Financial Reforms, Obama style.

This is the fourteenth in a series of articles on the financial reforms sought to be initiated by the Obama Administration in U.S.A.

Elimination of the Thrift Charter:  The Thrift Charter came into existence in the wake of the Great Depression, as a specialized class of depository institutions focussed on residential mortgage lending.  

The Obama Administration proposed closure of these thrift charters, in due course, as their importance to the financial system had come down over the years, on the one hand, and they have been badly affected on account of the housing mortgage crisis, on the other.   However, the Administration proposed to retain the applicable interstate branching rules and apply them to the State and National Banks.

National and State Banks:  Though the National and the State Banks are seen as being subject to regulation that has improved over time, still certain areas needed a closer look to improve supervision and regulation.   One of the major concerns of the Administration now is to eliminate the scope for arbitrage oportunities arising from the remaining multiple bank charters and supervisors.

Further, the differences in applicable policies and regulations to national and state member banks, and state non-member banks would be reduced.   And last but not the least, the practice of switching charters and supervisors by the troubled Banks would be restricted.

Interstate Branching:  Presently, Banks do not have the facility of interstate Branching without having to go through a cumbersome process including acquisition of an existing Bank.   Though some states do permit interstate Branching, Banks are unable to operate freely across interstate borders on account of the restrictions of other states.

In order to promote competition among Banks, to promote a wider choice to the consumer, and to provide services in under-served areas, and to improve the resilience of the Banks to economic adversities, Banks would be  allowed to freely open Branches across states.

                                                                                             To be concluded.

The Supervisory Capital Assessment Program-Part XVIII

This is the eighteenth in a series of articles on the SCAP.

Category-wise review and assessment(contd):

Pre Provision Net Revenue:  Business projections made by the BHCs formed the basis for the analysis of their PPNR submissions.   The assessment focussed on their consistency with the overall macroeconomic scenarios.   The firms’ internal management and financial reports were also studied, to get a proper perspective of the issue.  

Supervisors reviewed the ALCO documents of the firms, to compare them with their SCAP submissions.   The ALCO, or the Asset Liability Committee, is a high powered committee in a Bank, that normally determines the interest rates to be offered by the Bank.   Supervisors also studied the yield curve assumptions, net interest income projections, and economic value of equity assessments made by the firms, in the course of their planning process.

Also examined for this purpose, were the historical trends in the major parts of the PPNR, as the net interest income, non interest income, and non interest expenses.   This data was obtained from the regulatory reports, submitted by the firms, as well as their published financial statements.

The above evaluation was done with the help of a thorough assessment of the firms’ estimates about revenues, and the risk of losses.   Wherever necessary, supervisors made changes to the firms’ forecasts, including key assumptions to ensure consistence with the macroeconomic scenarios.   Such modifications included those to the projected growth rates, and stock price indexes.   Peer analysis was another tool employed in the process and used to identify overall trends.

The historical relationship between PPNR and its main components, to measures of macroeconomc activity were also examined.   The firm-specific differences in PPNR were identified.   The components of the PPNR that were more volatile in the past were identified, as such components would be less sustainable in strained economic conditions.

After going through the above process, the lesser of the two estimates, between the firms’ submissions, and the supervisors’ estimates were applied.

Advance for Loan and Lease Losses(ALLL):   Projections were made by the supervisors, for the required level of reserves at the end of the scenario period.   Based on these projections, they developed suitable benchmarks.  

Two distinct portfolios were identified for the purpose of determining the reserves required.   One, the vintage loans left over from the end of 2008, and, two, the new credits extended over the scenario horizon.   The total of the loan amounts in the vintage category was calculated by taking the loan book balance as at the end of 2008, and reducing these balances by the estimated losses calculated.

Coming to the new loans, the figures for these were taken from the firms, or in cases, where a firm reported nil growth in new loans, the supervisors assumed this figure as being equal to the estimated loan losses between 2009 and 2010.   Sufficient reserves were sought to be built up to cover the losses on the portfolios in 2011.

Loss rates for the vintage loans were arrived at, as being equal to the firms’ 2010 loss rate, reduced by the anticipated average percentage reduction in losses in 2011.   However, for newly extended credit, to which more stringent underwriting norms were applied, loss rates by category, from 2007 were used, to represent the expected losses in 2011. 

                                                                                               To be concluded.

