Ccountant: Islamic Economic System

Accountant
The Pakistan
July-August 2007
Magazine of the Institute of Chartered Accountants of Pakistan
Islamic Economic System
Accountant
The Pakistan
July-August 2007
Contents
Vol # 41 Issue # 3
July- August 2007
PUBLICATIONS COMMITTEE
Chairman and Chief Editor Abdul Rahim Suriya, FCA Members Abdulwahid, FCA Abdul Rab, ACA Adnan Ahmad Mufti, ACA Ahmad Saeed, FCA Ahsan Ghaffar Mehanti, ACA Asif Jamal, FCA Faisal Habib, FCA Faisal Imran Hussain, ACA Fazal Mahmood, FCA Hena Sadiq, ACA Jehan Zeb Amin, ACA Junaid Haji Zikar, ACA Kashif Ilyas, ACA M. Arshad Siddiqui, FCA Muhammed Amin Bhimani, ACA Muhammed Mahmood Marfatia, ACA Omar Mustafa Ansari, ACA Raheel Abbas Rizvi, ACA Rahil Rafiq, ACA Shakil Akhtar Qureshi, FCA Sophia Ahmed, ACA
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Editor's Letter President's Page Faith and Finance Islamic Finance - Emerging Challenges of Supervision Dr. Shamshad Akhtar
Cover Story
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An Islamic economic system seeks to implement an economic system based on the equitable distribution of wealth, payment of zakat, and The Facets of Islamic Economy banking without interest. The launch Abdulwahid, FCA of Islamic bonds in the international Financial Corruption market that comply with a variety of Sadia Kaleem, ACA Shariah based criteria, and the recent rise in Islamic financial Wealth Distribution products and services offered in the Nadia Azhar, ACA West, further establish the growing popularity of Islamic finance and Agriculture economics. Mehreen Wahid
THE COUNCIL
President Imran Afzal, FCA Vice Presidents Rafaqat Ullah Babar, FCA Shaikh Saqib Masood, FCA Members Shahzad Hussain, FCA Nasim Hyder, FCA Syed Shahid Husain Jafri, FCA Farrukh Viqaruddin Junaidy, FCA Razi-ur-Rahman Khan, FCA Rashid Rahman Mir, FCA Ahmad Saeed, FCA Asad Ali Shah, FCA Abdul Rahim Suriya, FCA Mohammad Abdullah Yusuf, FCA Syed Mohammad Shabbar Zaidi, FCA Arif Mansur (Deceased) Dr. Faizullah Khilji (Retired) Executive Director Moiz Ahmad, FCA Secretary F. H. Saifee, FCA
Publications Coordinator Asad Shahzad
20 The Rise and Fall of Structured Credit Danish Ahmed Siddiqui, ACA 23 Credit Risk Management Abdul Razzaq, ACA 28 Reverse Mortgage Loan in India Dr. Pradeep Kumar Singh 32 Open Letter - Why it is Important to Maintain Audit Quality 34 View Point: In Conversation with Richard Dyson, President ICAEW
In-House
37 The Fall of The Soviet Union and The Rise of Russia 39 People 42 World in Focus 43 Books
EDITORIAL OFFICE
The Pakistan Accountant Chartered Accountants Avenue, Clifton, Karachi-75600 (Pakistan) Phone: 9251636-39 Fax: 9251626 E-mail: asad.shahzad@icap.org.pk Website: www.icap.org.pk
Students Section
44 What is a Corporate Credit Rating
The Pakistan Accountant can be downloaded from Institutes website at www.icap.org.pk The views expressed here do not necessarily represent the official policy of the Institute.
Editor's Letter
T
he fact that conventional financial institutions all over the globe are now recognizing Shariah compliant products as a valid category of their overall investment portfolios signals the growing maturity of the Islamic financial sector. Swiss and German banks are making efforts to implement elements of Islamic finance in their systems. The Japanese Government has recently announced issuance of sukuk bonds for infrastructure development, which indicates that Islamic financial products are attracting non-Muslims and even corporations seeking new means of acquiring capital. In order to maintain its popularity this sector must now seek integration in the emerging and developing economies of Southeast and South Asia. 'The Malaysian market accounts for most outstanding sukuk, but interest is growing in the rest of Asia, obviously in jurisdictions such as Indonesia and Pakistan.' This recent statement by the Assistant Vice President of Moody's Corporate Finance is ample evidence of the fact that Pakistan's potential as a center for Islamic finance is growing. Dr Ishrat Hussain, former Governor, State Bank of Pakistan, and Chairman of the National Commission for Government Reforms in Pakistan has noted that 'Islamic finance has to become part of global finance to survive, or risk catering only to a niche market.' The Muslim world, including Pakistan, must concentrate all efforts to implement and integrate an Islamic financial market into local markets. If Islamic finance is to become a major alternative in the global financial market, it must constantly innovate and modify itself to conform to global standards. In Pakistan's context, policy stability, sound regulatory framework, strong economic fundamentals, a thriving private sector and advanced communication infrastructure will be needed to boost the growth of the Islamic fund management industry in the country. .
The first Islamic bond was sold by Shell Malaysia in 1990. Since then, the demand for sukuk has skyrocketed.To date, most sukuk have been corporate, but the potential for a sovereign Islamic bond market could be huge. The UK Treasury and Japanese government are preparing to launch debut sovereign sukuk in 2008 representing growing worldwide popularity in Shariahcompliant debt issuance. The global outstanding sukuk issues totaled US$82.2 billion by the end of July 2007, and close to 62 percent of these were denominated in Malaysian ringgit. The growth of the sukuk market is expected to rise from US$600 million in 2002 to a staggering $70 billion in 2007, and according to ratings firms Bloomberg and Standard & Poor's, will rise to $100 billion in 2010. The growing popularity of sukuk owes itself to the fact that sukuk offer a share in the proceeds of a business venture rather than paying out interest. Sukuk replace coupons by payouts and are backed by tangible assets.
Abdul Rahim Suriya
July-August 2007
The Pakistan Accountant
President's Page
T
he Islamic banking and finance industry has seen tremendous growth in the recent years not just in Pakistan or other Muslim countries but in fact through out the world. Currently, over US$400 billion worth of funds are being managed by this industry via approximately 250 Islamic banks and institutions operating across the globe - a 45 fold growth since 1982 - and the figures are continuing to improve at an impressive rate of fifteen to twenty percent per annum. The products offered are not just used by the Muslim population, but an increasing number of non-Muslims are also being attracted to the ethical values of these products as more and more investors begin to realize that ethics and profitability in banking and finance do not have to be mutually exclusive. The products offered by the industry are also revolutionizing from being Shariah compliant products to Shariah based products. Introduction of such products has enabled the industry to seek its unique identity and to provide a credible alternative to conventional banking products. In order to keep up with the growing demand for Islamic financial products, conventional banks are branching out towards Islamic products, while Islamic banks are continuing to expand their product base. The Development Bank of Singapore (DBS) has recently established its Islamic banking and finance subsidiary, the Islamic Bank of Asia, to focus on wealth management and capital market instruments for corporate and private banking clients in the Middle East and Asia. The Reserve Bank of India (RBI) is exploring the possibility of setting up Islamic banks in India as a viable alternative to commercial banks, to attract even the non-Muslim majority to park their funds with these banks. The Unit Trust of India (UTI) is already running a $250 million fund for Muslim Non Resident Indians (NRIs) in the Gulf. Realizing the growing popularity of Islamic Banking, the central banks and other regulatory authorities throughout the world are trying to incorporate the products offered by this industry into their regulatory framework. In 2005, in an effort to align the Islamic and western fund concepts, the UK Treasury introduced similar tax treatment and relief for Islamic mortgages based on Ijara and Musharaka and for profit rates on Islamic savings accounts, as those enjoyed by conventional products. This important step by the UK Treasury has considerably improved the attractiveness of the industry in the UK. London, today is becoming the center of Islamic finance outside of Gulf. Important steps are being taken in Pakistan as well to increase the acceptability of Islamic banking by the masses. State Bank of Pakistan (SBP) has played an active role in streamlining the adoption of Islamic Standards and has issued instructions and guidelines for Shariah compliance in Islamic Banking institutions from time to time. The Institute's Committee on Accounting and Auditing Standards for Interest Free Modes of Financing and Investments has developed two Standards - IFAS 1 Murabaha and IFAS 2 Ijarah which have been notified by the Securities and Exchange Commission of Pakistan (SECP). Standards on 'Diminishing Musharaka', 'Profit and Loss Sharing on Deposits' and General Presentation of Financial Statements of Islamic Financial Institutions are also being developed to help the industry. The future of Islamic banking and finance looks bright. Strong, sensible regulation and continued governmental support would ensure sustainable growth of the industry. There is a need for rapid convergence of regulatory and auditing standards for Islamic banking and their products. We need bigger, more consolidated, convergent Islamic banks that can handle larger projects and compete successfully given that the emphasis in a non-interest based banking system is not so much on the size of the collateral than on the viability and success of the project itself. In order to compete globally, Islamic banks will have to look beyond short-term trade finance towards longterm equity financing. Of course, this would require expertise beyond conventional banking and the institutional infrastructure to support the growth of Islamic financial instruments. Given the enthusiasm being show by all concerned we can hope for a better tomorrow of Islamic banking in Pakistan.
Imran Afzal
July-August 2007
Cover Story
Faith and Finance

The Evolution of Islamic Banking and Finance (IB&F)
Islamic finance is essentially a contract-based system of financing, practiced according to the Islamic principles prescribed in the Shariah known as Fiqh Al-Muamalat (or Islamic Commercial Jurisprudence). Islamic banking and Finance (IB&F) operates on the principle of sharing of both profit and loss by the borrower. The first modern Islamic savings bank was set up by Ahmad El Najjar in the Egyptian town of Mit Gharnr in 1963. By the year 1967, nine such banks were operative in Egypt, investing mostly in trade and industry, without charging or paying interest, and sharing their profits with their depositors. These banks were essentially savings investment institutions. In 1971 The Nasir Social Bank was declared the first interest-free commercial bank though the bank's charter made no reference to Islamic Shariah law. In 1974 the Organization of Islamic Countries (OIC) established the Islamic Development Bank (IDB) to provide interest free, fee based financial services and profit sharing financial assistance to member countries. The mid 70s witnessed the establishment of several Islamic banks in the Middle East, notably the Dubai Islamic Bank (1975), the Faisal Islamic Bank of Sudan (1977), the Faisal Islamic Bank of Egypt (1977), and the Bahrain Islamic Bank (1979). Malaysia is another country with a strong presence of Islamic banking and financial system alongside a conventional banking system working in a competitive environment. The share of Islamic banking operations in Malaysia grew from zero in 1983 to above 8 percent of the total financial system in 2003. The Government has plans to enhance this share to 20 percent by the year 2010. Standard & Poors has assigned a BBB+ rating to the US$600 million Shariah compliant Sukuks (trust certificates) issued by Malaysia Global Sukuk Inc. Bank Negara Malaysia (BNM) has announced issue of new Islamic Bank licences to foreign players. The Financial Sector Master plan maps out the liberalization of Malaysia's banking and insurance industry in three phases during the next decade.
Origins of Islamic Banking in Pakistan

In Pakistan the legal framework of the country's financial and corporate system was amended on June 26, 1980 to permit issuance of a new interest-free instrument of corporate financing named Participation Term Certificate (PTC). An Ordinance was promulgated to allow the establishment of Mudaraba companies and floatation of Mudaraba certificates for raising risk based capital. Amendments were also made in the Banking Companies Ordinance, 1962 (The BCO, 1962) and related laws to
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Commission, it was essential for the introduction of a Shariah compliant financial system to have a legal infrastructure conducive to the working of an Islamic Separate interest-free counters started operating in all the financial system through launching a massive education nationalized commercial banks, and one foreign bank and training program for bankers and their clients, and (Bank of Oman) on January 1, 1981 through an effective media to mobilize deposits on profit and campaign to create public loss sharing basis. From July 1, awareness about the Islamic A Committee was 1982 banks were allowed to provide financial system. finance for meeting the working constituted in the Institute capital needs of trade and industry of Chartered Accountants of The CTFS constituted a Committee on a selective basis under the for Development of Financial Pakistan (ICAP), wherein technique of Musharaka. Instruments and Standardized the State Bank of Pakistan Documents in the State Bank to By January 1985 domestic banks prepare model agreements and were operating both 'interest-free' (SBP) was also represented, financial instruments for the new and 'interest-based' windows. From system. for development of July 1, 1985 all commercial banking accounting and auditing in Pak Rupees was made interestA Taskforce was set up in the standards for Islamic free. However, foreign currency Ministry of Finance to suggest ways deposits in Pakistan and interest on to eliminate interest from modes of financing. The lending of foreign loans continued Government financial transactions. as before. In November 1991 the Committee is reviewing the Another Taskforce was set up in the Federal Shariat Court (FSC) Ministry of Law to suggest standards prepared by the declared the procedure adopted by amendments in legal framework to Bahrain based Accounting implement the Court's judgment. the banks, based largely on markup with or without buy-back and Auditing Organization This Taskforce proposed arrangement, as un-Islamic. The amendments in the House Building for Islamic Financial Government and some banks/DFIs Finance Corporation (HBFC) Act to preferred appeals to the Shariat Institutions (AAOIFI) with a make it Shariah compliant by Appellate Bench (SAB) of the shifting back its rent sharing view to adapt them to our Supreme Court of Pakistan. operations to a non-interest based circumstances and if system. The amendment was On December 23 1999, the Shariat considered necessary, to promulgated, and in 2001 HBFC Appellate Bench (SAB) of the launched its Asaan Ghar Scheme propose new accounting Supreme Court of Pakistan gave its based on Diminishing Musharakah. landmark judgment banning interest standards. A Committee was constituted in the in all its forms and directed that laws Institute of Chartered Accountants involving interest would cease to of Pakistan (ICAP), wherein the have effect finally by June 30, 2001 State Bank of Pakistan (SBP) was also represented, for with exemption for dealing with foreign parties. Thus development of accounting and auditing standards for ensued the partial transformation of Pakistan's financial Islamic modes of financing. The Committee is reviewing system from interest based to Shariah compliant. Islamic the standards prepared by the Bahrain based Accounting banking and finance have since been operational in and Auditing Organization for Islamic Financial Pakistan parallel to conventional banking. Institutions (AAOIFI) with a view to adapt them to our circumstances and if considered necessary, to propose SBP's Commission for Transformation new accounting standards. include provision of bank finance through PLS, mark-up in prices, leasing and hire purchase.
of Financial System (CTFS)

