THE GREAT INTEREST RATE SLIDE

Falling!   Falling!   Falling!   Interest Rates!   They are a falling.   And how?!   From the United States to India and in Britain, in between, interest rates have been sliding as never before in history.

The rationale for the frequent cuts in the interest rates is, among other things, to make credit more affordable to individuals and corporations, with the expectation of increase in the offtake of credit, and also to create a set of new borrowers!

Central Bankers around the world seem to think that reducing interest rates would do the trick of increasing public lending.   Rather simplistic, one might argue.   Because, public lending operations are carried out by Commercial Banks that are obliged to adhere to certain norms in their lending operations.   Non adherence to these norms can not only jeopardise the loan asset, but also get them into trouble with the Regulators, the Central Banks themselves.   That apart, they (commercial banks) would be doing a disservice to their depositor customers by violating sound lending norms.   In fact, the current banking crisis in the West is, in large measure, a result of non-compliance of sound banking principles and the lending norms.

What does a Commercial Banker look for in a potential borrower?   Among other things, the borrower’s eligibility for the loan requested by him, and his capacity to repay the loan, alongwith interest in the stipulated time.  

Reducing interest rates might increase the demand for loans, but a lending decision hinges on the borrower’s financial health.   To the extent that reduction in interest rates contributes to the increase in the number of eligible borrowers (those that qualify for a loan, and have the capacity to repay the same), interest rate reduction would have served its purpose.   But is that really the case?   A simple increase in the number of people lining up before the Banks for a loan is not sufficient indication of the success of the interest rate reduction formula.

The key to increasing lending, not only to corporate borrowers but also to the retail segment, is the increase in the demand for loans from quality borrowers, and not just an increase in the supply of money available for lending.   That is the crux of the matter.   Whereas Central Banks may have control over the levers that enable them to increase the money supply, and thereby the demand for loans, they do not have control over the supply of quality borrowers.   That depends on the overall economic situation, especially the job situation.

The current job scene as it is now, with layoffs, freeze on new hiring, business failures across sectors, etc., becoming a daily occurance, the number of quality borrowers, would, in fact, tend to come down.   How then would you expect the commercial  banks to lend more?   And to who?   Must the banks lend to second and third rate borrowers and risk the health of the institution, apart from earning the wrath of the regulators?   That is the million dollar question.   It also underlines the limitations of the Central Banks in living up to the expectations of the political establishment, as well as the general public.

The coming months may see a war of sorts between the Central Banks and the Commercial Banks, each blaming the other for not doing enough to alleviate the pains of the current economic crisis.   The truth of the matter is that this crisis is a result of faulty policies  pursued over a long period of time, and can neither be wished away, nor easily resolved.

It may be some time before the crisis plays out its course, and normalcy is restored.   How long a time would that be?   Does anyone know?

Views expressed above are personal.

ISLAMIC BANKING SERVICES: MUZARAA

The partnership form of business is quite common around the world.   Usually, we see each partner contributing to the business in his own area of specialization, which benefits the business as well as the partners mutually.  

 Perhaps, the most common form of partnership is that where one partner contributes the capital of the firm, and the other contributes technical, and or managerial knowledge and expertise.

Muzaraa:  In Islamic Banking and financial system, there is one type of partnership called the Muzaraa.   This type of partnership is essentially an arrangement, that concerns agricultural activities.   In this partnership, one partner is an owner of agricultural land.   However, he either does not have the time, or the inclination, or the knowledge and expertise to engage in agricultural activities, and derive benefits from his land.   The result is the land lies fallow, and becomes a source of avoidable expenditure to the owner in the form of land taxes and rates as applicable, minimum upkeep expenses, etc.

How It Works:  This is where the Muzaraa type of partnership comes in handy.   Under this contract, the owner of the land allows a farmer or cultivator to put the land to use, and to generate income for mutual benefit.   The land is given to the cultivator in trust, and the ownership remains with the owner.  

