investors, at around5000, compared to several other such scams.  

What Madoff did was quite simple.   He offered a higher return on investors’ money compared to others, in the market.   Which means more money in a shorter time.   And as might be expected, his scheme attracted hordes of greedy, or guillible, if you prefer, investors, rubbing their palms in anticipation of a  regular, and probably unending, windfall.

Next, Madoff is said to have deposited his clients’ money in a commercial Bank, instead of investing it in the market.   Of course, this deposit in the Bank would not have fetched him the same kind of returns that he had promised his clients.   So how did he comply with his own promise to reward his clients at a higher than the accruing  rate of return from the deposits?   He simply withdrew the money from the Bank, and paid his clients, as and when due, or on demand, as the case may be!   That Simple!

In other words, Madoff paid off his first client with the money of his second one, and so on!   Naturally, his clients must have been mighty pleased with him, and congratulated themselves for having chosen the right Money Manager!   And as any marketer would tell you, word of mouth publicity is the best variety of it, and authentic cases of satisfied clients are the best source of new ones.

And so it went on, for 20 long years, according to his prosecutors.   In monetary terms, it is believed to be in the region of USD 65 billion.   That is the amount of money that should be lying in his clients’ accounts.   But in actual fact, since Madoff kept paying off his clients by digging into the Principle amount, a sizeable amount of the collections were withdrawn, leaving a fraction of the original amount in the Bank.

This dream scheme might have gone on indefinitely, but for the economic crisis.   This economic crisis has exposed the underbelly of the Western, especially the American financial services industry, and it is not a pretty sight!   Scores of the industry professionals, once revered as Demi Gods, for their steel solid integrity, as well as their divine money management skills, must be having nightmares of lynch mobs at their doorstep, waiting to have a go at them!

Coming back to the Madoff scam, which he admitted was a “Ponzi Scheme”, two issues stand out in this scam.   One, the role of the regulators, and the other the greed of the investors.

But before that, a brief look at what is a Ponzi Scheme.   Well the Ponzi Scheme is exactly what Madoff ran!   Actually, this kind of fraud is attributed to one Charles Ponzi, who is said to have migrated to the United States from Italy in the early 1900s.   He is credited of having launched an investment scheme in the United States, that raked in the Dollars, through promises of high returns that were practically not viable of compliance.   More than a century later, fraudsters continue to make money in the same fashion!   And investors continue to faithfully make the same mistakes as their previous generations!   Life goes on!

Now, the two most important issues arising from the Madoff scam.   The Regulators’ role, and the Investors’ Greed.

Ironically, the more evidence the regulators dig up against Madoff, the more they get exposed in the process!   And the more vocal the duped investors get in their criticism of Madoff, the more they expose their own greed!

As an ex top honcho at NASDAQ, Madoff knew all the loopholes in the system, and as a good psychologist, he knew how to earn the confidence of the public, enough to make them part with their money.   A devastating combination indeed!   And this unbeatable combination of inside knowledge and an intrinsic understanding of human nature, elevated Madoff to such heights, that lesser mortals, both criminal and otherwise, could only look up to, and salivate at.

Regualtion of the American, or for that matter, any other, financial services industry, is a double edged sword that requires skilful handling, to avoid casualties on either side.   A little more, or a little less, can have the same kind of comparitive, negative impact.   The experts know it.   The authorities know it.   But how to put it across to the general public, that is, in fact, part of the problem?!   For, no amount of regulation can insure the public against their own greed.    It is the investors’ greed that motivates the criminals to take the risk of committing frauds, apart, of course, from their own greed!   Demand and Supply!   Greed Demands-Greed Supplies!   An unholy tango that sends both the Investor and his Money Manager crashing to the dance floor!

Conclusion:   So how do we deal with this issue?   Is it possible to avoid such frauds?   What steps need to be taken in this direction?

The fact is that there are no easy solutions.   Precisely, because it has to do with human nature.   And human beings, being what they are, it is difficult to think of a world free of financial frauds, as much as it is difficult to think of a world free of other types of crimes.   The best that can, perhaps, be done is to minimize such incidence of fraud.