The Commission for Transformation of Financial System (CTFS) was constituted in January 2000 in the State Bank of Pakistan under the chairmanship of I.A. Hanfi, a former Governor State Bank of Pakistan. According to the In September 2001 it was decided that the shift to interest free economy would be made in a gradual and phased manner and that the State Bank of Pakistan would consider:
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w setting up subsidiaries by the commercial banks for the purpose of conducting Shariah compliant transactions; w specifying branches by the commercial exclusively dealing in Islamic products; and banks
earning capabilities, future earning prospects of the bank, managerial capabilities, bank's liquidity position, track record of the bank's adherence to prudential regulations, credit discipline, quality of customer services and the convenience and the needs of the population of the area to be served by the proposed branches.
w setting up new full-fledged commercial banks to carry out exclusively, banking business based on proposed Islamic products.
SBP's Musharakah based Islamic Export Refinance Scheme (IERS)
State Bank of Pakistan has introduced a MusharakahAccordingly, the State Bank issued detailed criteria in based Islamic Export Refinance Scheme (IERS) to meet December 2001 for establishment of full-fledged Islamic the export financing requirements of banks conducting commercial banks in the private sector. operations under Islamic Modes. Al Meezan Investment Bank received Islamic Banking Institutes (IBIs) the first Islamic commercial banking While functioning can avail this facility under both license from SBP in January 2002 and parts of SBP's Export Finance within the framework Meezan Bank Limited (MBL) Scheme (EFS). The framework commenced full-fledged commercial of the IERS is based on the of Shariah, Islamic banking operation from March 20, concept of Profit & Loss Sharing. 2002. The State Bank shares the banks can perform a actual profit of the Musharakah Private sector Islamic banks have crucial task of resource pool of the Islamic Bank. been established and existing However, in case the actual profit commercial banks have established mobilization, their of the pool is more than ongoing subsidiaries and stand-alone branches rates under conventional EFS, to conduct Islamic banking. The State efficient allocation on the excess profit so received by Bank of Pakistan houses a full fledged SBP would be credited to the the basis of both PLS Islamic Banking Department and a Takaful fund, a reserve fund to Shariah Board comprising two Shariah be maintained by SBP under (Musharakah and scholars and three experts in banking, Islamic modes for risk mitigation accounting and legal framework to Mudaraba) and nonthat would be used to meet advise the SBP on Shariah future losses arising on compliance. PLS (trading and implementation of IERS.
Subsidiaries & Standalone Islamic Banking Branches (IBBs)
In January, 2003 the State Bank issued BPD Circular No. 01 outlining detailed instructions on setting up of subsidiaries and stand-alone branches for Islamic Banking by existing commercial banks. The criteria for subsidiaries are almost similar to the criteria for setting up scheduled Islamic commercial banks with emphasis on complete segregation of accounts of Islamic banking subsidiaries and the parent banks doing conventional banking. The subsidiaries shall have minimum paid up capital of Pak Rs. 1,000 million that is equal to the capital requirement for full-fledged commercial banks.
leasing) based categories of modes and strengthening the payments systems to contribute significantly to economic growth and development.
Future of Islamic Banking
With the refining of Islamic financing techniques and the need for infrastructure development in Muslim countries, Islamic banks are now participating in Shariahcompliant retail products to highly complex structured finance and large-scale project lending including power stations, water plants, roads and bridges.
The criteria for opening stand-alone branches pertain to financial strength of the applicant bank as evident from its capital base, adequacy of its capital structure, record of
While functioning within the framework of Shariah, Islamic banks can perform a crucial task of resource mobilization, their efficient allocation on the basis of both PLS (Musharakah and Mudaraba) and non-PLS (trading and leasing) based categories of modes and strengthening the payments systems to contribute significantly to economic growth and development. The Pakistan Accountant
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Islamic Finance Emerging Challenges of Supervision
Dr. Shamshad Akhtar Governor, State Bank of Pakistan
As traditional boundaries between banks and non-bank financial institutions erode, supervisors face a dual challenge of promoting financial diversifiction, on the one hand, and encouraging appropriate risk mitigation on the other. I. Background
Diversification and structural transformation in financial sector has been accompanied by increasing integration among different segments of the financial sector. The traditional boundaries between banks and non-bank financial institutions are eroding and we are witnessing the growth of universal banking and/or mergers among different segments of sectors. This trend has its benefits but has associated risks as well. Supervisors face a dual challenge. On one hand, supervisors are promoting financial diversification and consolidation to achieve market development and innovation. On the other hand, supervisors have to position themselves to recognize the new dimensions and types of risks and encourage appropriate risk mitigation. These considerations have triggered world wide debate on how to effectively supervise different segments of financial sector in conglomerate and universal structure. So far these debates had been concentrated around conventional banking but now it is widely gripping the world of Islamic Finance (IF). Stronger interdependencies among different segments of IF are emerging largely because Islamic Financial Institutions (IFIs), in principle, have features and inherent characteristics and more compulsion, than conventional banking, to conform to universal banking or to evolve inter-linkages among different market segments.
II. Factors driving cross-sector linkages and interdependencies

First and foremost, IFIs' depositors/borrowers desire to conduct financial transactions that are Shariah compliant. It can be assumed that a person preferring to bank with an Islamic bank will also seek to use other faith-based financial services such as Takaful and Islamic mutual funds. This faith-driven feature in itself forces and incentivizes IFIs to offer, along side bank-based services (i.e. deposit and loans), a wide range of financial services. As a result, Islamic banks end up undertaking non-core banking activities such as fund management, capital market operations, securitization, leasing, and housing finance. This has enhanced the degree of integration between various segments of IF. For example: Islamic banks are likely to be strongly integrated with the Shariah capital markets since on credit portfolio side, Islamic banks do not have the same investment avenues as those available to their conventional counterparts. The outcome is that Islamic banks either end up taking large exposure in the capital markets directly or acquire subsidiaries which primarily engage in such businesses. Second differentiating aspect is the nature of contractual arrangements that drive deposits mobilized by conventional banks as compared to Islamic banks. Conventional bank deposits are interest based contracts
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with guaranteed interest return whereas Islamic banks raise deposit on a profit and loss sharing basis in either a Mudaraba or Musharaka structure. Mudaraba/Musharaka contracts transform the Islamic banks' deposits into essentially a fund management product (although currently most regulators recognize these as equivalent to conventional deposit contracts) and this impacts the corresponding asset portfolio. There is a need therefore that Islamic banks acquire assets on a PLS basis as well and eventually move beyond fixed return products, like Murabaha and Ijara. This pushes an Islamic bank towards universal banking since in order to manage the portfolio profitability; it needs to invest across sectors in businesses based on Shariah principles, like equity and Sukuks in the capital market and trade contracts like commodity Murabaha, Musharaka, Ijara and Takaful. Thirdly, further development of Islamic banking itself depends on concurrent development of Islamic capital market. For instance, development of Islamic debt market is key to the provision of adequate liquidity support while providing additional investment avenues. Likewise, Takaful development is critical to provide insurance coverage to Islamic banking products, like auto and consumer financing, while strengthening secondary capital and Islamic bond markets by being a major buyer of Islamic instruments. It is the confluence of these factors that have induced regulators to encourage and IFs to promote rapid and deeper financial inter-linkages and integration.
These risks apply equally to both Islamic and conventional modes of finance. However, Islamic banks have thus far not erected firewalls, like conventional banks, to separate legally, financially and managerially their investment and commercial banking activities. Obviously these risks pose a challenge to the supervisors and necessitate that appropriate changes be made in the supervisory regime. Secondly, Shariah compliance issues necessitate taking a more aligned view across IF businesses as user of Islamic products may be oblivious of ideological differences as well as varying perceptions and interpretation of the Shariah advisors or boards and/or by regulators. Since institutions being supervised by one regulatory authority may be offering products of institutions being supervised by a different regulatory body, this could introduce complications and the challenge of ensuring uniform Shariah compliance across financial institutions and products. Thirdly, traditionally different segments have been regulated by their specialized supervisory authorities. These authorities have adopted risk management principles and supervisory stances which are strictly in line with the risk profile of supervised sectors in isolation. With sector integration, supervisors have to coordinate closely in policy formulation and regulation as well as onsite supervision. They have to coordinate creation of necessary firewalls, remove moral hazards and govern the degree of cross segment exposure. This may even call for institutional restructuring through merging various supervisory bodies into a single entity or for closer coordination between supervisors through creation of a third coordinating body.
III. Supervisory challenges posed by cross-sector developments

It is some of these above considerations that have augmented strategic alliances and linkages of various types among IFIs, both within country and cross borders. As such, IFIs are evolving either as part of a global financial concern or as a domestic bank acquiring or establishing subsidiaries and/or the two arms, i.e. Islamic and conventional banks coexist. Moreover, as the conventional parts of financial institutions move towards cross-sector integration, their Islamic counterparts (either as specialized window or as independent entities) will also follow eventually. While it has by now been well established that there are significant benefits of enhanced integration and interlinkages or conglomeration in IF, such as the economies of scale, operational synergies and effective use of scarce human resource, there are definitely certain risks1. In this area, I would like to offer few basic observations. Firstly, it is inevitable that enhanced exposure of Islamic banks into capital markets exposes them to the volatility in associated businesses. Likewise, conglomeration, whether through universal banking or through parent subsidiary model2, exposes them to a variety of issues such as contagion risk, regulatory arbitrage, high group exposures, conflict of interest etc.
IV. Sector inter-linkages of Pakistan's Islamic finance system

In Pakistan, besides offering trade loans, like Murabaha, Islamic banks are offering equity and quasi equity products, such as Musharaka and diminishing Musharaka, and investment banking activities such as loan syndication, structured finance, etc. The six full fledged Islamic banks with a network of 108 branches and another 58 stand alone Islamic branches of 13 conventional banks have registered phenomenal growth and as of April 2007, the Islamic banking sector constituted 3.3 percent of total banking assets. In view of the equity based nature of Islamic banking and lack of Shariah compliant financial instruments, central bank has allowed Islamic banks a relatively higher exposure (35 percent direct and 10 percent future of their equity) in capital markets compared to conventional banks (20 percent direct and 10 percent future). In addition, the State Bank of Pakistan (SBP) has relaxed statutory reserve requirement (SLR) for Islamic banks at 8 percent versus industry norm of 18 percent. The Pakistan Accountant
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Furthermore, Islamic banks are allowed to nurture parentsubsidiary/affiliate model whereby Islamic banks are by and large setting up asset management companies, brokerage firms and, now, Takaful businesses. Thus far the supervision of IFIs is bifurcated, with Islamic banks being regulated by SBP and non-bank IFIs, namely, Modarabas, Islamic mutual funds, Takaful companies and securities operations under the regulatory oversight of Securities and Exchange Commission of Pakistan (SECP). Sector specific supervisory approach is also characterized by varying regulatory requirements vis-vis operational matters, governance framework and Shariah compliance across the range of IFIs. The differences extend to minimum capital requirements ranging from Rs.6 billion for Islamic banks (by the year 2009), Rs.500 million for family Takaful operators (by the year 2011), Rs.300 million for general Takaful operators (by the year 2011) and Rs.30 million for Islamic fund managers to Rs.2.5 million for Modaraba management companies. The low capital base of financial institutions, engaged in the business of Takaful or fund management, poses a significant risk to the solvency of financial conglomerates that characterize the Islamic financial markets. In terms of financial reporting, Takaful companies are not required to circulate quarterly accounts among shareholders whereas all other Islamic financial institutions are required to do so in terms of the legal and regulatory framework. The segregated supervisory approach has resulted in carving of legal framework specific to each sector for both conventional banks and IFIs3 but eventually there is a need for addressing the idiosyncratic nature of IF industry, products and market players. Moreover, with regard to IF, both the regulators are following different approaches towards Shariah compliance in the institutions regulated by them. SBP requires Islamic banks to appoint Shariah advisors according to a prescribed fit and proper criteria and a Shariah Board has been constituted at the level of SBP to deal with issues relating to Shariah interpretation and compliance among Islamic banks. SECP's approach varies across different segments of IF. A Religious Board, constituted by the government, is responsible for approving the prospectus of each Modaraba containing the types of business to be conducted, management, etc. While the Religious Board has a significant role, there is no requirement for Modarabas or their management companies to appoint Shariah advisers at individual fund level. Islamic mutual funds and Takaful operators, on the other hand, are required to appoint Shariah Council/Boards but no explicit fit and proper criteria has been laid down by SECP in this regard. SECP is also authorized to appoint a Central Shariah Board under the Takaful Rules, 2005, which has not been established as yet. The greatest challenge resulting from different Shariah compliance practices followed by Islamic banks, Modarabas, Takaful companies, etc. is the reputational risk faced by IFIs
and misperceptions in the minds of public about Shariah compliance. This issue, therefore, needs to be addressed through coordination amongst the supervisors. Another issue arises from overlapping supervisory jurisdiction. The Banking Company Ordinance allows banks to act as Modaraba management companies for floatation of Modarabas. In terms of Modaraba Companies Ordinance, Modarabas can be formed to conduct any type of business, which is permitted under Shariah, be it trading, manufacturing, airline, financing, leasing, services, etc. and these are regulated by SECP. Due to overlapping regulatory jurisdictions, banks are floating modarabas through separate subsidiaries 4 resulting in higher administrative, set up and regulatory costs. For sometime (from 1991-1997), these Modarabas were under the regulatory control of SBP, but the powers relating to licensing, winding up, etc. were retained by SECP; consequently the regulatory authority has been reverted to SECP. Again, this highlights the need for cross sector regulation of IFIs. Eventually there is a need to develop mechanisms for oversight of financial sector in an integrated manner. Besides coordination and cooperation among regulators, there is a need for consolidated supervision framework for financial institutions, guidelines for consolidated public financial statements and application of regulatory prudential limits on group wide basis and coordination to examine the intra group linkages with industrial and commercial entities. While conventional and Islamic financial industry would have to adopt similar approaches to integrated supervision, it has to be recognized that the latter is a relatively nascent industry and hence the targets should be modified to match the ground realities.
V. Conclusion
IFSB's ten year roadmap has highlighted the cross sector nature of IFIs and the resultant need for supervision to evolve accordingly. It is in recognition of these factors that IFSB has sought to broaden its membership to securities and insurance supervisory authorities as Full Members of IFSB. IFSB's efforts for developing Islamic regulations as well as accounting, auditing and governance standards will facilitate adoption of unified principles for the development, operation and regulation of Islamic financial services. ---------------------------------------------------------------------------1. Financial Sector Regulation: Issues and Gaps, IMF 2004 2. Universal Banks: First structure is of universal bank, in which all financial operations are conducted within a single corporate entity. The second model is the parentsubsidiary or operating subsidiary model, in which operations are conducted in and regulated as subsidiaries of another financial institution, usually (but not necessarily) a bank. Finally, in a holding company model activities are conducted in legally distinct entities, each with separate management and capital but all owned by a single financial or sometimes (unregulated) non-financial institution 3. Fund management, as used here, refers to management of Islamic mutual funds and Modarabas. 4. A number of banks have formed subsidiaries and floated modarabas like NBP, HBL, ABL, Habib Metropolitan Bank, etc. No Islamic bank has yet floated a Modaraba.
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The Facets of Islamic Economy