The farmer or cultivator, by virtue of his knowledge and expertise, apart from need, cultivates the land and extracts the bounties of the land.   The expenditure required for the agricultural operations like seed, fertilizer, water, farm machinery etc., is either provided by the land owner in full, or the owner and farmer may agree to share the expenditure in agreed proportion.  

On the other hand, the owner of the land is not obliged to contribute anything by way of labour, knowledge or expertise in the actual agricultural operation, and the entire operation from sowing the seed to harvesting the crop is the responsibility of the farmer.   This also gives freedom to the farmer to carry out the operations on the land according to his own plan of action without interference from the owner.   This is especially beneficial when the owner is not very knowledgeable about agricultural operations.

Some of the other important features of this type of contract are that all the critical details of the arrangement have to be worked out in advance.   For example, what crop to grow, what would be the cost for various inputs required and the sources thereof,  the time required for the entire operation, the possible issues that might crop up in the course of the operation, and how to tackle them, so on and so forth.   Further, there is a strict segregation of duties wherein the owner is not permitted to interfere in the management of the farm, but only to contribute the capital and enjoy his share in the profits.   In other words, to the extent possible, all steps are taken to avoid possible misunderstandings, as well as pitfalls, so that the partnership becomes a successful venture.

Another noteworthy feature of the above contract is that the profit sharing arrangement betweena the owner and cultivator of the land is restricted to the produce generated from the land, and does not relate to anything else.   Moreover, if the partnership incurs a loss, then neither of the partners  gets any returns from the same.   The possession of the land will revert to the owner who loses the money spent on providing various inputs for the agricultural operation.   As for the cultivator, he ends up getting nothing for his efforts.   This type of partnership is usually for a specific period, and at the end of it, may be renewed by mutual consent.

Author’s Note:   This article is not meant to be an exhaustive study of the Muzaraa contract.

ISLAMIC BANKING SERVICES: ISTISNA

Definition:  Istisna refers to a contract of Manufacture!   Manufacture?   But what has Banking to do with manufacture?   Does an Islamic Bank engage in the activity of manufacturing goods?   But is an Islamic Bank not a service organisation?  

Of course, an Islamic Bank is a service organisation and not a manufacturing one.   However, under the service called Istisna the Islamic Bank contractually undertakes to manufacture but practically does not!   What it does is to supply the goods for which its customer places an order by sourcing the same from a manufacturer of such goods.

How It Works:  Firstly,  this type of contract applies to goods that have to be manufactured, like a fountain pen.   It does not apply to something like wheat or barley that are grown.   The product or commodity should have gone through the process of manufacture to be eligible for financing under Istisna contract.  

For example, a customer, running a stationery shop approaches a Bank with a proposal for purchase of, say, one million fountain pens.   He would like to stock fountain pens of different brands in different quantities, to offer a wide choice to his own customers.  

The customer gives details of the fountain pens that he wishes to deal in, the brands, the price range, etc., to the Bank.   The Bank examines the request of the customer and negotiates with him the terms and conditions under which it is prepared to supply the fountain pens to him.  

Once the customer agrees to the terms and conditions of the Bank, the Bank, in turn, approaches the manufacturer(s) of the different brands of fountain pens and negotiates for their purchase as per the request of their customer.   Naturally, the Bank negotiates to buy the fountain pens from the manufacturer(s) at a lesser rate than what it had negotiated with its customer to supply the pens.   The difference in these two rates would be the profit of the Bank from the transaction.

In the above deal, there are actually two transactions or contracts.   One between the Bank and the Customer.   And the second, between the Bank and the Seller.   The Bank acts as a go-between the manufacturer and the seller.   It makes payment directly to the seller, who’s more confident in dealing with the Bank for obvious reasons.   Similarly, the buyer does not have to deal with the manufacturer(s) and can rely on his Banker to supply him the product as per his own specifications.   The Bank enjoys the confidence of both the buyer and the seller and capitalizes on it to make a profit from the deal.   Further, the delivery of the above consigment may be made by the seller either to the Bank, or at the instructions of the Bank , to the Bank’s customer directly.   The various modalities of this transaction are worked out before hand to obviate the possibility of any trouble arising at a later date.

