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Monday, 13 October 2008

Time to look at Islamic banking

LONDON: If last week was another week of turbulence in the global financial markets, with the International Monetary Fund (IMF) warning of a global financial systemic meltdown and governments all over announcing bailout packages for their failing banks, then this week perhaps could be a week of reckoning as banks embark on forced recapitalization and part-nationalization exercises.
President Bush, meeting the G-7 finance ministers meeting in Washington on Friday, called for global cooperation and solution to the crisis, and British Prime Minister Gordon Brown yesterday was in Paris ahead of an emergency summit of European leaders trumpeting the UK blueprint for rescuing the banking and financial sectors based on recapitalization, part nationalization and tougher regulation.
The irony, of course, is that unlike in America, where some of the bankers accused of fraud and miss-selling are in jail or facing prison sentences, in the UK senior bankers have been living in denial and have shown an indecent lack of contrition in acknowledging any or even part of the responsibility for causing the ‘Crash of 2008.’
While senior banking executives seem to be getting away with corporate murder, it is the hapless depositor and taxpayer that seem to have drawn the short straw once again. Governments are scurrying around to announce a range of deposit guarantee schemes to preempt runs on banks and supposedly to protect depositors funds. This has gained a momentum of its own over the last few days in the wake of the banking collapse in Iceland, which has left British depositors facing potential losses of over $2 billion through deposits with Icesave, a subsidiary of the troubled Landsbanki, which was nationalized recently.
In this case, depositors, including charities, county councils and local authorities, have shown a remarkable disdain for the handling of public funds of which they are supposed to be trustees. They have shown to what extent the greed culture has become pervasive not only in market economies but globally. For the sake of a marginally better interest rate they have opted for placing their deposits in dodgy banks with impenetrable ownership structures. Of course they will blame the money websites and the financial advisers who urged them to opt for the likes of Icesave, Heritage and Kaupthing Edge, offering unrealistic interest rates.
The reality is that the City warned of the lack of soundness and dangers of these online banks from Iceland more than six months ago; Moody’s, the international rating agency, published a report earlier this year stressing the fragile state of these Icelandic banks; and even the IMF said in a report in July that the Icelandic banks are most likely to fail.
And yet these greedy organizations were chasing these unrealistic returns. Now of course they want the taxpayer to bail them out as well. Council and local authority money is taxpayers’ money. As such the taxpayer is hit with a double whammy. Yesterday morning too three more countries — New Zealand, Australia and the UAE announced that they would guarantee all ordinary deposits in their country’s banks — a move started by Ireland two weeks ago and since followed by a number of countries including Germany and Greece. The UK, typically, has dithered in the end raising the deposit guarantee ceiling from 35,000 pounds to 50,000 pounds. In the UAE, according to the Central Bank of the UAE, local citizens own 75 percent of bank deposits; other Arab citizens from neighboring countries own another 8 percent of deposits; while the remaining 17 percent of deposits are owned by other nationalities.
The protection of deposits in the Western banking system is a major misnomer and one of the biggest red herrings in conventional banking theory and philosophy. It also concerns the nature and definition of deposits. The impression given is that deposits are sacrosanct in conventional banking and are therefore guaranteed as soon as a customer deposits money into a bank. As the spate of banking collapses over the last few decades have shown, this is not the case. And yet governments and regulators have been in collusion with the banking sector in perpetuating this myth.
In the conventional system, the depositor is a lender to the institution. Deposit funds collected under sight and time deposit accounts constitute an ultimate liability, as the principal plus a fixed and pre-determined rate of return (deposit interest income) is fully guaranteed by the bank (underwritten by the bank’s assets).
The impression given is that the guarantee is absolute. In reality this is not the case because otherwise why have the deposit insurance scheme? Also no amount of capital reserves will suffice because to cover deposits absolutely would be too expensive for conventional banking. The very nature of capital of banks has changed and become diluted over the last two decades. We now have core capital; tier1, 2 and 3 capital; subordinated capital; hybrid capital — with banks given greater license to play around with portions of their capital including speculating on the market the further it gets from core capital.
To put it in another way, in conventional banking, money is a product, which you can buy and sell, and trade and make money. A conventional bank buys money from depositors cheaply, say at 2 percent and it sells the money expensively by lending to other customers, say at 6 percent, and makes the margin.
In contrast, guaranteeing of deposits has traditionally been the problem area for Western central banks authorizing Islamic banks. I remember a discussion in the 1990s to this effect with Governor Eddie George of the Bank of England. At that time the UK did not have a single Islamic bank, the reason being that such banks could not guarantee deposits from an ethical point of view. And yet Governor George acknowledged that deposits in conventional banking could not be guaranteed absolutely because it would be too expensive and unrealistic.
In Islamic banking, the depositors of course are account-holders who participate in the risk-taking, according to the type of account — specific, restricted, or unrestricted. The deposit resembles an ‘open-ended mutual fund,’ and accordingly the depositor opening a profit-and-loss sharing account with an Islamic bank is not a creditor to the bank, but a capital owner, authorizing the bank to manage the funds in the best possible manner in return for an agreed management fee but at the entire risk of the depositor. As such the funds deposited are not a commitment to the bank, as neither the principal nor any type of pre-determined rate of return are guaranteed to the depositor.
In Islamic banking money is not a commodity but a measure of value through which there can be an exchange of goods and payment of debts. The principles are that money alone cannot be used to make more money, in other words no interest may be charged on loans; that lenders should share in the risks and profits of the enterprise; and that wealth-creation is for the improvement of the whole of society, and not merely for the benefit of a small elite.
Mushtak Parker | Arab News
As such, the number of Islamic banks authorized in the UK recently had to give voluntary assurances through one or two mechanisms as a condition of their authorizations to ‘guarantee’ their depositors’ funds.
The fact that deposits in Islamic banks are not treated as a liability on the balance sheet does not mean that they should not have a minimum capital requirement. Apart from collecting and investing deposits, Islamic banks offer a cornucopia of other services including current accounts and cheque book services; letters of credit, acceptances; and confirmations. Liabilities arising from these activities are fully underwritten by the assets of the bank. Islamic banks carry risks some of which are unique to them.
These include fiduciary risk, governance risk, enforcement risk and Shariah compliance risk. Two countries — Turkey and Malaysia — also have Islamic deposit insurance schemes in place based on Takaful.

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Alfalah Consulting - KL: www.alfalahconsulting.com 
Islamic finance consultant: www.ahmad-sanusi-husain.com 
Islamic Investment Malaysia: www.islamic-invest-malaysia.com

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