Abdulwahid, FCA Several institutions, universities, and research centers are involved in carrying out research work on various aspects of an Islamic Economy. This article summarizes some of the key issues in an Islamic economy.
By the middle of the 20th century, many Muslim countries had been freed from the shackles of colonial rule. These countries were looking for development and improvement in every field, specially their economies. Being predominantly Muslim, they were naturally inclined to adopt the Islamic Economic System. Consequently, a lot of literature was produced in a short time on the subject of Islamic Economics. Several institutions, universities, and research centers are involved in carrying out research work on various aspects of an Islamic Economy. This article summarizes some of the key issues in an Islamic economy. Economics, as one of the social sciences, needs to resort to history in order to derive the long-term trends of economic variables. History provides economics with two major indispensable aspects, namely, the history of economic thought and the history of economic units such as individuals and firms. Little has been done to present the history of Islamic economic thought. There is no documented 'Economic Theory of Islam' and not much formal writing in the area of Islamic economics. This is unfortunate and the need of the hour is to bring to light the economic theories of great Islamic thinkers. The first attempt to demarcate the boundaries between the economic philosophy of Islam and subsequent economic theories was made by Al_Sadr in 1964, followed by Muhammad Najatullah Siddiqi in 1971.
Islamic Banking
Islamic banking is the most popular and well-known instrument of Islamic economics. It is prevalent in both Muslim and non-Muslim countries. Main reason for its success is the belief of Muslims that the profits derived are interest free and allowed in Islam. If there is any defect or fault in this, the onus is on the religious scholars who are certifying them as Shariah compliant. Muslims in the oil producing and developed countries hold substantial cash and liquid assets. To attract their deposits conventional banks have also established their branches or at least counters for Islamic banking. Many Muslim scholars have argued that borrowing for expansion of business is a commercial deal and the borrower must pay some share of the profit to the lender. Profit sharing in a business is a sharing in the net profit. Islamic bankers and scholars do not openly define the factors involved in interest bearing. They try to convince customers that every sort of financing scheme provided by these titled Islamic banks falls within the gambit of
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Islamic banking, which is not the fact. They also claim that any agreement between the borrower and lender also makes it Islamic. Over a period of time, measures taken to promote Islamic banking have not been very ethical. For instance, in 1979, when profit loss sharing (PLS) banking accounts were introduced to replace Savings Bank (SB) accounts in Pakistan, the rate of profit for the first half year was 9 percent per annum which went on decreasing till it came down to 1 percent last year. What could be the justification for such a big dip. Was this merely a ploy to attract the public towards PLS by offering a very high rate of profit?
Theory of Production
The production theory in a capitalist economy encourages production from cheaper sources, with highest possible profit margins. In a socialist economy, production should be based on the requirements of the public. In Islamic economics, it is a combination of both; production should be based on the requirement of the masses at a cost affordable to them.
Motives of Production
Islamic view of man and universe is that man should derive all possible advantages from God's universe. There are two ways to regularize these, first by ethics and secondly by legislation. Ethics are teachings of Islam from Qur'an and Sunnah, while legislation is man made in the form of rules and regulations. Every entrepreneur wants to make profit and if he does not follow the ethics of the Qur'an and Sunnah, government is bound to limit his profit.
Theory of Consumption
This theory has developed in the capitalist economy. In the Islamic way of life, social values and consumer ideology are much different. Islamic economists have criticized the prevailing theory of consumption, but have failed to provide an alternative. This theory can be split up into three parts: a. Rationalization of consumer behaviour b. Concept of goods and services c. Ethical considerations for Muslim consumers Consumer behaviour in the West developed on the basis of utility, capitalism, and with an eye on commercial success and concentration of wealth. The theory of consumption in capitalism is based on maximum acquisition. The traditionalism of consumer in an Islamic system has the following elements: (i) Concept of Progress Islam does not allow for selfishness and the concept of success depends on the welfare of every one irrespective of their financial or social status. Islam does not restrict material progress, but desires that everyone's basic necessities be met.
Objectives of Production
Under an Islamic economy, a Muslim producer shall not make a heavy profit; his goal is the Hereafter. This has three important implications: a. Moral values as established in the Holy Qur'an prohibited items and industrial activities that are not allowed are specified. b. Social aspect in the production process and distribution of benefits in the most equitable manner are the prime economic objectives. c. The problem is not shortage of production or supply, but human inefficiency in reaping the full benefits of God's benevolence. Islam recognizes the right of the less able in the wealth of those who have greater ability or the opportunity to produce greater wealth (Mirakhor,1989).
(ii) Concept of Wealth: Wealth in Islam is only God given. Holy Qur'an provides us with a unique concept of products and commodities; the word Al Tayabat meaning good, pure, clean and wholesome things has appeared in Quran 18 times, the second word Ar-arizq reported in Holy Qur'an 120 times, means godly or divine. It means that all commodities are God given. (iii) Ethics of Consumption: All the consumables are God given and for everyone. It is only by chance that few are holding more than their share. In Qur'an, Allah rejects the argument that the rich do not owe to the poor.
Macro Economics
Islam has the most efficient system of Macro Economics. Zakat can alleviate poverty. Qarze Hasna or Interest free loan can meet the financial requirements of all. Interest / profit on capital is included in the cost of production. If it is reduced, cost shall be reduced and prices will come down for the benefit of the public. The Islamic system of economics is based upon the balance between personal benefit and the benefit of society as a whole. The Pakistan Accountant
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Financial Corruption
Sadia Kaleem, ACA
Like other religions Islam also dislikes and loathes frauds, financial scandals, cheating, bribery, or taking undue advantage of one's position. According to Sunnah: "Bribe payer, receiver and the middle man, all shall go to Hell." No country is completely free from the evil of corruption. Generally speaking, the poorer a country the more corrupt it is. A political system, which is unrepresentative and unaccountable, makes it worse. Corruption does not mean bribery alone. To counter this problem in Pakistan, the federal and provincial arms of the National Accountability Bureau (NAB) are functioning. They deal with cases referred to them. These cases generally involve huge amounts of money and are against government officials, politicians and businessmen. Financial Corruption is not a new phenomenon. In the days of Akbar, the great Mughal Emperor, one of his courtiers was notorious for corruption. After receiving numerous complaints against him, Akbar assigned the corrupt man the duty of counting the waves of the River Jamuna near Delhi. Akbar then forgot about this assignment. After two years the emperor happened to visit the site and was surprised to see a big palace on the bank of the river, while the corrupt man was still performing his duty of counting the waves of the river. The emperor appointed an investigation committee, as is done these days after some unsavory incident has occurred, to investigate the matter. Next day he was told that people crossing the river, washing their clothes, taking baths, cleaning their buffaloes, and passing boats etc. had to pay a few coins, because by their acts they were disturbing the waves, while according to the emperor's orders, the waves had to be correctly counted. Financial corruption at lower level, involving petty amounts of cash, may be on account of the following reasons: 1. Income is limited while expenditure is unlimited. People resort to corruption to meet their needs. 2. In old age, future is neither safe nor secure, and so everyone plans to save for the future. When pension may be the only source of income and needs would go up- medical expenses, higher food costs, daughters' marriages, house rent if currently living in government
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provided housing, would become an extra financial burden. This uncertain situation may induce some people to resort to corruption. 3. Undue comparison with others. People compare themselves with others in many aspects, say ownership of mobile phones, cars, clothes, residence, furniture, electronic equipment and even in the number of servants, drivers, babysitters, maid servants, guards, gardeners etc. that they employ. People may resort to financial corruption to meet their exaggerated needs. A person may pay bribe for the following reasons: 1. In government offices, there is pending work at every desk and so every visitor is asked to come after four or five days. The visitor has spent time and money on conveyance and so to save that expense at a later date, he would be willing to pay the bribe. 2. Sometimes a public person is in urgent need of a matter and has to pay bribe as urgent service charges. 3. To receive undue favours - to outclass others and to get what they are not entitled to. Now the question arises where and how these corrupt people keep their unlawful bribe collection. The following might be used singly or jointly with one another: 1. The first use of bribe money is at home, in domestic expenditure on both consumable and durable items. Consumable items are not visible to outsiders while the durable items come to the knowledge of the public or at least to visitors, guests and relatives. 2. Prize bonds. At present prize bonds are for maximum of Rs 40,000 each, purchasable and sellable at the bank counter without any questions asked. 3. Other bearer items like shares, with open transfer deed, foreign exchange viz. euro, dollar, sterling pound, and yen etc. 4. Real estate is the main item where the value of property shown is hardly 20 to 25 percent of the actual value and therefore 75 to 80 percent is paid off the record i.e. through black money.
5. Benamis and Power of Attorneys are the other modes of investment of black money. In big towns, small houses and bearer files for plot schemes exchange hands. These are also financed by black money. 6. Illegal money collected through financial corruption is also a source of capital, out of which new businesses, industries, buildings are acquired or expanded.
To control bribery or palm greasing, following measures may be considered: 1. Bearer investments (prize bonds, shares with bearer transfer deeds, bearer real estate documents etc.) should be totally discontinued. 2. Every citizen with wealth, at present market value above a figure, say in Pakistan, Rs. 1 million, must compulsorily declare his wealth on the closing of the government financial year whether his income is exempted from income tax or not, like agriculturists. Such persons should also file their expenditure statements for the year. 3. Lockers should be made transparent to the tax authorities. 4. Money laundering is the main source of movement of black money. Foreign exchange agents are very much available almost in every country. Their transactions are not recorded. Bank accounts in foreign countries, specially Switzerland, also need to be checked. 5. Size of currency notes should be bigger and thicker. Credit Cards and Debit Cards should be encouraged and their usage should be made common. Any bank charges should be on the seller and not the cardholder. 6. For real estate, owners should be allowed to declare the actual value of their property and the rate of stamp duty and court fees be reduced proportionately. 7. Currency notes of big denomination should be discontinued. 8. Cheque payments should be made reliable and safe. Sadia Kaleem, ACA, is also Chartered Secretary (England) and has passed Chartered Cost & Management, UK.
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Wealth Distribution
By and large, the main source of wealth is inheritance. Other sources could be windfall, and an individual's own labour and hard work. According to Islamic teachings the factors of production are to be paid immediately and equitably. Therefore, Islamic principles of factors' pricing are basically based on these teachings, and are geared towards avoiding concentration of wealth in few hands. In the early days of Islam, Hazrat Usman (RTA) was a very successful and wealthy businessman who made good profits from his business deals. As such it can be said that Islamic principles do not prohibit creation or accumulation of wealth, provided it is through clear and clean business deals. Islam desires equity in the distribution of wealth. However, in-equality is not taken care off by functional distribution of income, but is through transfer payments, that is, the transfer of income and wealth from the well-off people to those living below the poverty line. The philosophy is that wealth is created by Allah and belongs to Him. The right to property granted to a person is just a delegation by Allah, its Owner, to His agent (man), and the agent has to use it only as per His orders and instructions. Distribution of wealth, in Islam, is through three types of transfers: 1. Compulsory 2. Recommended 3. Inheritance 1. Compulsory transfers: There are several compulsory levies, ranging from 20 percent of the output (Ushr) to 2.5 percent of wealth (Zakat). Sadaqah tul Fitr, although very negligible in value, is also a compulsory levy for the benefit of poor on Eid ul Fitr. w Zakat: It is a well-known subject among Muslims. No doubt, different scholars have different views on various provisions of Zakat such as assets on
Nadia Azhar, ACA
which Zakat is levied and assets exempted from Zakat. There is also some difference of opinion about who is eligible for Zakat, and the method of distribution and disposal of Zakat. In the Holy Quran, the order to the Prophet (PBUH), who was also the chief of government, was: " Take from their wealth to clean it." This practice of centralized collection continued for about seven centuries. After Chingez Khan conquered Baghdad, Zakat came to be disbursed through mosques, and is now mostly paid individually. In the Quran, Allah's directive to the government is to collect Zakat. In Pakistan, it is in practice for more than 25 years, but the public's perception is that it is not being properly distributed. w Ushr: It is levied not on wealth, but on production. Its dictionary meaning is one-tenth. On agricultural production by own cultivation it is mostly one- tenth, and if it is due to rain then one-fifth. Similarly, fishing, mining, fruit gardening, sea products, etc. are also liable to Ushr at different rates of up to 20 percent. Zakat is to be distributed among: w w w w poor persons; miskeen, who are poor, but don't look like fakirs; employees of Zakat collection and administration; converts to Islam to foster friendship and cooperation that might strengthen Islam and newly converted Muslims; for the purpose of freeing slaves; those under debt and loan; in the way of Allah, which may include printing and distribution of Islamic literature, publicity, salaries of Islamic movement workers, etc.; wayfarer
w w w
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Ushr collection is to be utilized for providing financial assistance and food to the poor. 1. Recommended transfers: Apart from zakat Muslims have been directed by the Prophet (PBUH) to not eat a full meal if their neighbor is hungry. There is no limit on payment to meet such needs. Such payments are not out of mercy or kindness but are the right of the needy and poor. Hazrat Ali (RAT), the fourth caliph, put it in the following words: "Allah has ordained that the rich are to pay out of their wealth to the extent which is sufficient for the needs of the poor, so that if they do not find food or clothing, or struggle (unsuccessfully for their living) it would be because the rich are not doing their duty, and Allah will take them to task on the Day Of Judgment and will punish them. 2. Inheritance: In the Holy Quran and Sunnah, distribution of inheritance and its ratio and proportion are given in detail. According to Sunnah, if a pious man dies without proper distribution of his inheritance, all his good deeds shall go to waste. On the other hand, a man with not many good deeds to his credit, or who is not of a religious persuasion, shall go to Heaven if he distributes his inheritance properly. In different religions and cultures, different ways of distribution of inheritance are practiced. In one, only the eldest son is entitled to the whole wealth of the deceased. In the other, only sons are entitled to it while daughters are deprived of it. In Islam, the Quran outlines the principles as follows: "Allah enjoins you concerning your children's (inheritance), to the male (son), a portion equal to that of two females (daughters); but if there be only daughter, two or more, two-thirds of what the deceased leaves is theirs; and if there be one, for her is the half. For his parents, to each of them is the sixth share of what he leaves, if he has children; but if he has no child and (only) his parents inherit from him, for his mother is the third; but if he has brothers (or sisters), to his mother is the sixth, after (payment of a bequest, he may have bequeathed, or a debt); your parents and your children, you don't know which of them is nearer to you in benefit; this is an ordinance from Allah. Allah is surely all-knowing and all-wise." The heirs may be grouped in various ways and the principles of distribution amongst them are mostly explained in the Holy Quran. Parents should not differentiate among their children. They are allowed to gift them. They can also make bequest in favour of a person not a legal heir, not more than one-third of his assets. All these conditions are imposed to avoid concentration of wealth in a few hands.
State and Wealth Distribution:

Our Prophet (PBUH) was the head of the government also and so all directives and instructions to him are also to be followed by Muslim governments. In the last fourteen centuries, the financial position, importance of money, sources of income, concentration and collection of wealth, social status, rights of neighbors and family members have all changed. Looking towards other religions, we see that in all three religious books followed by the Jews and Christians, as they exist today, the direction of God is to bring 10 percent of the income to one's own household. It appears that this formula was the basis of introducing the income tax as the noble men, two or three centuries ago, in this field were Jews or Christians and they must have derived the formula for charging income to meet government expenses, from these Holy Books. It is the responsibility of the government to reduce the difference in income and wealth of the rich and poor by levying taxes on income and wealth, except those assets on which Zakat has been paid. Islam does not impose any restriction on setting up factories and business units that are not against public interest and Islamic teachings. Government may also have some industries in the public sector, particularly public utilities, defense industries, heavy industries, etc. where private establishments are risky or are against public interest. To achieve this objective government may prohibit certain industries for the private sector and even nationalize some of the private established industries through payment of compensation, which it considers to be run well under the public sector. The basic needs of the public are the responsibility of the government. According to Hazart Umar (RAT) everyone has equal rights in the wealth of the community. Poor, unemployed, handicapped etc. are the responsibility of the government. According to the second Caliph, he (the Caliph) will be questioned on the Day of Judgment, if a dog dies of hunger on the side of the River Nile.
Conclusion:
Concentration of wealth is not allowed in Islam. Poor, unemployed, widows, handicapped etc., as per Islamic teachings, have a right to the wealth of the rich people. Laws of inheritance, compulsory collection of Zakat, other moral obligations, as per Islamic teachings, are to meet the requirements of the poor, which at present is being undertaken by various NGOs in different fields and different areas. However, in an Islamic economy the basic responsibility to maintain equity in income and wealth falls on the government.
Nadia Azhar ACA is also ACCA. She is a partner in a professional firm.
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Agriculture
Mehreen Wahid
The main ingredient for agriculture is land since without land there can be no agriculture. At the beginning of human civilization, population was little and land was in abundance so there was no question of ownership of land. Till a few centuries ago, cultivation on any land was not a problem i.e. whosoever cultivated, harvested, and whatever one sowed or reaped. Man is not the creator of anything. Allah has created everything for him. Ownership is a trust vested in the owner by God. According to Surah Al-Baqarah: He it is Who created for you all that is on earth. (2:29) On earth will be a dwelling place for you and an enjoyment for a time (2:36) Who has made the earth a resting place for you and the sky as a canopy and sent down water from the sky and brought forth therewith fruits as a provision to you. (2:22) The Holy Quran describes the personal and individual ownership of everything consumable or durable or productive. In short, Allah has created all these for the benefit of human beings and not only for the owner. Islam permits all types of commercial activities and creation of wealth, but does not allow for it to be held for the benefit of oneself only. The poor of the nation are also the responsibility of the rich and they have a right to their wealth. Land is of different types viz. owners' land, trust land, government land, uncultivated land, bordered land, surrendered land, and residential area. 1.Owners' Land It is owned by someone, inherited, or purchased or its ownership is due to any other reason. 2. Trust Land It is land which the owner has assigned for charitable purposes, for example, education, mosque, publicity, Islamic workers, etc. 3.Government Land It is land that is owned, controlled and retained by government. 4.Uncultivated Land It is away from the cultivated area 5. Bordered Land If someone raises the borders by constructing a stonewall around an area by preserving it for himself for cultivation at a later date.
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6.Surrendered Land If any cultivator or owner is not in a position to keep it up, he may surrender it for the use and benefit of others. 7.Residential Area It is the part of the village which has been used for residential purposes like school, playground, hospital and such other amenities. No doubt individual or a group of persons on joint basis can own the land. However, it should be used for the benefit of general public and its use must not be harmful to others.
Imam Abu Yusuf are also in favour of it, but Imam Abu Hanifa and Imam Shafaee do not consider it proper. Maliki scholars allow it with some more conditions. 3. The third situation is when land is of owner, cultivation is by farmer, both provide seeds and agricultural equipment and the product is shared at an agreed ratio. Imam Shafaee has not allowed it. Imam Malik allows it with some more conditions. 4. The fourth position is when the land, seeds and equipment all are provided by the landlord and the farmer puts in labour only and the crop is shared at an agreed ratio. Imam Hambal, Imam Abu Yusuf and Imam Muhammad support this situation but Imam Abu Hanifa, Imam Malik and Imam Shafaee do not consider it proper. 5. According to the scholars following Imam Malik, land rent, labour wages and rent of agricultural equipment should all be fixed in terms of money beforehand. Both provide equal quantity of seeds and when the crop is ready they shall first get compensation for items provided as agreed and in cash. Then the balance should be shared as agreed. The basic conditions for sharing cultivation as planned are: a. Land is fit for cultivation; b. Area is fixed; c. Situation and location of the land is defined; d. Farmer should have a free approach to the site; e. The period should be fixed, at least sufficient for an entire crop. Agreement may be for the crop if not for the fixed period i.e. from sowing to harvesting.
Sharing Cultivation
If one owns the land and the other cultivates it, it is called Sharing Cultivation. Several verses of Sunnah are in its favour and some are against it. Land taken on rent for agriculture is different from other assets taken on rent. There can be unforeseen damages that can destroy the total crop. If it is rain cultivated area and there is no rain, there will be no production and so the tenant will be totally in loss. The land which is waterlogged or saline, in other words, is not fit for cultivation. Letting it out on rent is not allowed. If there is no crop for reasons beyond the tenant's control, no rent shall be payable. Fixing of rent subject to certain conditions is not justified. Similar to other assets on rent, land rent should also be free from the condition of earning profit by the tenant. The tenant may sell the product at high profit, low profit, at cost, or at loss. It does not affect the owner or the rent agreed. The cost of natural acts like floods, locust swarms, or insecticides destroying the crop in full or in part is borne by the tenant. It is up to the landlord to forego or discount the rent. In certain cases, land revenue, water charges, agricultural taxes, etc. are payable on the land so rented out. It may be clarified at the time of making the rent agreement as to who shall bear how much of these taxes. According to the scholars the Prophet (PBUH), himself, cultivated on sharing basis. Thereafter several examples of such cultivators by his followers are confirmed. There are many types of cultivation on sharing basis, some of which are: 1. Landowner provides only land while the farmer uses his owns seeds and equipment. According to Imam Hanifa, it is not allowed but Imam Muhammad and Imam Abu Yusuf allow it. Imam Malik and Imam Shafaee disallow it. 2. The other type is that the landlord provides the seeds also and the product is shared at an agreed ratio. Hanafi scholars confirm it. Imam Muhammad and
Sharing agriculture is just like Modaraba where one has capital and the other is working on it. But the difference is that in shared farming the capital which is land will never be lost. While in Modaraba, the whole investment may be lost. Landlords are sure to get some profit but not to share the losses, while in Modaraba the financier may have to loose his capital. According to Sunnah and the practice of our Prophet (PBUH), ownership of land is allowed. Cultivation on sharing basis which is very much beneficial for poor landless farmers is also allowed in Sunnah and Fiqh. Mehreen Wahid, is a CA finalist.
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The Rise and Fall of Structured Credit

Danish Ahmed Siddiqui, ACA
How the Sub Prime Mortgage Crisis in the US became a global financial crisis
In recent months financial markets of the world witnessed another episode of credit related problems. While this is not something completely new or unexpected, this is peculiar in the sense that the markets had largely ignored the warning signs flashed near the end of the last year by various banks when they issued profit warnings on the back of expected losses from the sub prime lending in the US. The wave started in the US by March this year and, despite reassurances from the Federal Reserve (Fed), continued to grow stronger as the economic data started to show signs of economic slow down. It continued to gain momentum and by June Merrill Lynch sold collateral to recover its investments in two hedge funds managed by Bear Sterns that had invested in securities backed by sub prime loans. However, US markets still remained positive of the future and Dow Jones gained 2.2 percent on 6 August despite the country's 10th largest mortgage lender American Home Mortgage Investment Corporation's filing for Chapter 11* bankruptcy protection on the same date. The reason for the filing was inability of the company to renew existing funding or raise new funds for its business. ---------------------------------------------------------------------------* Chapter 11 is a chapter of the United States Bankruptcy Code under which a troubled business or its creditors can file with a federal bankruptcy court for protection. A Chapter 11 filing is usually an attempt to stay in business while the court supervises the 'reorganization' of the company's contractual and debt obligations. The fear of losses from the sub prime credit started to manifest itself into a liquidity crunch as investors decided to cut their losses and move on to other sectors which looked more promising. On 8 August a $4.9 billion merger deal was put off because the acquirer suffered a billion dollar losses in its mortgage subsidiary which faced problems in financing its operations. On 9 August BNP Paribas stopped valuing its three funds and suspended all withdrawals by investors considering the evaporation of liquidity. Goldman Sachs's largest fund reported 26% losses in 2007, later it announced that another if its funds lost 28% of its value in one week and was bailed out by investors who put in $3 billion. By this time investors had started to move away from the credit market, share prices of mortgage lenders and investors in those lenders around the world fell and liquidity started to dry up. The crisis hit Europe and reached as far as Japan and China, stressing the global nature of the economy. As could have been predicted, the Fed, European Central Bank (ECB) and Bank of Japan (BOJ) stepped in to bail out the markets and injected billions in the bond markets to provide much needed liquidity. The Fed went as far as cutting the discount rate by 50 basis points while keeping the Fed rate same and temporarily allowing Citibank and Bank of America to support their investment banking arms using the federally insured retail bank money.
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Sub prime Mortgage Crisis in US

w The sub prime mortgage financial crisis refers to the sharp rise in foreclosures in the sub prime mortgage market that began in the United States in 2006 and became a global financial crisis in July 2007. Rising interest rates increased newly-popular adjustable rate mortgages (ARMs) and property values suffered declines from the demise of the housing bubble, leaving home owners unable to meet financial commitments and lenders without a means to recoup their losses. w The effects of the meltdown spread beyond housing and disrupted global financial markets as investors, largely deregulated foreign and domestic hedge funds, were forced to re-evaluate the risks they were taking and consumers lost the ability to finance further consumer spending, causing increased volatility in the fixed income, equity, and derivative markets. w Sub prime woes have been blamed for causing the U.S. dollar to continue its decline. w Sub prime mortgage refers to a loan to a borrower who does not qualify for market interest rates because of poor credit history, or the inability to prove that he has enough income to support the monthly payment on the loan for which he is applying. Since the borrower is considered sub prime, lenders charge a greater interest rate to make up for possible default on the loan. Sub prime loans or mortgages are risky for both creditors and debtors because of the combination of high interest rates, bad credit history, and murky financial situations often associated with sub prime applicants. The crisis posed a threat to the global economy and has highlighted various market related issues and the debate may lead to interesting conclusions. Many have blamed it on the sustained level of high liquidity in the market which was supported at least in part by the structured credit and markets, a lack of market's detailed understanding of the risks of structured credit products and the role of rating agencies in incorrect pricing of the structured credit products. A liquid market searching for profitable venues responded positively to these structures. A key feature of these structures was the ability to issue investment grade debt backed by non investment grade assets which encouraged banks to flex the lending criteria applied to retail borrowers which in turn helped to sustain the liquidity in the economy despite the rate increases in 2006. Many of these structures are set up by larger banks which also provide some contingency liquidity line or guarantee to help these through difficult conditions. However, if the situation becomes very bad, as has been noted recently, the level of liquidity support required may affect the rating downgrades or compulsory winding up under the investment agreements. In some cases the parent may not be willing or able to provide the support. As a short term measure, central banks took steps to provide liquidity by injecting funds, cutting rates and allowing deviations from the regulations. However, if macro economic factors that lead to the higher liquidity e.g. emerging market growth and corporate profits still remain positive investors may soon be lured again into investing in high yield assets - probably a different class of assets, but may as well be in the structured products after the prices reflect the fundamentals and there is better awareness of the true exposures.
Fostering liquidity
The recent liquidity crunch in the markets has ironically been attributed by some to a prolonged period of high liquidity in the market which was fostered by low interest rates, growth in the foreign exchange reserves of the growing Asian economies and healthy corporate sector. Low interest rates encouraged consumers to borrow specially as house prices increased consistently over the last few years. This created demand for credit which might not have been met equally by the supply if it was not for a lack of profit opportunities elsewhere in the debt market. As the booming Asian economies invested their foreign exchange reserves in the risk free US Government bonds they drove the prices up and lowered the yields which made them less attractive for the profit seeking investors. In search of profits, investors turned to risky alternatives which put a similar pressure on the prices and yields of the non investment grade debt and soon the spread between the investment and non investment grade bonds narrowed to a level where the returns on non investment grade bonds no longer seemed attractive. The financial markets responded to this situation by creating structured products that promised better returns.
Promise of returns
Structured credit products generally offered high returns compared to other instruments with the same rating and also allowed investors to take derivative exposure but present it as investment in bonds in their accounts. The The Pakistan Accountant
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provide some contingency liquidity line or guarantee to help these through difficult conditions. However, if the situation becomes very bad, as has been noted recently, the level of liquidity support required may affect the Fairer values and truer rating downgrades or exposures Market's uncertainty as to the true compulsory winding up exposures of the market participants under the investment to the sub-prime lending also agreements. In some contributed to the chaos. This highlighted the need for better and cases the parent may timely disclosures on risk exposures especially for complex structures. not be willing or able to provide the support. Accounting standards allow the use of
housing market meant low recovery rates and high losses for the mortgage lenders. Lending to the subprime sector in some aspects is similar to a bet on the real estate than pure credit lending. The bet was that house prices will continue to rise in the US and current expectations of the housing markets in the US offer no comfort as the prices are falling and might take a long time to get back to the levels seen in the recent months. valuation models if a market price is not available. Although various disclosures are required to explain the assumptions and models used to determine the values, these disclosures might not have attracted due attention in the past. This may change and investors may demand more explanation of the management judgement applied in determining the fair values and risk estimates.
ease of selling a structured credit product encouraged interested in the answers and this may lead to new lenders to create more assets which, combined with legislations. continually rising house prices in the US lead to relaxed attitudes towards credit risks in respect of mortgages. Rating agencies maintain that they have to observe the Lenders accepted higher loan to value ratios and higher data before they take any downgrade actions and are loan to income multiples when issuing mortgages. Lastly likely to support their ratings. they tapped into the sub-prime sector This has also focused attention on the which means lending money to risk management tools used by the individuals with bad credit history or Many of these structures issuers, investors and rating low income. agencies. This crisis may force the are set up by larger market to invest in new systems and Rising interest rates environment over banks which also models to more accurately measure the last few months, coupled with high and report the credit risk. repossession rates and a declining
Market adjustments
The crisis has jolted the financial markets and if investors' confidence in the structured credit does not return, banks may have to find alternative ways to fund their assets or reduce their funding needs by cutting supply of credit. Basel II will remove some of the incentives for taking assets offbalance sheet; this factor combined with investors wary of the traditional strucutures may force financial engineers to come up with new improved structures of investment vehicles or conduits. Credit structures as an asset class allow investors to short credit, something which cannot be easily achieved otherwise. Therefore, these are not likely to fall out of favour with the investors. However, the structures may need to address credit and other risk issues in a different manner and offer a much higher yield to compensate for the perceived risk.
Rating agencies
Rating agencies have survived the criticism for quality and relevance of the information they provide. This crisis has aggravated it for them as they downgraded billions of dollars of securities in July in the middle of the crisis. Questions have been raised about the models used by the agencies to assign investment grade ratings to securities that had sub prime backing and why they did not downgrade these securities earlier. US Senate is
There may be additional regulations issued to address investor concerns. Investment bankers are generally against regulations and favour a free market; however, when there is a crisis they want the central bank to step in and bail them out. In this recent episode, central banks had to provide billions of dollars in order to support the market. In order to avoid a repeat they may want to put some checks in place. The recent episode is likely to last for a short to medium term which is likely to lead to changes in investor attitude, risk management practices, funding structures, rating processes and regulations. Financial markets are likely to come out of this crisis better and stronger but it will take some time before they get there - and when they get there it may be a slightly different world.
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Credit Risk Management