Pros and Cons:  As can be seen from the above, this transaction, like many others under Islamic Banking, are a bit complicated and fraught with consequences not usually faced under conventional banking.   There is a lot of emphasis on the moral and ethical aspects of commercial transactions, and this places a peculiar burden on the parties to the transaction.

It is also not easy to rescind or withdraw from transactions of this nature without loss of face, apart from monetary loss, and the possibility of losing business on account of the possibility of being branded unreliable and untrustworthy.   But the fact remains, that these type of transactions have been in vogue in Islamic communities around the world, especially in the Middle East for centuries, both in the formal and informal sectors, and have become a part and parcel of their lives.

Author’s Note:   Readers please note that this article is meant to be an introduction to one of the banking services available under Islamic Banking and not an exhaustive study of the subject.

THE GULF DOOM!

Is it the end of the Gulf Boom?   Is it time to write the obit of the Gulf Boom?   By all available indications, yes!   A regular stream of expatriates is returning to India and other countries of the Third World, with broken dreams in their suitcases.

The lucky ones are those that have already made their pot of gold, and have to look for a job in their country, more for an occupation than for subsistence.   The unlucky ones are those that had borrowed money to chase their dreams, and have now to go back to their places and face the moneylenders.   It is a tragedy being played out across the Indian subcontinent, and some other countries in the less developed world.

So how do we rationalise this tragedy?   Who do we hold responsible for this unfolding tragedy?   The Government, the Citizens, fate, circumstances?   On balance, it would appear that the Governments and their citizens are responsible in almost equal measure, with the scale tilting slightly towards the Government.

One of the simple and abiding truths of life is, when you depend on others for anything, you are risking your own interests, and putting yourselves at the sweet mercies of the others.   The overdependence of countries like India on overseas jobs to take care of their unemployed millions has now boomeranged on them, and it may be only a matter of months before the deluge of returning for good expatriates delivers a body blow to their already wobbling economies.

It is an undeniable fact that Governments in many of the less developed countries like India, Pakistan, Philippines, etc., have taken the easy way out to deal with the unemployment problem by encouraging their citizens to migarate to the Gulf and other prosperous destinations, instead of making concerted efforts to fulfil their basic responsibilities towards their citizens.   What’s more they get cheap foreign exchange by way of remittances from the expatriates.   On their part, the citizens of these countries have also not bothered to fight for their rights in their own land.   Rather, they have taken the easy way out by taking up jobs abroad, than traverse the rough road of activism to bring about responsible governance in their own countries.  

So long as the going was good, neither the Governments, nor their citizens bothered about the implications of their respective actions or inaction.   But all good things have to come to an end.   And so it is with the Gulf Boom.

What now?   Increase in unemployment, social tensions, religious strife, political instability, economic chaos, crimes etc., etc.   We are in for some pretty tough times ahead.   It is a scary scenario alright!

On the brighter side, this situation offers both the Governments and the citizens of the affected countries, to ponder over their past mindless conduct, and their penchant to skirt chronic problems, and to finally put their collective heads together and find solutions for the exploding problem of the Gulf Doom.   And if that happens, there may yet be a chance to escape the worst consequences of this developing tragedy.

Views expressed above are the personal ones of the author.

My Word!

The recent spat between the British Prime Minister, Mr.Gordon Brown, and Sir. Fred Goodwin, the disgraced, Ex Chief Executive of the Royal Bank of Scotland, is quite interesting to study, as a case of the Politician Vs the Banker.

Mr.Brown clearly thinks, that Sir Fred Goodwin, does not in the least deserve the ₤ 703,000.00 pension that RBS has so generously granted to one of their fallen angels.   So incensed is the British Prime Minister with this affront to all principles of  corporate governance, that he has even threatened to have the pension revoked etc.