Acknowledgement:  Adapted from the official document of the Board of Governors of the Federal Reserve System.

The G-20-Part I

Introduction:  The G-20, or the Group of 20, is a group of both developed and developing countries, that play an important role in international economic and financial matters, and are hence considered to be systemically important at the global level.

The member countries of the group are Argentina, Australia, Brazil, Canada, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, United States of America, and the European Union.   The member countries are represented by their Finance Ministers and Governors of their Central Banks.   Apart from these countries, the International Monetary Fund and the World Bank are also represented in the group, on ex-officio basis.   The G-20 does not have a permanent Secretariat.

Origin:  The G-20 came into being in the year 1999.   The late nineteens saw a lot of turbulence in the financial markets of the world(that has now assumed the dimensions of a full blown recession).   It was felt, at the time, by the industrialized nations, that the earlier exclusive groups like the G-7 may not be sufficient to deal with the myriad challenges thrown up by the chaotic markets.   They then decided, albeit grudgingly, to give more scope for the developing world to play a role in discussing and debating key issues relating to the global economy.

Purpose of G-20:  The basic purpose of the G-20 is to promote and accelerate the process of development throughout the world, through a process of dialog and discussion between the industrialized world, and the emerging market economies.

The G-20 seeks to strengthen the international financial structures and frameworks through co-operation between the developed and the developing economies, and to institutionalize this process to ensure long term growth and development.   It gives voice to the less developed and emerging market economies, about their aspirations and concerns.

The G-20 seeks to understand the dynamics of an integrated global economy, and the problems and prospects of individual components of this global economy, and how to ensure a peaceful and profitable partnership betweeen these often competing forces.  

Many a time the interests of the developed and the developing economies are divergent and even conflicting with each other.   The G-20 forum promotes a dialog to resolve such issues, so that the process of development extends through the length and breath of the world.  

Historically, the marginalization of the developing world in the process of global economic governance, and the appropriation of the levers of development by the developed world led to the alienation of a good chunk of the world population.   This in turn led to the developed economies losing out on the opportunities in the emerging markets.

By seeking to include the developing economies in the formulation of international economic and financial policies, and also in the role of international financial institutions, the G-20 hopes to reduce, if not eliminate, friction between the developing and the developed world, and replace it with co-operation between the two sides.

                                                                                                              To be concluded.

Finance: Forfaiting-Part II

In a previous article, we learnt what is forfaiting.   In this article, we shall examine an actual transaction, to understand how the mechanism works.

How It Works:  Let us study the example of M/s. Fresh Meats, a meat processing company, based in Chicago.   The Company has an export order worth USD:1.00 million on hand, for supply of 50 tons of sheep meat to M/s. Arabian Imports of Dubai.   The shipment has to be executed within 30 days, and in one lot.   Further, the importer demands 30 days credit for payment for the consignment.

Fresh Meats is a small but fast growing company that is keen to take up the order.   However, it does not have the resources to afford 30 days credit to its importer.   It therefore approaches M/s. Sun Forfaiters, a forfaiting house, and requests for a forfaiting facility to execute this contract.   Sun Forfaiters study all the details of the export order bagged by Fresh Meats regarding the quantity, quality, delivery schedule, payment terms, credit terms, etc., and having satisfied themselves about the viability of the transaction, agree to take up the same on their standard terms and conditions.

Generally, Sun Forfaiters require the exporter to obtain a pre-accepted Draft from the importer, also supported by an “Aval” of the importer’s Bank to honor the payment under the transaction, irrespective of their clients conduct in this regard.   An Aval is a kind of guarantee, or commitment to pay, on part of the importer’s Bank, on behalf of the importer, in the event of the importer’s default.   This commitment is irrevocable.

If these terms of forfaiting are acceptable to Fresh Meats, they in turn approach the importer and request them to get confirmation from their Bank on providing the Aval.   Once the importer confirms his willingnes to pre-accept the Draft and also arrange for it to be avalized to Fresh Meats, they confirm the same to the Forfaiter.

The Forfaiter now advises the exporter, Fresh Meats, on the documents to be submitted, including the pre-accepted Draft.   The Draft is drawn for a certain amount over and above the value of the order, the differece being the forfaiter’s interest and charges.   In the current example, the value of the order is USD:1.00 million, involving only one shipment.   The exporter draws a Draft for say, USD:1,015,000.00.   Of the USD:15,000.00, say, USD:10,000.00 represents the interest, which rate is linked to the LIBOR, for the period the forfaiter is out of funds;  of the remaining amount, say USD:2,000.00 represents the forfaiter’s margin, for the risk he is undertaking in relation to the importer’s country;  and the remaining USD:3,000.00 represents the charges for the forfaiter for any possible delay in receiving payment from the importer’s Bank.