Abdul Razzaq, ACA
Guiding Principles for Implementation

In the past decade, rapid innovations in financial markets and the internationalization of financial flows have changed the face of banking almost beyond recognition. Technological progress and deregulation have both provided new opportunities for and increased competitive pressures among banks. In the late 1980s, margins attained from traditional banking business began to diminish and capital adequacy requirements began to increase. Banks have responded to these new challenges with vigor and imagination by forging ahead into new arenas. The growth in international financial markets and a greater diversity of financial instruments have allowed banks wider access to funds. At the same time, markets have expanded, and opportunities to design new products and provide more services have arisen. While the pace of these changes appears to be quicker in some countries than in others, banks everywhere are generally becoming more involved in developing new instruments, products and services, and techniques. Traditional banking practice - based on the receipt of deposits and the granting of loans - is today only one part of a typical bank's business, and is often its least profitable. New information-based activities, such as trading in financial markets and income generation through fees, are now the major sources of a bank's profitability. Financial innovation has also led to the increased market orientation and marketability of bank assets, in particular through the introduction of concepts such as loan swaps and sales. This process has been achieved using assets such as mortgages, automobile loans, and export credits as backing for marketable securities, a process known as securitization. The correlation between different types of risk, both within an individual bank and throughout the banking system, has increased and become more complex. These developments have increased the need for and complicated the function of risk measurement, management, and control. The quality of corporate governance of banks has become a much debated topic, and the approach to regulation and supervision has changed dramatically. Within an individual bank, the new banking environment and increased market volatility have necessitated an integrated approach to asset-liability and risk management techniques. Amid changing banking environment, worldwide, the State Bank of Pakistan (SBP) has also recognized the importance of risk management within financial institutions and has issued a set of guidelines on Risk Management vide BSD Circular No. 7 dated August 15, 2003, with an advice to the financial institutions to make concrete efforts to implement these guidelines in letter and spirit. The risk management framework envisaged four major categories of risks that the banks are exposed to; vis-vis credit, market, liquidity and operational risks.
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Since asset base of the financial institutions primarily comprises loans and advances, management of credit risk within the banks is of utmost importance for these financial institutions. Credit or counterparty risk - defined as the chance that a debtor or financial instrument issuer will not be able to pay interest or repay the principal according to the terms specified in a credit agreement - is an inherent part of banking. Credit risk means that payments may be delayed or ultimately not paid at all, which can in turn cause cash flow problems and affect a bank's liquidity. Despite innovation in the financial services sector, credit risk is still the major single cause of bank failures. The reason is that more than 80 percent of a bank's balance sheet generally relates to this aspect of risk management. The three main types of credit (counterparty) risk are as follows: w personal or consumer risk; w corporate or company risk; w sovereign or country risk. Because of the potentially dire effects of credit risk, it is important to perform a comprehensive evaluation of a bank's capacity to assess, administer, supervise, enforce, and recover loans, advances, guarantees, and other credit instruments. An overall credit risk management review will include an evaluation of the credit risk management policies and practices of a bank. This evaluation should also determine the adequacy of financial information received, from a borrower or the issuer of a financial instrument, which has been used by a bank as the basis for investing in such financial instruments or the extension of credit and the periodic assessment of its inherently changing risk. Credit risk management in a financial institution primarily constitutes the following essential elements: (a) (b) (c) (d) (e) (f) Clearly defined lending policies Credit portfolio quality review Credit risk management policies Policies to limit or reduce credit risk Asset classification Loan loss provisioning policy
consideration but which do not fall within the parameters of written guidelines. Flexibility must exist to allow for fast reaction and early adaptation to changing conditions in a bank's earning assets mix and market environment. Considerations that form the basis for sound lending policies include the following: w Limit on total outstanding loans A limit on the total loan portfolio is usually expressed relative to deposits, capital, or total assets. In setting such a limit, factors such as credit demand, the volatility of deposits, and credit risks should be considered. w Geographic limits These are usually a dilemma. If a bank lacks understanding of its diverse markets and/or does not have quality management, geographic diversification may become a reason for bad loan problems. On the other hand, the imposition of strict geographical limits can also create problems, particularly in the case of regions with narrow economies. In any case, a bank's business market should be clearly delineated and commensurate with its market knowledge and managerial and staff experience. Bank officers should be fully aware of specific geographical limitations for lending purposes, an aspect that is particularly relevant for new banks. w Credit concentrations A lending policy should stimulate portfolio diversification and strike a balance between maximum yield and minimum risk. Concentration limits usually refer to the maximum permitted exposure to a single client, connected group, and/or sector of economic activity (e.g., agriculture, steel, or textiles). This is especially important for small, regionally oriented or specialized banks. A lending policy should also require that all concentrations be reviewed and reported on a frequent basis. w Distribution by category Limitations based on aggregate percentages of total loans in commercial, real estate, consumer, or other credit categories are common. Policies related to such limitations should allow for deviations that are approved by the board. w Type of loans A lending policy should specify the types of loans and other credit instruments that the bank intends to offer to clients and should provide guidelines for specific loans. Decisions about types of credit instruments should be based on the expertise of lending officers, the deposit structure of The Pakistan Accountant
(a) Clearly defined lending policies

Formal policies laid down by the board of directors in all pertinent areas are important. However, these are perhaps the most critical with regards to bank's lending function, which requires that the bank must adopt a sound system for managing credit risk. A lending policy should contain an outline of the scope and allocation of a bank's credit facilities and the manner in which a credit portfolio is managed, i.e., how loans are originated, appraised, supervised, and collected. A good lending policy is not overly restrictive, but allows for the presentation of loans to the board that officers believe are worthy of
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a bank, and anticipated credit demand. Types of credit that have resulted in an abnormal loss should be controlled by senior management or avoided completely. w Maturities A lending policy should establish the maximum maturity for each type of credit, and loans should be granted with a realistic repayment schedule. Maturity scheduling should be determined in relation to the anticipated source of repayment, the purpose of the loan, and the useful life of the collateral. w Loan pricing Rates on various loan types must be sufficient to cover the costs of funds, loan supervision, administration (including general overhead), and probable losses. At the same time, they should provide a reasonable margin of profit. Rates should be periodically reviewed and adjusted to reflect changes in costs or competitive factors. Rate differentials may be deliberately maintained either to encourage some types of borrowers to seek credit elsewhere or to attract a specific type of borrower. Guidelines for other relevant procedures, such as the determination of fees on commitments or penalty interest rates, are also an element of pricing policy. w Lending authority It is often determined by the size of a bank. In smaller banks, it is typically centralized. In order to avoid delays in the lending process, larger banks tend to decentralize according to geographical area, lending products, and/or types of customers. A lending policy should establish limits for all lending officers. If policies are clearly established and enforced, individual limitations may be somewhat higher than would normally be expected, depending on the officer's experience and tenure with the bank. Lending limits could also be based on group authority, which would allow a committee to approve larger loans. Reporting procedures and the frequency of committee meetings should be specified.
loan amount and 50 percent of the number of all foreign currency loans and of all loans with maturities greater than one year. In addition, a detailed credit portfolio review should include the following: w all loans to borrowers with aggregate exposure larger than 5 percent of the bank's capital; w all loans to shareholders and connected parties; w all loans for which the interest or repayment terms have been rescheduled or otherwise altered since the granting of the loan; w all loans for which cash payment of interest and/or principal is more than 30 days past due, including those for which interest has been capitalized or rolled over; w all loans classified as substandard, doubtful, or loss. In each of these cases, a loan review should consider documentation in the borrower's file and involve a discussion of the borrower's business, near-term prospects, and credit history with the responsible credit officer. When the total amount due exceeds 5 percent of a bank's capital, the analysis should also consider the borrower's business plans for the future and the potential consequences for debt service capacity and principal repayment. The specific objective of these reviews is to assess the likelihood that the credit will be repaid, as well as whether or not the classification of the loan proposed by the bank is adequate. Other considerations include the quality of collateral held and the ability of the borrower's business to generate necessary cash. Beyond loans, interbank deposits are the most important category of assets for which a bank carries the credit risk. This category may account for a significant percentage of a bank's balance sheet, particularly in countries that lack convertibility but allow their citizens and economic agents to maintain foreign exchange deposits.
(c) Credit Risk Management Policies

Credit risk is the most common cause of bank failures, causing virtually all regulatory environments to prescribe minimum standards for credit risk management. The basis of sound credit risk management is the identification of the existing and potential risks inherent in lending activities. Measures to counteract these risks normally comprise clearly defined policies that express the bank's credit risk management philosophy and the parameters within which credit risk is to be controlled. Specific credit risk management measures typically include three kinds of policies. One set of policies includes those aimed to limit or reduce credit risk, such as policies on concentration and large exposures, adequate diversification, lending to connected parties, or overThe Pakistan Accountant
(b) Credit Portfolio Quality Review

One of the essential elements of credit risk management framework is the ongoing monitoring of quality of the credit portfolio. Such quality checks are performed on frequent basis so as to cover all the facilities disbursed during the year, except those managed on portfolio basis such as consumer loans. When feasible, the loan portfolio review should normally include a random sampling of loans so that approximately 70 percent of the total loan amount and 30 percent of the number of loans are covered. It should also consider at least 75 percent of the total
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exposures. The second set includes policies of asset classification. These mandate periodic evaluation of the collectibility of the portfolio of loans and other credit instruments, including any accrued and unpaid interest, which expose a bank to credit risk. The third set includes policies of loss provisioning, or the making of allowances at a level adequate to absorb anticipated loss - not only on the loan portfolio, but also on all other assets that are subject to losses. The assessment of a credit risk management function should consider loans and all other extensions of credit (on- and off-balance-sheet) to ensure that the following factors are considered: w the level, distribution, and severity of classified assets; w the level and composition of non-accruing, nonperforming, renegotiated, rolled-over, and reduced-rate assets; w the adequacy of valuation reserves; w management's ability to administer and collect problem assets; w undue concentrations of credit; w the adequacy and effectiveness of, and adherence to, lending policies and credit administration procedures; and w the adequacy and effectiveness of a bank's process for identifying and monitoring initial and changing levels of risk, or risk associated with approved credit exposure.
ability to exert control over or influence a bank's policies and decision-making, especially concerning credit decisions. An additional concern is whether credit is based on market terms or is granted on terms that are more favorable with regard to amount, maturity, rate, and collateral, than those provided to the general public. Most regulators establish limits for aggregate lending to related parties, typically stipulating that total lending to related parties cannot exceed a certain percentage of tier 1 or total qualifying capital. If such a limit has not been established by prudential regulations, a bank should be expected to maintain one as a matter of board policy. A prudent banking practice would require all loans to related parties to be approved by the board. Another dimension of risk concentration is the exposure of a bank to a single sector of the economy or a narrow geographical region. This makes a bank vulnerable to a weakness in a particular industry or region and poses a risk that it will suffer from simultaneous failures among several clients for similar reasons. This concern is particularly relevant for regional and specialized banks or banks in small countries with narrow economic profiles, such as those with predominantly agriculture-based economies or exporters of a single commodity. Renegotiated debt refers to loans that have been restructured to provide a reduction of either interest or principal payments because of the borrower's deteriorated financial position. A loan that is extended or renewed, with terms that are equal to those applied to new debt with similar risk, should not be considered as renegotiated debt. Restructuring may involve a transfer of real estate from the borrower to the bank, receivables or other assets from third parties, a debt-to-equity swap in full or partial satisfaction of the loan, or the addition of a new debtor to the original borrower. A good practice is to have such transactions approved by the board of directors before concessions are made to a borrower. Bank policies should also ensure that such items are properly handled from an accounting and control standpoint. A bank should measure a restructured loan by reducing its recorded investment to a net realizable value, taking into account the cost of all the concessions at the date of restructuring. The reduction should be recorded as a charge to the income statement for the period in which the loan is restructured. A significant amount of renegotiated debt is normally a sign that a bank is experiencing problems. An exception to this general approach applies in a market environment of falling interest rates, when it may be in the interest of both debtors and creditors to renegotiate the original credit terms. The Pakistan Accountant
(d) Policies to limit or reduce credit risk

Bank regulators have traditionally paid close attention to risk concentration by banks. A regulator's objective in credit risk management is to prevent banks from relying excessively on a large borrower or group of borrowers, but not to dictate to whom banks may or may not lend. Modern prudential regulations usually stipulate that a bank should not make investments, grant large loans, or extend other credit facilities to any individual entity or related group of entities in excess of an amount that represents a prescribed percentage of the bank's capital and reserves. Most countries impose a single-customer exposure limit of between 10 and 25 percent of capital, although in some jurisdictions it may be as high as 30-40 percent. The Basel Committee on Banking Supervision has recommended a maximum of 25 percent, with the intention of reducing it to 10 percent as soon as this is practical. Lending to connected parties (commonly known as related party lending) is a particularly dangerous form of credit risk exposure. Related parties typically include a bank's parent, major shareholders, subsidiaries, affiliate companies, directors, and executive officers. This relationship includes the
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(e) Asset classification

Asset classification is a process whereby an asset is assigned a credit risk grade, which is determined by the likelihood that debt obligations will be serviced and debt liquidated according to contract terms. In general, all assets for which a bank is taking a risk should be classified, including loans and advances, accounts receivable, investments, equity participations, and contingent liabilities. Asset classification is a key risk management tool. Assets are classified at the time of origination and then reviewed and reclassified as necessary (according to the degree of credit risk) a few times per year. The review should consider loan service performance and the borrower's financial condition. Economic trends and changes in respective markets and the price of goods also affect evaluation of loan repayment. The evaluation of certain classes of smaller loans, however, may be based only on repayment performance, in particular small consumer loans such as residential mortgages, installment loans, and credit cards. Assets classified as "pass" or "watch" are typically reviewed twice per year, while critical assets are reviewed at least each quarter. In some advanced banking systems, banks use more than one rating level for assets in the pass category. The objective of such a practice is to improve the quality of portfolio analysis and trend analysis to be able to better differentiate among credits of different types, and to improve the understanding of the relationship between profitability and the rating level. Banks engaged in international lending face additional risks, the most important of which are country, or sovereign, and transfer risks. Transfer risks are the difficulties that a borrower might have in obtaining, the foreign exchange needed to service a bank's loan. The classification of international loans should normally include both country and transfer risk aspects. A bank may be asked to provide for international loans on a loan-byloan basis, whereby the level of necessary provisions is increased to accommodate additional risk. Alternatively, a bank may determine aggregate exposures to country and transfer risks on a countryby-country basis, and provide special reserves to accommodate for risk exposures. Additionally, foreign currency risk aspects may also affect loan classification in cases where a debtor has borrowed in one currency but generates cash flow in another currency. In effect, the foreign currency risk aspect magnifies the credit risk taken by a bank. Such cases are especially relevant in emerging market economies or in economies where the domestic currency is unstable and/or lacks full convertibility. The loan classification should, in such cases, also include considerations related to the likelihood of currency devaluation, the ability of the debtor to
cover or hedge the risk of devaluation, or the debtor's capacity to adjust product or service pricing.
(f) Loan loss provisioning policy