Sir. Goodwin, on his part though, has stood his ground against all attacks against his retierment benefits.   Who does not want to lead a peaceful retired life!   That apart the gentleman is, perhaps, also upholding his honor as a Knight of the British Empire!

The real interesting part of this episode is that, politicians have, perhaps, for the first time, an opportunity to show someone other than themselves in poorer light!   The recent Bank failures have, in general, cast a shadow on the respectablility and integrity of Bankers.   Public perceptions of Bankers and the Banking industry as a solid pillar of society have taken a beating, and it might take a long, long time to restore their faith in this institution, and those who run it.

The politician sees a great opportunity in this Banking mess to present himself as ‘cleaner than them’.   No wonder Mr.Brown, the good politician that he is, doesn’t want to let go this opportunity.   The future course of this controversy would be worth watching and learning from!

Views expressed above are personal ones of the author.

ISLAMIC BANKING SERVICES: IJARAH

Definition:  Ijarah is the equivalent of Leasing offered by Islamic Banks and Financial Institutions.   The activity of Leasing involves permitting the usage of a property, say a car, or a shop etc, owned by one person, by another, for a consideration, i.e. a monetary return.   While the ownership of the asset remains with the owner, or the lessor, the lessee, or the person that leases out the asset, will have the freedom to put such asset to beneficial use, in order to gain some benefit from the same.   There are two types of Ijarah-Ijarah Salam and Ijarah wa Iqtina.

Ijarah Salam:  Under this type of lease agreement, the lessee retains the possession of the asset for the duration of the productive life of such asset, which may be 10 years or 15 years as the case may be.  

 For example, a person takes a car on lease whose productive life is estimated to be, say 10 years.   The lessee would be entitled to the use of the car for 10 years by paying the lease rentals as agreed upon in advance,  for the fixed amount within the stipulated date without default.   The car will remain in the possession of the lessee for the duration of its productive life cycle, in this case, 10 years, after which the lessee will return the asset to the owner, who by the way, continues to retain the ownership of the car during the lease period.   This type of lease contract is convinient to both the lessor and the lessee and fulfils their respective requirements.  

Ijarah wa Iqtina:  Under this type of lease contract, the lessee has the option, though not the compulsion, to buy the asset leased out from the lessor upon completion of the lease period.   The rate at which the asset would be purchased by the lessee would be mutually decided upon by both the parties to the lease contract.   As in the first type of lease contract, the ownership of the asset vests in the lessor and the lessee would only have the right to put the asset to beneficial use.   And the lessee would be obliged to pay the lease rentals at the rate agreed upon at the stipulated intervals without default.   At the end of the lease period, the lessee would have the option of buying the asset off the lessor and become the owner of the same.   The rate at which the asset would be sold to the lessee would depend upon the quality of the asset, the remaining life cycle of the asset, the market conditions, the demand and supply position etc.

Beneficial Arrangement:  Ijarah and Ijarah wa Iqtina contracts are  beneficial to both the lessor and the lessee.   The lessor, who owns the asset,  may not have the time and the inclination to put his asset to beneficial use and may only be incurring expenditure in maintaining the same.     This arrangement provides an ideal way for him to put his asset to good use and derive some financial benefit from it.   In the same way, the lessee may have the necessary skills to utilize the asset and derive financial benefit from the same, but may not have the capital to purchase the asset.   This lease arrangement, thus provides him the medium to possess the asset without owning it and to apply his knowledge and skills to put the asset to beneficial use.   What’s more , he has the option to buy the asset from the owner, in future, if that suits his needs.   Hence it is a mutually beneficial arrangement.