And in the matter of controlling frauds of the Madoff variety, and also the others that have bloodied Wall Street, three things need to be done.

First, outlaw and disallow esoteric investment schemes, that are based, more on mathematics, than money.   Spinning multiple transactions out of a single asset backed one(transaction), is one such example.   Any scheme that offers out of ordinary returns must attract the attention of the authorities, as much as it does, of the investors.

Second, handle the sword of regulation carefully.   “Trust But Verify”

Third, and most important, educate the public.   If only the American Government and the mass media took as much trouble in educating the American public against get-rich-quick schemes, as they do in educating the rest of the world about the virtues of the American system, perhaps, these kinds of frauds could be greatly minimised!

BANKING AND MONEY LAUNDERING

Definition:  What is money laundering?   Money Laundering is a process, in which, money earned from various criminal activities, like smuggling, black marketeering, drug peddling, etc., is channelled into the Banking system, in the form of legitimate commercial transactions.   Money, thus parked, in a Bank, acquires a seemingly legitimate and legal status, and can be utilized, thereafter, for genuine commercial and other transactions.    Simply speaking, money laundering is the process of converting Bad Money into Good Money.

Of course, it is not an easy task, and the money launderers take considerable pains to accomplish their task!   The methods adopted in converting bad money into good money vary from place to place and time to time.   For example, in India, it may involve the money launderer  purchasing a winning lottery ticket from the genuine holder, by paying him the full amount of the lottery, and then substituting his bad money for the lottery money.   This way the criminal’s bad money becomes good, and the original winner of the lottery does not pay his taxes due on the winning ticket.   This is, but just one of the hundreds of ways in which criminals launder their ill gotten wealth into clean money, that can be used for engaging in regular business transactions.

The FATF:  FATF stands for Financial Action Task Force.   What is this organisation about, and what does it do?   The FATF is an international body of experts, promoted originally by  the members of the G7 group of countries, dealing in money laundering issues.   The body was set up in 1989, and presently has about 35 members.   Their key responsibility is to deliberate and come up with practical recommendations for preventing the misuse of the financial and banking system by criminals.

The job of the FATF can be summarised as:

1.  To act as a central agency and clearing house on all matters related to money laundering;  and to coordinate with national and international institutions, etc., in efforts to prevent money laundering through the financial system.

2.  To study the various techniques and modus operandi employed by criminals throughout the world, in the process of money laundering, and to come up with recommendations that can be practically implemented to combat the menace of money laundering.

3.  To follow up with member countries to ensure compliance of their recommendations, and where such recommendations pose a problem, to study the same further, and come up with suitable modifications, with the primary aim of countering money laundering.

4.  To act as a sort of pressure group to promote necessary legislation and regulations by the member states to fight money laundering.

5.  To cooperate with other international agencies engaged in similar work, for example, anti terror organizations,to exchange notes on their respective activities, and to help each other.

6.  Most of the member states of the FATF have set up specialized agencies to deal with the problem of money laundering.   These agencies coordinate with the FATF, and financial institutions, in effectively implementing the laws relating to money laundering.

Role of Banks:  What are the Banks expected to do, to detect and to prevent, the incidence of money laundering through their systems?   Simply speaking, Banks are expected to identify and stop transactions relating to money laundering, that are sought to be channellised through them.

For instance, money launderers may open accounts in a Bank, with the help of fictitious documents, in assumed names etc.   They may tempt the Bankers with promises of good business to them.   And seek the Bank’s ‘cooperation’, in opening such accounts and conducting business through them.   On the face of it, the documents and also the persons involved, may appear to be perfectly normal to the Bankers.   And so, in good faith, the Bankers, in their eagerness to get business, may patronise such customers, and get themselves into trouble.

The money launderers take advantage of the eagerness of the Bank to do business, and put through transactions of a dubious nature, by passing them through various layers of legitmacy, thereby misleading their Bankers, who accept the transactions as genuine.   This way, money earned in various criminal activities, gets into the Banking system, and acquires legal status.

Therefore, Banks are expected to take due precautions in opening accounts, and following all the laid down norms in this regard.   Being vigilant at the first point of the criminal’s entry into the Banking system would go a long way in preventing money laundering.