Asset classification provides a basis for determining an adequate level of provisions for possible loan losses. Such provisions, together with general loss reserves that are normally counted as tier 2 capital and are not assigned to specific assets, form the basis for establishing a bank's capacity to absorb losses. In determining an adequate reserve, all significant factors that affect the collectibility of the loan portfolio should be considered. These factors include the quality of credit policies and procedures, prior loss experiences, loan growth, quality of management in the lending area, loan collection and recovery practices, changes in national and local economic and business conditions, and general economic trends. Assessments of asset value should be performed systematically, consistently over time, and in conformity with objective criteria. They should also be supported by adequate documentation. Policies on loan-loss provisioning range from mandated to discretionary, depending on the banking system. The tax treatment of provisions also varies considerably from country to country, although many economists believe that provisions should be treated as business expenses for tax purposes. In countries where the legal framework for debt recovery is highly developed, such as the United States, studies have demonstrated that approximately 10 percent of substandard assets eventually deteriorate into loss. The percentages for doubtful and loss classifications are approximately 50 percent and 100 percent, respectively. In developing countries where the legal frameworks and traditions for debt collection may be less effective, provisions in the range of 20 to 25 percent of substandard assets may be a more realistic estimate of loss potential.
Robust MIS support

Effectively managing credit risk in today's banking environment is extremely important for the institutions. Effectiveness of the credit risk management framework is dependent on the level of understanding of the higher management of the institutions engaged in day-to-day risk management responsibilities. In addition to the precise understanding of the framework, implementation of the risk measurement and monitoring tools requires robust MIS capable to generate management reports, which may then be utilized for monitoring of the limits and compliance with the predefined policies on bank wide basis. Traditional banking softwares, which were mostly incapable of generating countrywide information on timely basis, are no more useful, if institutions are to implement risk management framework in letter and spirit and to stay alive in this rapidly changing financial sector. The Pakistan Accountant
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Reverse Mortgage Loan (RMLs) in India:

Rationale, Concept and Application
Dr. Pradeep Kumar Singh With the fall in returns on savings due to the soft interest rate regime and increased longevity, Reverse Mortgage Loans (RMLs), enabling senior citizens to earn a steady income by pledging their homes for a comfortable living, have recently been introduced to the Indian financial market. Rationale for RMLs:
With unstable interest rate movement, it becomes difficult to earn these days by investing in traditional instruments. Alternatively, investing in riskier instruments, which offer higher returns as compared to traditional instruments is not advisable for people at this stage of life. They simply cannot afford to gamble with their hard-earned money. Moreover, not all of them are fortunate enough to have sufficient deployable funds for investment and majority of them do not receive any pension. At present, there are only two main sources of obtaining cash against one's house, either by selling it or borrowing against the house. In the former, when the house is sold, one has to move out, while in the latter case, the person would have to make monthly loan repayments, both of which might not be feasible in old age. With the fall in returns on savings due to the soft interest rate regime and increased longevity, Reverse Mortgage Loans (RMLs), enabling senior citizens to earn a steady income by pledging their homes for a comfortable living, have recently been introduced to the Indian financial market. Unlike life insurance, where a person pays throughout life to get a lump sum amount at the end, reverse mortgage, a loan against home, enables a person to get payment either in lump sum or on monthly basis or as customised by borrower and requires no repayment till death. A recent World Bank study found that only 10 per cent of the population had any sort of social coverage in India, which indicates that nearly 90 percent of the population has no formal social security. National Housing Bank commissioned a research that found there were 3.87 million house-owning individuals above 65 years of age in India in March 2006. Reverse mortgage loan requires no repayment for as long as the 'principal resident' lives in the house, but must be repaid in full, including all interest and other charges, when the last living borrower dies, sells the house, or permanently moves away. Reverse mortgage loan (RML) would be better suited for those issueless senior citizens so that after their death, the lender could dispose it in the market. Unlike the situation in India where people need money for maintaining a comfortable living due to the reduced employment prospects after retirement, in the US, these type of mortgages typically go to the oldest borrowers living in the most expensive homes. According to industry experts, it is the right time that the concept is brought into India, especially when real estate is showing healthy signs of recovery.
International Profile
(Reverse Mortgage (known as lifetime mortgage in the United Kingdom) is now a well exposed financial product in countries like USA, UK, Canada, France, Japan, Australia, Singapore and various other countries.) A
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banker named Nelson Haynes of Deering Savings & Loan (Portland, ME), Maine issued the first known reverse mortgage in 1961 USA. He delivered this product to Nellie Young, the widow of his high school football coach. In the US, the government launched the first RM product in 1991 through a government undertaking to build confidence in the product. Reverse mortgages were later used in other areas of USAas well, but it was not until the eighties that their existence received widespread popularity and government endorsement. Today, there are a host of both state insured reverse mortgages as well as privately funded products.)
payments from the lender. The National Housing Bank (NHB), a subsidiary of the Reserve Bank of India (RBI), has prepared the operational guidelines on reverse mortgage loan. Under the new scheme, a senior citizen, who owns a house, can be given a loan up to 40 percent of the market value of his house, if he is in the age group of 60-65 years. If the borrower's age is between 66-70, he can avail loan up to 50 percent of the market value. Similarly, for people belonging to the age group of 71-75, loans of up to 55 percent of the market value of the house will be given. For the age group of above 75 years, loans up to 60 percent the house will be offered. Borrowers can opt for receiving the money as fixed monthly payment also. In this case, the entire amount will be paid in the form of annuity (a sort of monthly income) for 15 years, which will be fixed, irrespective of the age at which borrowers take the loan. In terms of receiving the loan amount, the borrower can opt for monthly, quarterly, annual or lump sum payments or payments at any other point in time as per his requirement Also, a revaluation of the property has to be under taken by the bank/HFC once every 5 years. However, before resorting to sale of the house, preference will be given to the owner or his heirs to repay or prepay the loan amount, along with the interest, and to get the mortgaged property released. Lenders are entitled to retain only the amount loaned by them and any surplus over and above the original loan amount belongs to the borrower's children or legal heirs since the amount owed on a reverse mortgage can never exceed the value of the home at the time the loan is extinguished. The amount received through reverse mortgage is considered as loan and not income; hence it will not attract any tax liability, or affect Medicare benefits.
RML: The Concept

Indian finance minister introduced the idea of reverse mortgage in the 2006-07 Budget. To understand the concept of reverse mortgage, first let us understand what a regular mortgage is. In a regular mortgage, a borrower mortgages his new/existing house with the lender (Banks/PLI) in return for the loan amount (which in turn he uses to finance the property); the same is charged at a particular interest rate and runs over a predetermined tenure. The borrower then has to repay the loan amount in the form of EMIs (equated monthly installments), which comprise of both principal and interest amounts. The property is utilized as a security to cover the risk of default on the borrower's part. Under Reverse Mortgage loan (RML) citizens aged 60 years and above will be able to pledge their house and derive a monthly income or a lump sum for 15 years while living in it. If you go for the lump sum amount, you can deposit it in a bank, withdraw from your account according to your requirements and keep earning interest on the balance. It is mainly meant for 'home rich' senior citizens who are otherwise cash-poor. Reverse Mortgage works like a traditional mortgage loan, only in reverse direction. A borrower does not make regular payments to a lender; instead he receives
How Does RML Work

w Reverse Mortgage Loan (RML) allows senior citizens to mortgage their residential property to a bank or a housing finance company while retaining the right to stay. The house owner who mortgages gets a steady income to meet old age exigencies. w According to the draft RMLguidelines issued by the National Housing Bank (NHB), a subsidiary of the Reserve Bank of India (RBI), the house owners who have crossed 60 years of age will be allowed to seek loan up to 60 per cent of the value of the residential property which they need not repay. w The house owners can opt for monthly, quarterly or annual payments to supplement their income. They may also prefer one time payment or a committed line of credit from the bank/Housing Finance Company (HFC) to be used in times of need. According to the draft guidelines, the income, which a house owner receives by mortgaging his house, will go up with revaluation of property which has to be undertaken by the bank/HFC every five years. w The bank/HFC will recover the loan along with interest on death of the owner or expiry of mortgage period by selling the house and remit the excess amount to the owner or his heirs. The owners will also have the right to repay the loan to discharge the mortgage.
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This kind of mortgage avoids the necessity of the senior citizen selling his property and, thereby, losing possession of the property during his life time. It is quite likely that whatever income they are having by way of pension or interest would be losing in value due to inflation, making it inadequate for their living, so that reverse mortgage offers a solution for aged citizens with the house they live in. They can continue to live in the house till death and if the agreement is so worded, till the demise of oneself or their spouse, whichever is later. In India, PNB is one of the first state-run banks to launch the product. Corporation Bank has signed up with the country's largest insurer, Life Insurance Corporation of India, to jointly launch a reverse mortgage product soon. Dewan Housing Finance Company Ltd. introduced the first Reverse Mortgage product named Sakhsam, in 2006. Of late, ICICI has launched a new product in this segment.
Issues and Challenges for RMLs

Legal issues: Various legal issues arise in case of RMLs. In case of a simple housing loan product now we have the Securitization Act to take care of defaults. In case of reverse mortgage, the legal heirs may not agree to dispose off the property though they may be reluctant to settle the debt with lenders or may not have the funds to do so. In that situation a separate law is required to protect the RML lenders. Social issues: It is one of the common phenomena, that joint families are still widespread in many parts of India, although their numbers have reduced. In many cases, the culture of joint families continues even after nuclearisation. In this scenario, many parents would still prefer to leave their house to their children rather than live off it. Social status and emotional attachment is one of the challenges for RMLs. Regulation and Transparency issues: RML products require solid regulation and transparency. In India it is better to permit those banks and PLIs for RML that have good track record of financial dealing and they are particular about transparency in their transactions. At least they should disclose their entire scheme to the borrowers before the RML agreement, i.e. their loan amount, interest rate, any variation in future etc. Financial issues: For banks and HFCs it is a big challenge to maintain level of capital as per their requirement, because in traditional mortgage every month they are getting some amount as instalment of loan and it will provide liquidity to the banks. But in case of RMLthey have to pay monthly instalment of loan to the borrowers and after a long period of time (after 15 years or more) they will get entire amount back. During this period management of capital as per the requirement is one of the big challenges for the Banks /HFCs.
RMLs and Taxation Issues

Following are the main taxation issues involved in RMLs: 1. As for the tax planning angle, such a person who has to mortgage the property for his living expenses is not likely to have any tax liability, especially in the light of exemption up to Rs. 1, 95,000 for senior citizens above 65 years of age. Since what he receives is a mere loan, even if he receives it in instalments, it should not be taxable. 2. There would be liability only, if the property is surrendered for an annuity, which is always taxable. 3. For the lender (banks/FIs), there is no saving in tax, as tax would have to be paid on interest on accrual or cash basis.
Disadvantages of RMLs:
w Reverse mortgage fees can be high, although the fees are often rolled into the loan and not paid upfront. A reverse mortgage can cost thousands more than a conventional mortgage. w It's important to calculate the cost of a reverse mortgage against what you would gain, because once you enter a reverse mortgage agreement, the mortgage company essentially owns your home. w In reverse mortgage plans it is better to discuss with legal and financial advisors, and family members, before making a decision. Because home ownership is often a person's most valuable asset, getting a reverse mortgage is essentially the same as spending the money you'd expect to leave to your heirs. w Be sure that the older homeowner is thinking clearly when making this decision because having a sudden arrival of cash can be a heady experience and it would be a shame to waste it or become the victim of a scam. w Reverse mortgages are often seen as a last resort if the homeowner needs cash and there are no other options.
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Accounting issues: For the banks /HFCs, accounting of RML product is also one of the big issues. In case of RML banks and financial institutions are earning interest every year but they are entitled to the entire amount (principal and interest) after 15 years or more. Now the question is whether interest of banks will be taxable on accrual basis or cash basis. If it is taxable on accrual basis interest earned by banks every year will be treated as income and it will be taxable. At the time of final disposal of agreement entire amount paid by the borrowers is exempted from tax. But another issue is that at final disposal if receivable amount is less than the total due (principal and interest) then what will be the accounting adjustment for the loss. Under cash method entire interest will be treated as income at the time of final disposal and during the RML tenure interest will not be treated as income. In that situation at the time of final disposal of loan total interest earned will be treated as income and it is a huge burden of tax for the banks and HFCs. Interest rate regulations and fluctuations: Interest rate regulation is one of the major issues among banks. From last two years interest rate on conventional mortgage loan has increased from 7.5 percent to 11 percent which is very crucial for borrowers, because their EMIs (equated monthly instalments) /duration of the loan increases substantially. How PLIs (Primarily Lending Institutions) mange their interest rate fluctuations, is equally important to senior citizens, because they are not in a position to cancel their RML and pay the entire principal and interest accrued so far.
'The success of RML will depend on the government recognising RMs as part of its own welfare obligation and ensuring they are not taxed as income in the hands of individuals. In India initial seekers of RM are likely to be individuals who have no family support or prefer to live independently rather than worry about inheritance laws or leaving assets for their heirs. It is advisable to ensure that regulations are structured to prevent any harassment of senior citizens through unreasonable property maintenance conditions, stoppage of monthly payments or the threat of eviction from their homes. The product must be developed with adequate sympathy and a realisation that the very ages of these borrowers prevent them from fighting long battles in consumer courts.
References:
NHB (2007): Operational Guidelines for Reverse Mortgage Loan, Published by National Housing Bank, 1. Vaidyanathan V (2004): Pension issues and challenges, Management Review, Sep., Indian Institute of Management, Bangalore Sept 2. Kapila Raj and Kapila Uma (2002): A Decade of Economic Reforms in India, Academic Foundation, New Delhi. 3. Bhalla V.K. (2004): Investment S.Chand and Sons, New Delhi. 4. Economic Times: 18 March 2006 5. Bhattacharjee Kalyan (2007): Reverse Mortgage - A novel financial product for elderly people, The Management Accountant, May. 6. www.nhb.org.in Management,
Conclusion
The extent to which the potential of reverse mortgage gets realised in India will depend a lot on the guidelines that will govern it. The government must ensure that only the most credible institutions are allowed to offer RM products; that they keep interest rates and service charges reasonable, with no hidden increase of rate that would make the entire loan due immediately.
Dr. Pradeep Kumar Singh teaches Commerce at the Mahatma Gandhi Government Arts College, Pondicherry India.