Once the exporter submits documents as required under the contract to the forfaiter, the forfaiter purchases the pre-accepted Draft and remits the full amount of the Draft, that is, USD:1,000,000.00 to the exporter.

Once Fresh Meats receives their money from the forfaiter, that is the end of the transaction, as far as they are concerned.   Now it is for the forfaiter to recover his money from the importer.   Normally the forfaiter is assured of payment, as the Draft is pre-accepted by the importer, and more importantly, is avalized by his Banker.

Now coming to the importer who has already taken delivery of the consignment of the meat, after he receives the documents, makes payment for the same through his Bank.   This brings the transaction to its end as far as the forfaiter is concerned.

This is a simple example of a forfaiting transaction, where everything goes well, and the transaction reaches its logical conclusion.

                                                                                                  To be continued

FINANCE: CREDIT CARDS PART II

In the previous article on Credit Cards, we had a glimpse at the credit card business, and how it works.   In this article, we shall take a look at the advantages and disadvantages of the credit card to the parties concerned.

 

Advantages of Credit Cards:  Credit Cards offer several advantages to the cardholers, the issuers and  the merchants alike.   Some of the important advantages are discussed below:

To Cardholders:  Among other things, the Cardholder is relieved of the burden of carrying large amounts of cash.   Carrying cash in large quantities is not only bothersome, but also risky, especially for old people.   The credit card is  a versatile payment system that gives flexibility to the Cardholder, who can buy goods and services from a vast choice of merchants, throughout the world practically.    And by doing a little research, he can the land the best  deals possible  from the merchants.   The card companies and their agents offer several incentives to cardholders to get them to use their cards.   They take advantage of special ocassions, like festivals, etc to offer special discounts and other such inducements to increase their business.   Credit card companies tie up with merchants and other vendors to offer special rates, discounts etc on usage of the cards.   Another popular incentive offered is called the ‘cash back’, wherein the cardholder is refunded a part of the money he spends on purchases through his card.    Credit cards also enable one to shop online, obviating the need to go physically to the market or the mall.   Especially during peak seasons of shopping, it can be quite tiresome, to go through the grind of visiting a shopping mall to make one’s purchases.   Credit cards are especially useful in making purchases of items that don’t require physical examination.

With increasing competition for the customers’ favors in this area, cardholders are enjoying a bonanza in the form of interest free credit, credit of points for amount spent that can be utilized for availing other services free of cost, or at concessional rate, so on and so forth. 

To Merchants:  In a way, credit cards increase the purchasing power of the consumer as they enable the cardholder to buy now and pay later.   And it is human nature to spend, if one can.   The credit afforded by the Banks through the credit cards  often means more business to the Merchants.  

That apart, they charge a commission on each  card transaction, as they do not get paid immediately for the sale.   Invariably, the amount of such commission charged by them is rounded up to the higher side.   That is they end up getting more than the loss by way of interest incurred by them.   Further, the risk of non payment is practically non existent, once the transaction is electronically authorized.   The merchant is assured of being reimbursed for the credit sale effected by him.   In due course, the merchant’s account with his Bank is credited with the amount of the credit sale.

Also the merchant saves money on  overheads and administrative expenses, when he transacts through the medium of credit card, as he does not have to deal with large amounts of cash, especially small notes and coins.

To Banks:  Banks that issue credit cards to their customers get a commission from the Card Issuer for each card they issue.   The facility of credit cards attracts more customers to a Bank, and generates other business for them.   It enables Banks to engage in cross-selling of products and maximize their revenues.

Further Banks charge very high interest rates for the credit offered through the credit cards.   Especially in case of default, the cardholder literally pays through his nose.   This interest charged by the Banks is way beyond the monetary loss suffered by them on account of late payments by the cardholder.

Disadvantages of Credit Cards:  Now a look at the negative side of the credit card business, and how it adversely affects the same parties that also enjoy its plus points.