Regulatory authorities in different coutries have laid down elaborate systems and regulations, to be complied with, by the Banking industry, in the fight against money laundering.   Some such requirements to be followed by the Banking industry, include reporting of suspicious transactions, especially those of large value, particularly in cash.  Similarly, records pertaining to such transactions, are to be preserved for a longer duration than other records, for future reference.   It is expected, that by following these stipulations, Banks would be able to effectively deal with money laundering, and all the implications it has for the Banking industry.

Points to Ponder: 

1.  While fighting money laundering is everyone’s business, and concern, it must be noted that this process has come into prominence only after 911, which gives it a distinct American flavor.

2.   There is no uniform application of the Anti Money Laundering (AML) provisions in various countries, not only on account of differing systems, but also differing perceptions of what constitutes money laundering.   For instance, in Switzerland, the law makes a distinction between tax evasion and tax fraud.

3.  Dividing the world into the Western and Eastern Hemispheres, it is observed that money laundering is more prevalent in the Western side, whereas the focus of the West, especially the United States, is on the Eastern Hemisphere.

Some of the major centers of money laundering in the Western Hemisphere are Switzerland, Channel Islands, Guernsey Islands, The Bahamas, Luxembourg, etc.   Switzerland, perhaps, would win, the vote as the world’s largest money laundering center.   Of course, the Swiss have a different story to tell.   Or rather, they would not tell any story at all, citing “Banking Secrecy”.   But intense pressure from the United States is cracking open the secret world of the Swiss Banking System, for the world to see.

4.  Apart from the perceived geographic bias, as seen above, in the fight against money laundering, allegations abound, about how Islamic Countries, Institutions and Muslim individuals are being unfairly targetted under the guise of fighting money laundering as also terrorism.

5.  After about a couple of decades of fighting money laundering and especially after 911, the financial services industry has come to realize, that for all the troubles taken by them, and the enormous amounts of money spent in fighting money laundering, the end result does not appear to be encouraging.  

This fight against money laundering has given birth, in its wake, to a new software industry, that comes up with more and more sophisticated, and expensive  software, supposedly to counter this phenomena of money laundering, without actually giving the desired results.   This is causing a lot of heart burning in the financial services industry, whose transaction cost of conducting business has gone up many fold.

Conclusion:  From the above, we may conclude, that to make the fight against money laundering more meaningful, the perceived and or real religious and geographical bias must end.   It must be ensured that the AML procedures and measures are focussed on the actual extent of the problem without exaggerating it.   The emphasis of the AML measures must be towards catching the big fish first, then the smaller ones.  

The West, especially the United States, must take care not to be seen practising double standards, therby weakening the system.   Money laundering centers in the West, especially, countries like Switzerland, must be made to comply with the AML rules in letter and spirit.   Uniformity in application of the rules should be promoted for a more harmonious result from such efforts.

And last, but not the least, a cost-benefit analysis must be done, to see  what has been achieved so far, by spending huge sums of money on hi fi software systems and other expensive gadgets, in countering money laundering.    Wherever necessary, corrective action must be taken to prevent mutual recriminations among various states so that the focus of the joint effort is not lost.

COMMERCIAL BANKING: TYPES OF ACCOUNTS

Introduction:  Banks and Banking institutions, of late, have been in the news for all the wrong reasons.   However, one cannot wish away the Banking industry and the services they render to society.   Banks are part and parcel of society, and perform within the overall limitations of the environment they function in.

In this article, we take a look at one of the basic services offered by Banks, namely, various Deposit accounts.   Banks in different countries offer variations of these type of accounts, and may carry different nomenclature.   What is discussed here, are three of the common varieties of accounts.

Current Account:  This is running account, usually opened and operated by businesses of various descriptions, although individuals with specific needs may also avail of this facility. 

Operations:  In this type of account, there is no restriction, as to the number of transactions, that can be put through in a day.   This account offers ease of operation, and convinience to conduct business transactions.   Cheques and other collection instruments may be deposited in this account for realization of proceeds.