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Open Letter
Why it is Important to Maintain Audit Quality

While there has been an improvement in the overall quality What can be done to improve audit quality at the individual of documentation on the files we review, we have found on engagement level? More rigorous auditing standards are a number of occasions that these were lacking in the part of the answer. For example, the recently revised ISA sufficiency of documentation to support key audit 230 on Documentation is a very timely change by IFAC. judgments. If key judgments are not properly recorded at the Documentation is not about ticking boxes on a checklist. It time, there is a substantial risk that the rationale may be is primarily about documenting what the auditor did in incomplete and that it will not be possible for our reviewers response to the principal risks and uncertainties that are to see from the documents on file the rationale behind confronted in every audit. The discipline of setting down for judgments. Also, if the firms' own audit files do not contain a posterity the important judgments made during the audit often improves the clarity of comprehensive record of the thought and quality of judgments. key judgmental aspects of the International Standard on Considering the enhanced role and audit alongside complianceAuditing (ISA) 230 (Revised), the importance of 'Audit related information, this may be detrimental to the on-the-job Audit Documentation, should Documentation' placed under the revised ISA 230, the DPSC&E had training of audit staff. We be read in the context of the issued Circular No. 3 dated 15 remind the firms that a focus on Preface to the International November 2006 to all practicing key audit judgments is central members. to the principles-based Standards on Quality Control, approach to auditing in Auditing, Assurance and It is important to highlight that Pakistan. gradual but relentless Related Services, which sets implementation of ISAs will require In smaller firms, there is often out the application and authority many audit firms, particularly Small an absence of any real system of ISAs. and Medium Size Practices of quality control. Too often, the (SMPs), to substantially change system is such that complete faith is placed on the engagement partner to ensure that the way they do audits. Many smaller firms do not yet fully every audit is done to a high standard of quality, without any realize the implications of the changing audit scenario. But double checks. For sole practitioners, the process of having they have the option to mobilize their resources through a double check within the firm is an inherent limitation. Networking or Mergers. Alternatively they might have to However, for sole practitioners, the ISQC 1 allows to appoint drop their audits of listed / public sector entities and external persons for the purpose of Engagement Quality concentrate more on audit of smaller companies and nonaudit accounting services, tax, general financial Control Review and Monitoring. consultancy etc. However, there is an important caveat. Even in firms with a more effective system of quality control, we sometimes find The Institute is working tirelessly and actively to address individual engagements with serious deficiencies, meaning the challenges facing the audit profession, especially in that the performance of the engagement is significantly assisting Small and Medium Sized Practices (SMPs) to below what is required by professional standards. This gear up for assimilating and integrating their practices with means that the key individuals assigned to the engagement global accounting standards through Networking and Mergers. We acknowledge that the best firms are the ones had failed to do their job as well as they should have. that maintain comprehensive records of key audit We recognize that audit partners and managers are busy judgments central to the principles-based approach to professionals doing a difficult job. That is the truth, but not audit, where firm leadership has established high an excuse. Surgeons are also busy professionals doing a parameters for quality, where performance is measured difficult job, but one expects them to do their best each time, against established benchmarks, and where there is low tolerance for preventable quality lapses. especially when one is at the sharp end of their scalpel.
Source: Directorate of Professional Standards Compliance & Evaluation (DPSC&E)
July-August 2007
32
In Conversation Richard Dyson, WithPresident ICAEW

Institute of Chartered Accountants in England & Wales (ICAEW)
July-August 2007
34
View Point
Richard Dyson foresees the ICAP- ICAEW relationship developing positively over time. The welcome that he and his team received and the enthusiasm shown by the accounting community in Pakistan were very encouraging. 'It shows that quality in both education and profession are important to all those involved. As members of the International Federation of Accountants (IFAC), both ICAEW and ICAP need to work closely to share best practices and to promote issues like corporate governance in the public interest,' Dyson added. Dyson believes ICAP is doing a good job in terms of maintaining professional standards and quality. 'For many years, ICAPwas mainly perceived as an organization that handed out initial qualifications, but now its role has evolved into one that is supportive and collaborative, especially its emphasis on Continuing Professional Development (CPD) for its members which is the only way to keep professional accountants updated and abreast of the changes in legislation and international accounting standards.' Over 25 percent of ICAPmembers are employed overseas which speaks of ICAP's high quality standards Dyson left a full time career as national risk management partner at Ernst & Young to take over the top job at ICAEW. He had been involved in the affairs of the ICAEW for more than two decades, initially as President of the Manchester Society of Chartered Accountants from 199596, and later as member of ICAEW's Council to which he was elected in 2001 as member for the Manchester constituency. Dyson specializes in investigation and forensic work and from 1982-2001 was responsible for building up due diligence and forensic accounting services practices for Ernst & Young. Dyson is also the Chairman of the Consultative Committee of Accountancy Bodies (CCAB) which is the umbrella body for the six UK professional bodies, an observer on the Financial Reporting Council, and a member of The Takeover Panel which is an independent body, established in 1968, to ensure fair treatment for all shareholders in takeover bids. Dyson says 'accounting is perceived as some sort of black art' which is why 'political recognition of accounting as an economic fundamental has not gone far enough.' He quotes Arthur Levitt* who warned that published accounts would no longer be trusted unless companies provide meaningful disclosure to shareholders, and insisted that integrity of information precedes competitive advantage. One way to do this is to 'ensure consistency of audit quality across borders,' Dyson adds. ---------------------------------------------------------------------------* Arthur Levitt was the longest serving Chairman (19932001) of the United States Securities & Exchange Commission. Widely hailed as pro-investor, he later came under fierce criticism for failing to act against the 1990s bull market abuses. The Pakistan Accountant
CAEW President Richard Dyson was on a whirlwind visit to Karachi in August to sign a Memorandum of Understanding with ICAP under which ICAP qualified Chartered Accountants will be eligible to gain the ACA qualification through work experience and examinations. The MOU will enable both Institutes to work together to strengthen bilateral accounting ties, enhance cooperation and share information and best practices with each other in order to develop the profession.
Unfazed by the sweltering Karachi heat, Richard Dyson sat down in the President's Room at ICAP to discuss strategy and good governance.
July-August 2007
35
View Point
competing Institutes.' How would the President of ICAEW like to respond to that? 'I think it is a fair comment,' answers Dyson. 'However, I'd like to point out that the ACA is a broader qualification and different in its approach to the MBA. MBAs do a lot of case studies but don't put them in to practice the way CAs do.' Richard Dyson is charting an ambitious course to recast the 127 year old Institute as a savvy, socially responsible global organization. ICAEW guides members on CSR reporting. 'We need to lead by example,' Dyson says. The ICAEW has significantly dropped its energy consumption and started double sided printing. The Institute intends to set up best practice in this regard and publicize what they are doing within the Institute so that it is emulated outside. 'Unfortunately not many Chartered Accountants are aware of the impact of CSR, though the younger member is more interested in initiating debate on issues involving economic, environmental and social performance. I believe that unless the captains of industry realize and embrace the importance of CSR we can't get much ahead.' Members working within industry are often distanced from their Institutes and express little interest in their activities. To a question whether professional Institutes are more inclined towards members in practice than members in business, Dyson's answer is an emphatic 'No!' Shouldn't the Institutes then come up with ways to deal with varying requirements of members in practice, business, public sector and those based internationally? 'Absolutely! When I talk to members I get the distinct feeling many of them question the Institute's (ICAEW) relevance to them. We've set up a number of advisory boards to ensure that the Institute continues to reflect their needs. As part of the Financial Capabilities Initiative, members in business volunteered to conduct a pilot program in secondary schools in Midlands, UK to introduce school children to the profession. This is a good example of the involvement of younger business members in Institute activities, and we intend to reciprocate.' 'In this regard a professional magazine also contributes greatly to bridge the gap between the Institute and its membership. The new and improved version of the ICAEW magazine has a circulation of over 150,000 copies and is part of a two-pronged strategy by the Institute to target members in business. 'The other aspect is to get out and about and meet up with members with whom we've lost touch,' Dyson acknowledges. The President is a strong advocate of Continuing Professional Development (CPD) both as part of lifelong learning and for maintaining professional accountants' edge. The underlying message to Chartered Accountants is not to be complacent.
Needless to say, without high quality financial information and high quality audit the profession will be unable to meet future business needs. 'I think the financial scandals of the late 80s and early 90s and more recently Enron, Worldcom and Parmalat have shaken public confidence. But these do not represent the profession as a whole, which thrives on public welfare and the trust reposed in it. I think that when qualified Chartered Accountants carry on their duties efficiently, it will increasingly instill public confidence in their role as key players in the economy.' Dyson has often lamented the fact that the cumulative weight of regulation is overburdening the audit profession as it detracts professionals from their work and would inevitably have an adverse effect on audit quality. 'I think it is a major risk. The constraints imposed upon the profession are great. We need to reduce the complexity of our practices and guidelines. The level of regulation is putting off quality professionals from audit as it creates unnecessary complexity for accountants. We need to regenerate the audit profession by unburdening it from overregulation. While I recognize the importance of independent oversight I believe there is an increased pressure of documentation which isn't necessarily very productive. It restricts the use of judgment and makes the audit profession less attractive.' Dyson is concerned that the delay in convergence of IFRS and US GAAP may not be serving the stakeholders well. He believes that unless the rules based, class actions based litigation culture in the US changes 'we will end up with two sets of accounting standards that can work in parallel', but not one set of similar standards that can 'assist the understanding of potential investors and improve confidence in reporting.' Paul Grant wrote in Accountancy Age that the 'MBA qualification poses a bigger threat to the ICAEW than
Rana Mustansir, for ICAP

