Monday, January 30, 2012

CREDIT RISK IN ISLAMIC DEPOSIT

CREDIT RISK IN ISLAMIC DEPOSIT

Islamic financial institutions mostly Islamic banks take in deposit in various forms, and employ such deposits in ways they deem fit as part of their so called Islamic banking business. In some jurisdictions the term Wadi’ah is normally used to refer to such deposits for convenience sake and for a purpose seemingly to impress upon the fact it is more of safekeeping arrangement undertaken by depositors with the banks concerned, as the term wadiah in its original sense connotes safe-keeping contract between owners of assets and safe-keepers or trustees-custodians.

But then when it come to banking business as commonly understood, such concept of custodianship is a misplaced term in the real application since in most cases the banks that accept the fund would as a matter of practical application use or employ the fund for their business operation. On this score alone it may be safely said that the use of such term as wadiah in the above context is not accurate to describe truthfully what actually happened in the context of the banking practice as described.

In Shariah parlance, when wadiah is created the basic objective is for safe-custody and not for usage by the custodian; if usage is intended it will depend on whether the deposited item or object is durable or perishable by usage or consumable in nature in which case the transaction is known as qard. If however the item is durable such that any intended usage will not diminish it, (meaning it may be returned safely after usage) then the arrangement is known as I’arah or borrowing or lending of durable item. From the foregoing discussion it has become clear that to be considered wadiah the purpose must be for safe-keeping rather than usage or borrowing as is in the case of either qard or iarah as explained.

The problem started to emerge when Islamic banking deposit was referred to as wadiah when it was clear right from the very beginning that the banks’ intention was to make use of such deposit as it deemed fit for their business purpose. If classical Shariah framework is to be applied such an arrangement with that purpose needs to be viewed as a form of qard considering the fact that the money collected and used/spent is not returnable as it moves from one hand to another in transactions. However when the term wadiah is used to refer to such deposit, misunderstanding is bound to arise just because wadiah from its very concept only connotes safe-keeping. To address this issue some banks added another term to the original wadiah thus the concept was said or described as wadiah yadd damanah ( wadiah/safe-keeping with guarantee); such combined term is in itself more confusing given that by conceptual definition wadiah is not supposed to be guaranteed in all circumstances the way qard/loan is.

According to Shariah, a custodian in the contact of wadiah is only liable in case of negligence or fault and not like a borrower who is under a duty to repay back what is borrowed in whatever circumstances. Wadiah custodian however will not be held liable if the reason for such inability to return back the deposit when demanded has nothing to do with any element of negligence or fault on the part of the custodian.

Deposit Guarantee and Mudarabah

Islamic banks also collect funds in the form of mudarabah investment deposits which are either general or specific investment account where the idea is to differentiate these deposits from those collected as wadiah as previously described. Up to this level such deposits that are said to be for investment on the basis of mudarabah pose no big problem, but if we move a layer below, it will become clear that in practice not all basic rules governing mudarabah are followed. This is apparent when we take into consideration that the bulk of the monies so collected by the banks (as mudarabah deposit or placement) is later employed mostly in either murabahah credit sales or BBA (deferred payment sale) in providing financing to their so-called customers. The issue is, when the banks collect such deposit, they thus become a mudarib/enterprenuer and as such are to be bound by the rule of mudarabah.

In the law of mudarabah, it is a settled principle that the mudarib shall have no right to be involved in granting facility in the form of deferred payment sale as a matter of right as a mudarib because such an act is viewed to expose the mudarabah fund to risk of non- payment by buyers i.e credit risk. which will eventually create a loss at the detriment of the investor/rabbulmal. The generally accepted opinion in Shariah jurisprudence is that if a mudarib performs such an act, he will be held strictly liable for any non-payment arising there from since such an action is considered not to be part of a role of a mudarib by default. Additionally it is also a generally accepted rule in Shariah that it is not permissible for a mudarabah contract to be made embedded with a capital protection clause as this is not in line with the very nature of mudarabah concept and application. There are however two general opinions regarding the mudarabah contract that is embedded with such a clause; one opinion goes on to state that the whole contract will become invalid by such a provision while the other one only regards the clause as not valid and of no practical implication due to such impermissibility. Thus the mudarabah contract as per this second opinion can still be operative but without such a clause.