Commercial Banks, normally, do not pay any interest on the balances lying in current accounts.   However, they may offer the facility of transferring the balances lying in this account, over and above the minimum required to maintain the account, to a seperate interest bearing deposit account.    That would not only help the customer take care of his business requirements, but also earn a little interest.

The balance lying in the current account can be withdrawn on demand, leaving aside the minimum required balance.   Under certain circumstances, Banks may allow the balance in the account fall below the required level also, in order to ensure that cheques drawn on such accounts are not returned unpaid for want of funds.   However, in such cases, Banks also levy a penalty in the account.

Savings Account:  Like a current account, a Savings Account is also a running account.   However, the profile of the Account holder and the nature of operations in this type of account are different.

Operations:  As the name of the account indicates, this account is meant for saving money, received either from salary, or other sources, periodically.   This account is not meant to carry out business transactions, though transactions like payment for utilities, etc, are permitted.

Banks may or may not stipulate a minimum balance required to be maintained in this account.    The minimum balance, where prescribed, is generally smaller than that prescribed for current accounts.    Further, there may be certain restrictions on the number of withdrawals or debits, especially in cash, that can be effected in this type of account, on a daily basis.   Savings account holders may also deposit cheques and other instruments in their account for realization of proceeds.

Normally Banks pay interest on the credit balances lying in the savings accounts, periodically.   Though the rate of interest paid is not very high, it is still an incentive for the general public to save.   Promoting the savings habit among members of the public is one of the major reasons for offering this facility.

Some Banks may also offer the facility of transferring the balance lying in the  savings account, over and above what is required to be maintained in the account, to a seperate deposit account, that carries a higher rate of interest.   That way the customer can maximize the returns on his savings.   This type of account caters to the largest cross section of society, taking care of their basic banking needs.

Fixed Deposit Accounts:  As the nomenclature indicates, this type of account is a deposit of money that is kept with the Bank for a specific tenure or period, say 90 days, or 180 days, or 1 year, and so on.   The tenure or period of the deposit is also called the ‘maturity’ of the deposit.

Operations:  Generally, fixed deposits fetch a higher rate of interest compared to other deposit accounts, because these deposits, as pointed out earlier, are kept with the Bank for a fixed period.   This allows the Bank to deploy the funds at its disposal,  more efficiently,  and to maximize its own returns from the market.   Hence, they offer a higher rate of interest on these type of deposits.

The fixed deposit accounts are subject to certain restrictions in regard to repayment etc.   Like they are  not repayable on demand.  However, Banks, rarely, if ever, refuse to repay a fixed deposit on demand, to the depositor.   But Banks do levy a penalty, by way of a reduction in the interest rate, for making payment of a fixed deposit before the completion of the term of the deposit.

This type of deposit is suitable for long term savings, to take care of periodic expenditure, or to make reinvestments etc., as per needs of the depositor.

Fixed Deposits are again divided into various types which will be discussed in a future article.

ISLAMIC BANKING SERVICES:QARD E HASAN

Introduction:  Islamic Banking is based on the principles of the Islamic Religion, of those pertaining to the commercial transactions.   One of the defining principles of commerce in Islam is the absence of Interest in commercial transactions.   Interest is replaced with Profit-sharing as the incentive for commercial activity.

Definition of Qard E Hasan:  Qard e Hasan literally means the beautiful loan.   Or more to the point in commerce, it means, a benevolent loan.   The element of benevolence is incorporated in this type of loan, by eliminating even the profit sharing aspect from it.   That is, Qard e Hasan is a loan that is totally free of cost to the borrower!   The borrower has to repay only the principal amount of the loan, and nothing else.   Profit-sharing, which is the basis of Islamic commercial transactions, is not a part of this loan, because it is meant for the specific purpose of accomodating those sections of the society that cannot afford to borrow at all.

Some authorities hold the view that Qard e Hasan is the only truly Islamic loan!   However, practically speaking, a commercial organisation has to make profits to be in business;  it has to pay remuneration to its employees, it has to incur expenditure for other overheads, etc.   Hence this type of loan is not extended to one and all.