As in other types of financing under the Islamic system, the Ijarah contract also relies to a great extent upon the integrity and honesty of the parties to the contract.   Some of the most important responsibilities of the parties to the Ijarah contract are:   the lessor should not only be the owner of the asset, but must have possession of the same.   Ownership without possession, or vice versa does not fulfil the requirements of this kind of contract.   In the same way, the lessee is expected to take good care of the asset, as he would if it belonged to him, even though he not the owner of the asset.

Note:  Readers please note that this article is not an exhaustive study of the Ijarah contract, but only meant to give a basic understanding of the same.

My Word!

The British Prime Minister is visiting the United States of America to meet with the new occupant of the White House, Mr.Barack Obama.   And both the countries have reaffirmed their ’special relationship’ after the first meeting of the two leaders.  

However, an undercurrent of tension could be discerned between the two traditional allies (especially  in rogue ventures)!   Also the kind of brotherhood evident between their predecessors, Mr. Tony Blair and Mr. George Bush was clearly missing here.

The British are  concerned by the seemingly protectionist tone and tenor of recent American Trade Policies, in the wake of the economic meltdown, for example the Be American, Buy American type of exhortations and stipulations, aimed at American Companies, especially those receiving Government fiscal and monetary support.

It would be interesting to see what sort of changes may come about in  this ’special relationship’ in the coming weeks.

ISLAMIC BANKING SERVICES: MUSHARIKA

Definition:  Musharika is a form of Venture Financing under the Islamic Banking System.   This type of financing is more risky compared to the Musharaka contracts, and as such, offered to only customers of high repute, integrity, and financial strength.   Usually, the customers are made partners in this contract.   This type of contract, in general, is a short term financing option in which both profits and losses are shared by the Banker and the Customer in the agreed proportion.   There are two types of Musharika contracts-Direct and Diminishing.

Direct:  Under this contract, the Bank and the Customer establish a partnership for the purpose of engaging in a commercial business and contribute to the capital of the same by mutual agreement.   As the partnership is essentially short term, the business undertaken would also be consistent with the duration of the partnership. 

All the details of the business to be undertaken are worked out in advance so as to avoid any kind of disputes and bad blood between the partners.   This usually relates to, though not restricted to, the nature of the business, the capital required for the business and the respective share of the partners in the capital, the responsibilities of the partners in conducting the business and the role to be played by each of them, the ratio in which profits and losses would be shared, and issues relating to the market conditions, the demand and supply position, the expected revenues as well as the expenditures etc.   It is to be noted here that the profit and loss sharing ratio between the partners is decided upon in advance, and is not in proportion to the capital contributed by them.

Diminishing:  The Diminishing Musharika is similar to the Direct Musharika discussed above, except that the Diminishing type provides for the exit of the Bank from the Partnership upon repayment of its share of the capital by the Customer.   That is, this contract enables the Customer become the master of the business, that was initally started as a partnership to which the Bank had also contributed capital.   The precondition being the repayment of the Bank’s share of the capital in full.

Pros and Cons:  As can be noted from the above, this type of financing fulfils the requirement of Islamic Laws for the absence of Interest in commercial transactions, by providing for sharing of profits and losses between the Bank and the Customer.   On the other hand, this type of financing is also fraught with risks not associated with conventional banking and demands a higher level of ethical and moral standards of the parties to the transaction, without which the venture is doomed to failure.   As such, this facility is extended to only top level customers with high credit rating and good track record.   But as in any business venture, the possibility of failure is a real one, and therefore, attention  needs to be paid  to each and every issue that can make or mar the success of the venture.   This only underlines the importance of the commitment of the parties to the contract to the principles of honesty, integrity, ethics, and morality in conducting themselves under the contract.

Venture financing, as a form of financing is quite popular in the West especially in regard to high technology ventures and untested technologies, with higher possiblity of failure.   Silicon Valley is a prime example of this type of financing being undertaken successfully.   In the Islamic world, however, this mode of financing in both the formal and informal sectors, has been in vogue for centuries, and stood the test of time.   In spite of the higher level of risk associated with this type of financing, it provides a vital and much needed source of finance for business and trade. 