From the above discussion it has become clear that had banks truthfully followed the correct rule of mudarabah by not involving in credit sales as widely practiced, there would have been no need to talk about credit risk from Islamic perspective the way it is understood in the conventional contact. Conventional banking institutions lend money to their customers so they have no alternative but to address the issue of credit risk as understood. Islamic mudarib banks, not only that they are not supposed to lend money to do business, but also they have to refrain from any involvement in deferred/credit sale as a matter of requirement of mudarabah rule. But when such a rule is not followed, whether they like it or not the issue of credit risk is there to be addressed as a matter of self-induced problem that should not emerge in the first place had the true concept and rule of mudarabah were correctly followed. Sadly as is always the case, it is much easier to replicate the conventional practice than sticking truthfully to the original concept; as originality has a price not everyone is willing to pay.

Friday, January 20, 2012

Is Being an Ideologue a Contributor to Stupidity?

A gratuitously provocative question?

Maybe not.

Consider the following equation:

TA * TR = TB.

Let's say TB represents some "financial obligation" among a group of people. Further, let's say that at some point in time, the group has a TB of 40. And then, almost 30 years later, TB equals 55.

Now, if you don't know the values of TA and TR, what would be logical to conclude about how they must have changed over that period?

This one is so simple, it couldn't stump an eighth grader who wastes most of math class staring out the window. For TB to increase on the right side of the equation, one of the two variables on the left side of the equation must have increased -- or perhaps both did, in some combination.

But what if you're an ideologue? And what if your ideology leads you to think a "TB" of 40 for this particular group is already high? And what's more, you vehemently insist that TR should be as low as possible, and that a lot of economic problems result from a high TR?

So what happens when you see:

TA * TR = 40

Jump to:

TA * TR = 55

It's clear to you what the problem is. TR! Because TR is always the problem! You don't spend a lot of time mulling over what may be going on here. You fixate on TR, because that's what you always fixate on.

In which case, your name might be Ari Fleischer.

Because this equation is really: "Taxable Amount (taxable income of the top 10% of the population) times the Tax Rate (tax rate of the top 10% of the population) = Tax Burden (the percentage of overall federal taxes paid by the top 10% of the population)".

Fleischer, President Bush's former press secretary, recently tweeted that the "Tax Burden" of the richest 10 percent soared from 40 percent in 1979 to 55 percent in 2007. The implication: the TR (Tax Rate) on this group is already high enough, and this group is carrying more than its fair share of the TB (Tax Burden).

But ideology -- his visceral dislike of taxation, and the welfare state, and wealth redistribution -- has made him too dumb to see how a simple equation works.

Because consider this thought experiment: if in 20 years, the income of the top 10 percent explodes and the other 90 percent of the population become their slaves and earn no income (and meanwhile the Tax Rate doesn't change at all), the top 10 percent will pay 100 percent of taxes (up from 55 percent). But what does that show? That they're being taxed too much?

Of course not. It shows that we've regressed to something akin to a feudal society.

There are two variables on the left side of this equation, TA * TR = TB. If you're an ideologue you tend to miss stuff like that. (See Mark Thoma proving here that, yes, the answer to the mystery of what happened with the Tax Burden does lie with "TA," as the richest scored the biggest income gains over the last three decades.)

But ideologues don't do nuance well. They also abhor cognitive dissonance.

This is why I think Peter Wallison has become a sort of trivial hand puppet for the right, a useless one-note screech owl in his vehemence that it was Fannie and Freddie that caused the financial crisis (and he apportions no blame at all to Wall Street's securitization machine). He can't see beyond his ideological blinders.

P.S. For those of you thinking that Fleischer's "tax burden" is a percent, not a straight-up number like 40, yes, I've simplified. But the argument isn't impaired by this simplification. The ratio just introduces a second layer of complexity. If you understand math, you know what I mean. If you don't, I can write it all out ...