How It Works:  This type of loan, i.e. Qard e Hasan, is part of the Islamic Bank’s social committment to society.   To help the needy and the poor.   That section of the society, that would find it hard to get a loan from a Bank, because they do not have the necessary financial credentials, normally required to obtain a loan from a Bank.  

The Bank sets aside certain portion of funds at its disposal to carry out social activities, free of profit.   These funds are part and parcel of the operational funds utilized by the Bank for carrying out its other activities.   The only difference being that, this part of its funds do not bring in any revenues to the Bank.   Rather this money in spent in social activities, in the path of Allah, as a social and moral obligation.

Every society has a section within that is neglected, for various reasons,  and hence falls back in the matter of economic, social and educational development.   These are people without a regular source of income.   These are people that cannot fall back on social security, and family support.   These are people who might suffer various disabilities-physical and mental.   It is this section of society, that benefit from the Qard e Hasan mechanism.

As pointed out earlier, the Bank allocates a portion of its regular working funds for the purpose of lending under the Qard e Hasan scheme.   Apart from this, the Bank may also contribute funds out of its Zakah funds (charity funds).   Similar contributions may also be made by the general public and institutions.   All of these funds are clubbed together to utilize for the purpose of Qard e Hasan loans.   The poor, the destitue, those affected by natural calamities like floods, Tsunami etc are favored under this scheme.

As such there is no specific list of people that can be financed under this scheme of Qard e Hasan.   Generally speaking, these funds are meant to provide timely relief and funds to the neglected and overlooked sections of society.   This not only takes care of their needs, but also plays a important role in reducing immoral and unethical activities among the people, pushed to a  corner.

For instance, a youngster who could have taken to crime on account of lack of resources for continuing his education, is saved from the wrong path, with a timely loan under this scheme.   A widow without family support, who might have otherwise taken to prostitution to keep her body and sould together, may be saved from this fate by extending a loan to her under the Qard e Hasan scheme.   A physically handicapped person, who would otherwise end up as a burden on his family, and live a life bereft of self esteem, can start a new life confidently with the help of a Qard e Hasan.

   These are some of the examples of how the Qard e Hasan can be, and is being utilized by Islamic Banks, and other financial institutions, for the good of the society.   By any standard it is a commendable feature of Islamic Banking and Finance, worthy of emulation.

ISLAMIC BANKING SERVICES: TAKAFUL

Insurance may be termed as a mechanism to hedge against different kinds of risks that may affect one’s interest in a particular asset, for instance, a motor car, or bike, or a house property etc.   The owner of the asset apprehends some kind of risk or danger to his asset that might erode the value of  his asset, or even completely destroy it,  and so, would like to take a monetary cover against such possible dangers, losses etc.

For example take the case of a motor car.   The owner of a car may insure it against theft which is fairly common.   The car owner would approach an Insurance Company, say AIG, who would insure the car against the risk of theft, by charging a fee called the insurance premium, to the owner.   Typically this facility (insurance) would come attached with strings that are called exclusions.   That is,  in the event of the car being stolen, the insurance claim of the owner would be settled subject to fulfilment of certain conditions.   In other words the claim would not be settled if the laid down criteria is not complied with.

Islamic Insurance, or Takaful, is a bit different from the conventional insurance.   Under this system, a group of persons,  having common interests, may come together to form a partnership, to protect their mutual interests, with the help of a contributory fund.   This fund is contributed to by all the partners, with the intention of making good, loss suffered by any one of them.  

How it Works:  For example, imagine a group of fishermen in Bahrain that regularly export fish to the United States and Europe.   There are many inherent risks in this business associated with the weather, product, etc.   In order to cover the risks associated with their business, these fishermen come together to form a partnership, to which they contribute funds, Tabarru,  according to a mutually agreed ratio.   These funds are then utilized to reimburse any of the partners that might suffer a loss in his business, on account of a reason that falls within the scope this arrangement.   This kind of arrangement offers protection to the individual fisherman that he alone may not be in a position to afford.   Pooling of resources by the partners ensures a higher level of protection to individual members.   It is a kind of self help program, or Ta’awum.   The partners appoint an agent to manage this partnership and administer the fund.