Disclaimer:  Readers please note that this article is meant to be a brief introduction to the Musharika contract and not an exhaustive study of the same.

My Word!

AIG seeks more funds from the U S Government to stay afloat.   Citigroup wants more and more of the same.   General Motors wants support from the American Government.   There is a long line of tottering giants waiting with bowls in their hands.

The American Government keeps shovelling billions into these apparently ‘bottomless pits’, while working up a Himalayan Deficit!

Guantanamo Bay Detention Centre to be shut down!

Why was it set up in the first place?   One American President sets up the centre, another one shuts it up.   And neither of them is accountable for his actions!   Imagine if all the countries of the world were to follow America’s example!

ISLAMIC BANKING SERVICES: MUDARABAH

Definition:  This is a type of Partnership between the Bank and the Customer for the purpose of carrying on any business, on a profit sharing basis.   The ratio of their respective shares in the profits is  decided upon mutually, in advance.   However, the losses, if any, are borne exclusively by the Bank!

How It Works:  Under this partnership, the Bank ususally provides the capital, and is called the “Rabb Al Maal”.   And the customer manages the enterprise, and is called the “Mudarib”.   The job of the Bank, or the Rabb Al Maal, is only to provide the necessary capital and let the Customer, or the Mudarib, to manage the show.   The Bank does not concern itself with the day to day running of the business.  

The Customer, or the Mudarib, has the sole responsibility of running the day to day affairs of the business, and is expected to make a success of the enterprise.   His skill and competence are, therefore, crucial to the success of this partnership.   Perhaps the most noteworthy aspect of this partnership is that the Bank shall bear all the losses, but share the profits with the Partner, the Customer or the Mudarib.   Which means, this is a fiduciary type of contract,  and much depends upon the integrity, moral and ethical standing of the Customer in making this partnership successful.    The peculiar nature of this partnership puts different kinds of pressure on the partners and hinges on the trust and faith existing between the two, apart, of course, from the competence of the Customer in managing the business.   The nature of business and the operating environment also play their own role in determining the success or otherwise of this partnership.

Another noteworthy aspect of this partnership is that the profits from the business are distributed between the Bank and the Customer only after the Bank or the Rabb Al Maal is refunded the capital provided by him for starting the business.   As an illustration, suppose the Bank or the Rabb Al Maal has provided a capital of, say, U S Dollars One Million for undertaking a particular business venture, whose life span is, say, one year.   Suppose, at the end of the year when the business venture is to come to an end, the partnership has made a profit of U S Dollars Twenty Thousand.   And suppose they have also incurred an expenditure of U S Dollars Ten Thousand as part of their business expenses.   That means they have made a net profit of U S Dollars Ten Thousand.   Now the Mudarib or the Customer has to return the capital in the amount of U S Dollars One Million to the Rabb Al Maal, the Bank, before he can lay claim to his share of the profit, as per agreed terms.   However, in certain cases, both the partners may agree upon to distribute the profits even before the cessation of the partnership.   In such an event,  care is taken to ensure the safety and security of the Bank’s capital, and the continuation of the business venture till the originally agreed upon period.   Eventually, the Bank’s capital would be repaid in any case.

Diminishing Mudarabah:  A variation of the above Mudarabah contract is the Diminishing Mudarabah.   In this type of Mudarabah, the Bank or the Rabb Al Maal agrees to sell its share of the business at agreed intervals to the Mudarib, the Customer, such that eventually the Mudarib becomes the sole owner of the business, upon full repayment of the Bank’s capital.

There is also a provision to terminate the partnership before the due date, by mutual consent, without adversely affecting the interests of either of the partners, and without jeopardising the business.   This however, makes it a risky proposition to both the Bank and the Customer and is the reason why this type of contract is not as popular as certain other contracts under Islamic Banking.

Disclaimer: This article is an introduction to the Mudarabah contract with a simple example, and is not meant to be an exhaustive study of the same.

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