July-August 2007
36
In-House
The Fall of The Soviet Union and The Rise of Russia

How Economic Policy Can Break and Remake A Superpower
'The best way to destroy the capitalist system is to debase the currency.' Nikolai Lenin, 1870 to 1924, founding member of the Soviet Union The purpose of socialist planning according to Marxist aspirations was to entirely eliminate the market and plan the economy as a serfdom. Stalin, Trotsky and Lenin envisioned a Union of Soviet Socialist Republics (USSR) based on a system of state ownership and administrative planning. The focus of Soviet economy was always heavy industry. Soviet Union was among the top three manufacturers of basic and heavy industrial products. From the Stalin era through the late 1980s the Soviet economy was managed through a series of Five Year Plans which failed to deliver results since a climate of political persecution and fear stopped producers and consumers to share reliable input and output information with the planners. As a result industrial units either over produced leading to accumulation, or under produced leading to shortages, specially in consumer goods, which came to be sold on the black market. While Soviet Union became the world's leading producer of oil, coal, natural gas and minerals, the economy slowed down drastically at the enterprise level with worker alienation, lack of innovation, and bureaucratic interference. During the 1950s, the Soviet ruble was considered a 'soft currency', almost impossible to be exchanged for hard currency, since the Cold War had induced international isolation of the Soviet Union. As a result, the Soviet Union sold commodities in exchange for US dollars. Those dollars could not be deposited in conventional American banks on the likelihood that the US government would freeze those accounts in the event of a confrontation between the two superpowers. Eventually, those dollars were deposited in European banks which issued a telex address code called 'euro-bank'. These deposits would be the start of the eurocurrency market. When Leonid Brezhnev died in 1982 the state of the Soviet economy had reached crisis proportions. Until the late 1980s government was dominated at all levels by the Politburo which formulated economic policy and planned and executed major investment projects. Mikhail Gorbachev took office in March 1985 and spoke of the need to effect 'deep transformations in the economy' and the whole Soviet social system through his policies of perestroika (economic restructuring) and glasnost (openness or political liberalization). Perestroika ushered in the legalization of cooperatives and other semi-private businesses, and the de-monopolization and legalization of price controls, but glasnost revealed dirty state crimes undermining public confidence in the state's ability to lead them out of poverty. Hundreds of thousands of political prisoners were languishing in the Gulag which became known as a mechanism for repressing political opposition to the Soviet state. Organized crime which had prevailed in the communist nomenclature became rampant. In 1988 Mikhail Gorbachev told the Central Committee of the Communist Party that except for vodka sales and the sale of Soviet oil, the economy had not grown for twenty years.
July-August 2007
37
In-House
Meanwhile, to the utter chagrin of Gorbachev, the liberals were rising under the colorful Boris Yeltsin, then speaker of the Russian Parliament. Supported by Boris Yeltsin, calls for independence from Moscow's rule grew louder from the Baltic Republics of Estonia, Lithuania and Latvia which had been annexed into the Soviet Union by Joseph Stalin in 1940. Nationalist movements also took hold in other Soviet republics such as Ukraine, Georgia and Azerbaijan. Perestroika and glasnost which had opened up the Soviet state to the western world, eventually led to the disintegration of the empire. The 'Washington Consensus', a familiar term in development policy, became the basis for the transformation of socialist economies after the fall of the Soviet Union. The Consensus broadly recommends fiscal discipline, tax reform, trade liberalization, privatization of state enterprises, and deregulation. Yeltsin became President by popular vote in 1989 and introduced his ambitious 'shock therapy' reform program to accelerate privatization and allow prices to float in order to move quickly towards a market economy. Privatization progressed but without increase in production, inflation and currency devaluation skyrocketed. Russia received US$40 billion from the IMF and other international lending organizations. Most of these funds were allegedly embezzled by Yeltsin 'insiders' and deposited in foreign accounts. Thus ensued the August 1998 financial crisis when the Yeltsin government defaulted on its payment of debts causing financial markets to panic and the ruble to collapse. By December, 12-month inflation had reached 84 percent compared to a target of 8 percent. GDPshrank by 4.9 percent. Russia faced high public debt and low international liquidity. Following the 1998 crisis Russia experienced a dramatic recovery. Macroeconomic policy goals shifted towards maintaining a competitive real exchange rate and sustainable public debt, facilitated by devaluation and debt restructuring.
Yeltsin retired abruptly on December 31, 1999 handpicking his successor Vladimir Putin, a former KGB spy who, interestingly, had conducted economic espionage in Dresden in the Soviet bloc in East Germany until the Communist regime there collapsed. The characteristic feature of Putin's reign has been authoritarianism. Seventeen years in the notorious KGB are reflected in his 'managed democracy' style with its set parameters of what is permitted, and what is prohibited. One of the first steps he took as president was to reform an inefficient tax system by introducing a 13 percent flat tax on personal income, increasing real revenues from Personal Income Tax by 25.2 percent in the first year. However, an IMF study showed that sharp increases in Russian GDP growth and tax revenue after the introduction of the tax were not the result of tax reform, but of the sharp rise in oil prices, growing internal demand and strong real wage growth. Putin has followed a reformist program from the beginning of his term. His economic program was aimed at placating Western lenders, on the one hand, with deregulation proposals and by doing away with Soviet-style bureaucracy that hampers private commerce, while strengthening state intervention in the economy. Despite restrictions on foreign investment, an improving overall business environment has led to increased inflows of Foreign Direct Investment (FDI). The new leadership and strategic shift in economic policy has been a critical factor in Russia's rebound. The ideological consensus among Russian elite is: There is no alternative to a market economy. Russia's principal means of power projection should be economic, not military. To further consolidate Russia's economic stance, Vladimir Putin has recently appointed Elvira Nabiullina as Economics Minister. The new minister is regarded as a low-key academic from a think tank that drafted President Putin's economic program seven years ago. Her predecessor, German Graf, was widely unpopular for his pro-Western free market economic reforms. Analysts in Russia are welcoming the move as an effort by Putin's government to fight corruption and strengthen financial controls over government policy. Vladimir Putin is considered a hero by the Russian people, but is barred by the constitution to run for a second consecutive term as president. Victor Zubkov, who headed Russia's anti money laundering agency for six years was named Prime Minister in a surprise move, and is being considered a strong candidate for the presidency.
July-August 2007
38
In-House
People
Jurgen E. Schrempp: Former CEO, DaimlerChrysler Legacy of A Chief Excutive
urgen Schrempp was the infamous architect of the failed Daimler-Benz and Chrysler Corp merger in 1998. Daimler-Benz is the maker of Mercedes-Benz automobiles and trucks and Germany's largest industrial conglomerate. Chrysler is America's third largest automaker. Schrempp's vision was to make DaimlerChrysler the world's leading automobile manufacturer. To do this, he merged Daimler and Chrysler in 1998, and took important stakes in Asian carmakers Mitsubishi and Hyundai in 2000.
For Daimler-Benz the merger promised immediate access to the North American mass market for automobiles without diluting the upscale image of its Mercedes-Benz brand. It would also give the German company production capacity outside Germany, where worker wages and benefits are among the highest in the world. But the fact remained that other big automotive mergers had not worked well in the past, and the partners in this marriage differed starkly in culture and product. Chrysler built middle-class Jeeps, vans and pickup trucks, and had a negligible European presence. Daimler-Benz was elite and European. Company officials in Germany acknowledged that it would be too dangerous to head too far in the direction of middle-class sedans under the Mercedes name. Though Daimler-Benz was expected to be the dominant partner in the merger, Schrempp and his associates pitched the deal to investors as a 'merger of equals'. The new company called DaimlerChrysler was incorporated in Germany with headquarters in Michigan and Stuttgart, while Daimler-Benz's shareholders owned the majority of the shares. It was agreed that the company would be jointly run for a number of years by Jurgen Schrempp, the chief executive of Daimler-Benz, and Robert J. Eaton, Chrysler's chief executive. Schrempp could take control after their joint term.
As Chairman of Daimler, Schrempp had initially won a power struggle with Mercedes-Benz Chairman Helmut Werner for a Mercedes-Benz Daimler reintegration as part of a reorganization approved by the Daimler-Benz AG Board of Directors. The move gave Schrempp more control over the profitable Mercedes unit which had been an independent division since 1989. In 1998, with Schrempp as CEO, Daimler-Benz AG announced its US$36 billion acquisition of the Chrysler Corporation. The deal became the biggest industrial takeover in history, and the biggest acquisition of an American company by a foreign buyer. The merger was destined to reshape the United States automobile industry by uniting America's third-largest car maker with Germany's renowned producer of luxury cars and heavy duty trucks.
July-August 2007
39
chrempp, 53, was aggressive, strong-willed and competitive. He had put Daimler through a radical overhaul since he took over as Chairman in 1995. Eaton was a low-key manager. The success of the merger depended on how well the two chief executives would get along. In their book Taken for a Ride: How Daimler-Benz Drove off with Chrysler, authors Bill Vlasic and Bradley A. Stertz describe the Schrempp-Eaton relationship: 'The Chrysler executives thought Eaton appeared intimidated by Schrempp. Their public appearances had taken on a set character. Eaton spoke first, generally on broad topics such as the economy or global consolidation. Schrempp tackled the hard business issues, laying out DaimlerChrysler's agenda, promising that profits would grow faster than revenue. But more than the substance differed. Schrempp was a natural-born speaker, entertaining and assertive, his confidence palpable in every word. Schrempp didn't exactly intimidate Eaton. He overwhelmed him. Eaton didn't cower. He abdicated.' Another important reason for the failed merger was that the two cultures never meshed, and expected synergies did not materialize. Also in Taken for a Ride: 'German and American teams flew back and forth, huddling on projects to share accounting techniques, computer software, and diesel engines. The PostMerger Integration team sequestered itself in a windowless fourth-floor office in Auburn Hills, painstakingly reviewing hundreds of practices that could be standardized. The dialogue was constructive as often as frustrating, yet the great divide between the Germans and the Americans seemed as deep as it was wide. They didn't just make cars differently. They lived in separate worlds.'
n October 2000, in an interview to the Financial Times, Schrempp admitted that the merger was never a merger of two equal companies as originally presented, but rather a takeover of Chrysler by Daimler-Benz. Schrempp's statement caused a riot. As a consequence, the reclusive American billionaire investor Kirk Kerkorian, the largest holder of DaimlerChrysler stock at the time of the merger with a 13.75 percent stake, filed a billion dollar fraud lawsuit against the company contending that the US$36 billion transaction that created DaimlerChrysler was in reality an acquisition of Chrysler, and had deprived him of the $1.2 billion premium he would have demanded under an outright takeover. Kerkorian alleged that Schrempp misled him in to believing that it was a 'merger of equals' while deceiving shareholders and the Securities & Exchange Commission.
By late October, Schrempp's credibility had fallen drastically. He was quoted as saying, 'Originally Chrysler was supposed to make a $3.79 billion profit in 2000. In July the expectation was reduced to about $3.03 billion. In October to about $2.11 billion. And now we are talking about less than two billion, and I fear we haven't yet seen the end.' By the end of November 2000, leading German and US investors were calling for Schrempp's resignation. By February 2004, the DaimlerChrysler Board was deliberating whether to extend the embattled Schrempp's contract which was set to expire in 2005. German news magazine Stern depicted Schrempp as isolated and suggested that he could be ousted if the company did not become solidly profitable soon. In July 2005, after years of poor performance and against general opinion, the Board terminated Schrempp's contract. On January 1, 2006, after ten years as the head of the company, Jurgen Schrempp was succeeded by Chrysler frontman Dieter Zetsche. Zetsche's cost-cutting strategies had successfully restored profits when he was director at Chrysler. The BOD decided to abandon the firm's worldwide strategy in favor of a refocus on the firm's core competencies. In February 2007, DaimlerChrysler announced they were interested in selling the Chrysler Group, the US arm of DaimlerChrysler. In April 2007, Kirk Kerkorian made a failed $4.58 billion bid for the group. In May, 80.1 percent of the Chrysler Group was sold to the private equity firm Cerberus Capital Management for $7.81 billion. Schrempp's case received worldwide attention, so much so that it became the basis for a paper titled Managerial Legacies, Entrenchment and Strategic Inertia* that investigated a firm's decision to retain or fire a poorly performing CEO when the CEO's strategy has long-term cash flow implications beyond his tenure, i.e. he leaves behind a legacy. The aim of this paper was to explore how managers create legacies in the firms they manage. The failure of the DaimlerChrysler merger demonstrated that while globalization holds promise, it is also fraught with unforeseen and inundating problems.
Schrempp's case became the basis for a paper titled Managerial Legacies, Entrenchment and Strategic Inertia that investigated a firm's decision to retain or fire a poorly performing CEO when the CEO's strategy has long term cash flow implications beyond his tenure.
Stock prices had been falling steadily since January 1999. On May 5, 1998, the day before the merger story broke, Chrysler stock traded at $41.38. Nineteen months after the euphoria of the Chrysler/Daimler deal, that share was worth $41.27 as DaimlerChrysler stock.
*Managerial Legacies, Entrenchment and Strategic Inertia by Catherine Casamatta @ University of Toulouse & Alexander Guembel @ University of Oxford and Said Business School.
July-August 2007
41
In-House
World In Focus
Pakistan Is an Emerging Market for Sukuk
According to Moody's Corporate Finance, Pakistan has huge potential as a sukuk (Islamic bond) market. Though still in a nascent stage as compared to Malaysia, the Pakistan market is expected to grow significantly over the coming years. Moody's believes the prospects for markets in sukuk and Islamic financing in general are very encouraging in Asia. Pakistan Sees Significant Improvement in Tax Collection Pakistan's tax revenue during the last financial year (JulyJune) reached an all time high of Rs.825 billion (US$13.75 billion). The government hopes to raise revenues in this financial year to more than Rs.1 trillion (US$16.66 billion) which is unprecedented in the country's fiscal history. This has been due mainly to a new tax regime with increased reliance on taxpayers to solicit information. However, the optimism surrounding the changing taxation culture in the country is dampened by the fact that currently taxpayers form a mere one percent of Pakistan's total population of 165 billion.
World Bank Sees Strong Global Growth

At the recent Asia Pacific Economic Cooperation meeting, World Bank President Robert Zoellick said that 'the underlying fundamentals for growth and development remain quite strong', but the credit squeeze in financial markets is forcing investors to reevaluate the amount of risk they want to take on. He also said the Asian banking sector was now better capitalized to withstand shocks than during the Asian financial crisis of 1998, but many Asian countries needed to develop their capital markets to attract much-needed foreign investment.
Telepresence Takes Over Videoconferencing

Hewlett-Packard, Cisco and several other technology firms have started selling a spruced up version of videoconferencing called 'Telepresence'. Users still communicate via live audio and video feeds, but the speed and quality of transmission have increased with multiple screens in order to create the illusion that the parties to a conversation are actually sitting across a table from each other. Rooms, furniture and wallpaper are often identical to aid the illusion. In order to give people the feeling that they are making eye contact, multiple cameras and enormous computing power are involved. The delays in sight and sound are kept below 250 milliseconds (the threshold at which the human brain starts to notice) so that people can interrupt each other naturally. HP charges US$350,000 for every room it rents out for telepresence. Cisco charges up to $299,000 per room. Research firm Frost & Sullivan says despite their high cost telepresence systems quickly pay for themselves by keeping travel bills down and saving time and environmental costs. It forecasts that the global market for telepresence will grow by 56 percent a year to reach $1.24 billion by 2013. The Pakistan Accountant
Subprime Crisis in US Causes Global Turmoil

Global financial markets faced a real crisis last month as a result of the subprime mortgage loan problems in the United States. The problem emerged in the US with the announcement early August of the bankruptcy of American Home Mortgage Corp. and the retrenchment of 7,400 employees. Its shares had dropped from $36.4 to $0.28 within a year. As fears spread across Europe, Japan and Australia, the US Federal Reserve pumped in two payments, the European Central Bank over 100 billion euros and the Central Bank of Japan over $8 billion to avoid the collapse of global financial markets. This was followed by further action from the central banks in China, Malaysia and Australia.
July-August 2007
42
In-House
Greenspan Speaks
For decades Alan Greenspan was known as the financial oracle whose cryptic statements had the power to move markets across the world. His words can still cause tremors, but now, in his first major book, he finally speaks in his own voice. Charming and clear, The Age of Turbulence tells a surprisingly personal story of his remarkable career and takes a brilliant look at the state, and the future, of the world economy. Available@amazon.com Hardcover US$ 20.99
Super Crunchers Why Thinking-by-Numbers Is the New Way to Be Smart

Ian Ayres Today, number crunching affects your life in ways you might never imagine. In this lively and groundbreaking new book, economist Ian Ayres shows how today's best and brightest organizations are analyzing massive databases at lightening speed to provide greater insights into human behavior. They are the "Super Crunchers." From Internet sites like Google and Amazon that know your tastes better than you do, to a physician's diagnosis and your child's education, to boardrooms and government agencies, this new breed of decision makers is calling the shots. And they are delivering staggeringly accurate results. Gone are the days of solely relying on intuition to make decisions. Super Crunchers. shows us the benefits and risks, who loses and who wins, and how super crunching can be used to help, not manipulate us. Paperback US$16.50
The Three Signs of a Miserable Job: A Fable for Managers and their Employees
Patrick Lencioni Patrick Lencioni, business guru and bestselling author, is on a mission to create widespread job satisfaction in a world full of workplace misery. In The Three Signs of a Miserable Job, he tells the tale of a high-flying, but dissatisfied executive who ditches power and perks for career bliss as a pizzeria manager! In this unusual and inspiring story, Lencioni shows how career happiness (or misery) depends on the manageremployee relationship. Available@amazon.com Hardcover US$16.47
July-August 2007
43
Students Section
What is a Corporate Credit Rating
Credit Rating is an assessment of the credit worthiness of individuals and corporations. It is based upon the history of borrowing and repayment, as well as the availability of assets and extent of liabilities. It is the process of providing independent objective assessments of the credit worthiness of companies and countries through a credit ratings agency which helps investors decide how risky it is to invest money in a specific company, investing instrument, or market, as well as decide which companies and which countries are good investment opportunities. The three top credit ratings agencies for the investment world are Moody's, Standard & Poor's (S&P's), and Fitch IBCA. Ratings are a measure of an entity's ability and willingness to repay debt. The ratings range from highest credit quality to default or junk. Triple A (AAA) is the highest credit quality and C or D is the lowest or junk quality. There are different degrees of each rating, which, depending on the agency, are sometimes denoted by a plus or negative sign or a number. AAA rating signifies the highest investment grade and means that there is very low credit risk. "AA" represents very high credit quality; "A" means high credit quality; and "BBB" is good credit quality. Ratings that fall under "BBB" are considered to be speculative or junk. Credit rating is a useful tool as a good investment rating elevates the status of a company, a security, or a country to global standards, and helps them attract foreign investment and boost a nation's economy. A Sovereign Credit Rating signifies a country's overall ability to provide a secure investment environment, which is the first thing institutional investors will look at when making a decision to invest in that country. A country with a good sovereign credit rating will, therefore, get more prominence.
July-August 2007
44

Ccountant: Islamic Economic System

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Accountant

Magazine of the Institute of Chartered Accountants of Pakistan

Islamic Economic System

July- August 2007

Abdul Rahim Suriya

The Pakistan Accountant

The Pakistan Accountant

Faith and Finance

Origins of Islamic Banking in Pakistan

The Pakistan Accountant

of Financial System (CTFS)

The Pakistan Accountant

SBP's Musharakah based Islamic Export Refinance Scheme (IERS)

Subsidiaries & Standalone Islamic Banking Branches (IBBs)

Future of Islamic Banking

Islamic Finance Emerging Challenges of Supervision

Dr. Shamshad Akhtar Governor, State Bank of Pakistan

II. Factors driving cross-sector linkages and interdependencies

The Pakistan Accountant

III. Supervisory challenges posed by cross-sector developments

IV. Sector inter-linkages of Pakistan's Islamic finance system

The Pakistan Accountant

The Facets of Islamic Economy

The Pakistan Accountant

The Pakistan Accountant

The Pakistan Accountant

Nadia Azhar, ACA

The Pakistan Accountant

State and Wealth Distribution:

Nadia Azhar ACA is also ACCA. She is a partner in a professional firm.

The Pakistan Accountant

The Pakistan Accountant

The Pakistan Accountant

The Rise and Fall of Structured Credit

The Pakistan Accountant

Sub prime Mortgage Crisis in US

The Pakistan Accountant

Credit Risk Management

Guiding Principles for Implementation

The Pakistan Accountant

(a) Clearly defined lending policies

(c) Credit Risk Management Policies

(b) Credit Portfolio Quality Review

(d) Policies to limit or reduce credit risk

(e) Asset classification

(f) Loan loss provisioning policy

Robust MIS support

Reverse Mortgage Loan (RMLs) in India:

The Pakistan Accountant

RML: The Concept

How Does RML Work

The Pakistan Accountant

Issues and Challenges for RMLs

RMLs and Taxation Issues

The Pakistan Accountant

The Pakistan Accountant

The Pakistan Accountant

Why it is Important to Maintain Audit Quality

The Pakistan Accountant

In Conversation Richard Dyson, WithPresident ICAEW

The Pakistan Accountant

Rana Mustansir, for ICAP