Other important details of this kind of insurance are that, in the event of the loss suffered by a member or members is more than the amount available in the pool, then the entire group of partners is obliged to settle the claim of such member(s)!   That is, the liability of the members is not limited to the amount of their contributions.   This would make the partnership appear to be a kind of a family venture, where each family member is committed to the welfare of the  other,  by a special bond.

Funds contributed by the members, (Tabarru), are invested in approved investments and the profits are shared in accordance with mutual agreement between them.   Such a arrangement corresponds to the Mudarabah contract;  the other type of arrangement being agency contract or Wakalah.   The rationale of the above arrangement, as can be seen, is basically to cooperate to prosper.

In conclusion, it may be said that like all other Islamic Banking and Financial activities, Insurance or Takaful also relies upon religious texts and their interpretations.   Further, there is a heavy slant towards the moral and ethical aspects of business, that impose special responsibility on those participating in such ventures.   The ultimate aim of such activities being the good of society at large.

Author’s note:  The above article is not an exhaustive study of the subject of Takaful, and intended to provide a glimpse into the practice.

ISLAMIC BANKING SERVICES: JUALAH & WAKALAH

Islamic Banking is known as Interest free banking.   Precisely, for this reason, many innovative and even peculiar type of contracts have been adopted in Islamic Banking to ensure an interest-free system.   The interest regimen has been substituted with the profit sharing one, and this has ensured that both the Banker and the Customer know where they stand, and what to expect from each other.   There is also a level playing field in Islamic Banking betwee Bank and Customer and neither of the parties are placed either in a disadvantaged position, or have an unduly advantageous position.   Among the various types of contracts prevalent in Islamic Banking are Jualah and Wakalah, briefly described below.

Jualah:  Jualah is a Agency Contract.   In an agency contract, as is known, one person, the Principal appoints another, the agent, to carry out certain tasks for him, and in return, the agent gets a payment, in the form of fees, etc., for doing the job.   Normally, there are some conditions attached to the job, and the agent is expected to comply with them.

In the same way, in the Jualah contract, there is a Principal and there is an Agent who does some work for the principal and gets paid for it.   A common example of a Jualah contract is the job  of a real estate agent.   In this contract, say there is a home owner who wishes to sell his home.   He engages an agent to find him a buyer.   The owner lays down conditions that the agent has to fulfil in executing this job.   The owner firstly provides all the necessary information of the property that he proposes to sell, and his expectation regarding the price.   Further, he also offers to pay the agent certain amount as fees, or commission etc.   Only if the agent succeeds in finding a buyer for this property, under the terms and conditions laid down by the owner, he (the agent) becomes entitled to his fees or commission, as the case may be.   Otherwise his efforts would go waste and he would not get anything for his labor.   This then, is a simple example of a Jualah contract.

Wakalah:  This is another type of agency contract.   This is somewhat different from the Jualah contract, in that, under the Wakalah contract, payment to the Agent is not contingent upon his doing completion of the job, but an attempt to do so sincerely and in good faith.

Under the Wakalah contract also, there is a Principal, and an Agent.   As like in the Jualah contract, the principal engages the agent to do some work for him.   There are terms and conditions to be complied with by the agent.   There is a time limit in which the job has to be completed.   And there is a result that is expected from the agent.   For his efforts, the agent is entitled to his fees or commission, as the case may be.  

However, the agent has to only prove that he has performed his job with the utmost sincerity and honesty in order to get his compensation.   It is not necessary for the agent to successfully carry out the operation entrusted to him.   Once the agent proves that he had carried out the job with trust and sincerity, he will be relieved of his liability under the contract and become entitled to his compensation.  

Conversely, if it is proved that the agent had not tried to perform his duties sincerely and had acted negligently, and without sincerity, the Principal gets the upper hand, and can renege on his promise to pay compensation to the agent.  

Even though there is an element of subjectivity in a contract like this, the fact is that the moral framework under which Islamic Banking functions, ensures that defaults are few and far between, and generally these contracts have been successfully employed in carrying out business for several centuries now.

Author’s Note:  This article is not an exhaustive study of the contracts of Jualah and Wakalah.

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