To Cardholers:  “Neither a lender nor a Borrower be!”.   Of course, in the modern economic system, it may not be practicable to pursue this goal.   However, it  is a fact, that, credit cards have ruined many a life, on account of indiscriminate usage by the cardholders.   When credit is available easily, the tendency of the cardholder is to buy goods and services that he does not really need, or to buy more expensive items that he would normally do.   The availability of credit, and that too without going through documentation and other formalities, like in a conventional loan, makes it even more tempting for the cardholder to spend.   Then there is the necessity of keeping up  with the Joneses.

There are any number of cases of cardholders going bankrupt due to their inability to pay off their card dues.   Apart from that, there are security issues also involved like the loss or theft of cards, misuse of cards by  others through fraudulent means, etc.

To Merchants:  Disputes in credit card transactions are a not-so- rare occurance, resulting in a lot of avoidable administrative and sometimes, legal work and expenses, for the merchants.

Fraudulent usage of the cards by crooks, is another headache for the merchants.   With increasingly sophisticated methods being adopted by fraudsters, merchants are forced to be extra vigilant, and thereby incur additional expenditure in the process.

For Banks:  For the Banks, of course, the number one problem is with payment defaults.   Monitoring the usage of millions of cardholders, and ensuring prompt payments from the customers is indeed a mammoth task.   Further, collecting overdues from defaulting cardholders can present administrative and legal hassles costing good money.   And fraudulent usage of cards is equally worrisome to the Banks.

Unlike in a regular or conventional loan, Banks do not follow any formalities in allowing credit to the cardholders.   Once the Bank grants a credit card facility to the customer, and so long as the customer keeps within his limits, the Bank does not bother customer.

Conclusion:   On balance, it may be said, that credit cards have contributed a lot of good to society at large, facilitating payments, that would otherwise be quite cumbersome, and risky.   The negative aspects of the credit cards may have to do more with human psychology, though it cannot be denied that usurious interest rates charged for credit card transactions have given them a bad name.

                                                                                                    Concluded

ISLAMIC BANKING AND FINANCE:MUSHARAKA

Literally speaking, Musharaka means partnership or a system of sharing. It is one of the several financing options available under Islamic Banking.
There are two types of Musharaka-Direct and Diminishing.

DIRECT MUSHARAKA: Under this option of financing, the Bank and the Customer form a partnership in which the Bank provides part of the capital to the customer and the customer manages the project apart from providing part of the capital. The proportion of capital provision by the two parties is mutually decided upon in advance. It is the customer that runs the business enterprise.
The notable feature of this partnership is that the liability of the partners is unlimited. When the business suffers a loss, it is distributed between the Banker and the Customer in the agreed proportion, whereas in case of profit, it is shared between the two in proportion to the capital contributed by them. The contract may also provide for the customer to be exempt from running the show or the business, in which case the share of the Bank in the profit would be proportionately higher.

The Musharaka contract is based upon real capital and specific limits and not on the basis of debt. Partners to the contract should know the extent of their participation in the capital and their share in the profits and losses at the time of making the contract. Uncertainty in the terms of the contract would vitiate the contract. Normally, these contracts are pursued by the partners till the final objectives of the venture are achieved. However it is permitted for either of the partners to exit the partnership with the consent of the other.

DIMINISHING MUSHARAKA: In this form of contract, the Banker agrees to part finance the project and also agrees to exit the partnership voluntarily upon repayment of his share of the capital by the other partner, the customer. This repayment must be made within the specified period. The customer agrees to bring in his share of the capital and act as a trustee for the entire capital.
Like in the case of the Direct Musharaka, the loss from the business venture is distributed among the partners in the agreed ratio, whereas profits are shared between them in proportion to their capital contribution.
As per agreement, the Bank agrees to sell its share of its capital to the customer over an agreed period of time, and the customer buys out the Bank share in the partnership so that eventually the customer becomes the master of the whole enterprise.
This type of financing is a very convinient form of financing where customers can rely upon the Bank not only for capital but also managerial expertise. And in the course of time, the customer becomes the sole owner of the business enterprise. For the Banker, this arrangeement ensures a regular, and steady income. Further, losses are shared according to respective share in the capital, thereby reducing the burden of losses.
There is a third kind of Musharaka financing that is akin to Venture Financing which will be the subject of another article.

Author’s Note: Readers may please note that the above article is meant to be a introduction to one of the forms of financing available under the Islamic System, and not an exhaustive study of the same.