Lessons from Financial Catastrophe

LESSONS FROM FINANCIAL CATASTROPHE <!--[if gte mso 10]> LESSONS FROM FINANCIAL CATASTROPHE By M. Iqbal Patel, Chartered Accountant, Karachi The world is in the grip of recession due to the recent worst financial turmoil since Great Depression in the world's super power United States is preceded by rising housing prices and rapid expansion of credit. Similar banking crisis were cropped around the globe over past 30 years. The present financial turmoil has number of lessons to be learnt from the episode for developing countries such as Pakistan in general and Muslims in particular. Credit agencies.---The regulators in US, Pakistan and the banks and financial institutions put greater reliance on the ratings assigned by the credit agencies. In the U.S. the banks allowed housing finance on the basis of rating given by the credit agencies to the borrowers, despite it the borrowers failed to repay their loans. It brought the credit agencies to the criticism for their failure in performing their obligation towards the banks. William Rutledge Executive, Vice-President of the Federal Reserve Bank (FRB), criticized ratings agencies for failing to adequately identify risks in sub-prime mortgages. He said that the US financial regulatory structure has been shown to have some major weaknesses. Many mortgage-backed securities that had been given triple-A credit ratings took losses. He further advised that the investors should move away from relying on ratings agencies and emphasized that these credit agencies also come under more scrutiny by US regulators after they underestimated the risk of failing sub-prime mortgage loans. The European Commission has called for clampdown on credit rating agencies. Leading rating agencies Moody's standard and Poor's and Fitch have come under fire for being to slow to alert investors to the dangers of investment based US high risk sub prime home mortgage loans. It has proposed for tougher rules for rating agencies to be one of the measures to be considered. These are (i) rating's agencies should be banned from doing consulting work over concerns about potential conflicts of interests, (ii) they would also be required to disclose how they make their ratings, (iii) and would not be allowed to rate a security if they did not have sufficiently reliable information to do so properly, (iv) Further they would also be required to have at least three independent directors on their boards whose pay is not tired to business performance, (v) internal reviews of rating quality would be required and (vi) annual transparency reports would have to be published. EU Internal Markets Commissioner Charlie McCreevy, said that these very exciting rules are necessary to restore the confidence of the market in ratings business in the European Union. The regulators in Pakistan has also lesson to learn that rating given by the credit agencies are not always be taken on face value, there should be a system to scrutinize the rating assigned by these credit agencies. The regulations governing the rating agencies should have provision for punishment; penalty etc. in case the rating proves to have been wrongly assigned by a credit agency. Similarly the banks and financial institutions should not rely the rating blindly but they should install a system to confirm the correctness of the rating. Financing Policies.---The financial crisis developed in the US may be attributed to lending financial policy of the banks who lent money to the borrowers against mortgage of the house to be purchased by them at low of interest and on easy repayment terms. It created ' intense competition among the banks that started to lend to even to the borrower who could not afford to purchase mortgages and were not meeting standard of creditworthiness. The borrowers could not afford the increase in interest rate by the banks subsequently; consequently they began to default in repayment of their loan instalments. Hence gradually the banks felt liquidity crisis. Similar situation is visible in our banking system. The banks have started to issue credit cards, auto financing or consumer financing on simple documentation without scrutinizing credit worthiness of the borrowers. Further intense competition among the bankers has deteriorated their scrutiny standards. The banks should learn lesson from the credit crisis of US and review their credit policy accordingly to prevent their down fall. The consumer financing in the form of credit card, auto financing and financing of luxury goods such as home electrical appliances etc. are some of the areas that the banks financed over the past few years instead of the industry which should have brought economic development and employment of the country. The State Bank of Pakistan has recognized that rapid credit growth in recent year has resulted .in high credit risk. The banks may earn profit initially from consumer financing but they will face similar credit crisis like cropped up in the US. as a result of similar financing policy. The SBP in order to avoid a repeat of like prime crisis of the US banks, should tight consumer financing standards. Weaknesses in Western Financial System.---There appears agreement among the European and other countries that present US financial turmoil has established that it is the capitalist system that has caused the financial crisis in the US and world over. There is consensus among all the developed countries including the US to create new financial architecture. The bailout package approved by the Congress was with a view to averting a collapse of capitalism. The economic discipline which has been developed in the West during last two centuries poses certain problems. The pursuit of efficiency and optimal allocation of resources have become the central problems, in addition the system lacks to other equally important factors such as equality, justice, the social and ecological consequences of economic efforts. All these factors have weakened the link between wealth and well-being. Finally money, which was primarily a medium of exchange; has become an objective in itself. Further the most important factor making their financial system is the institution of interest that has played a crucial role in this transformation. Consequently the economic system of West failed to address the problems of the mankind, instead, the miseries of the humanity remains unrelieved. It also leads the concentration of wealth in few hands, hence gap between rich and poor has widened considerably. This crisis thus has provided an opportunity to the Muslim countries to offer the Western world the Islamic Financial System as the solution to replace it with capitalism. The Islamic Financial System.---The world has learnt the lesson that the capitalism does not ensure the prosperity and is subject to weaknesses, hence new financial system requires to be framed. The Muslim countries should seize the opportunity and present the Islamic economic system to substitute for capitalism. The Islamic financial system provides for right of private property, freedom of enterprise, market mechanism and profit motive which are all integral part of the Islamic economic system like in capitalism. The distinct character and role of these factors are fashioned in the Islamic financial system by virtue of frame work of Islam. The fundamental difference being that Islam eliminates interest from its financial system which is corner stone in capitalism. But eliminating interest does not involve any denial of profitability of capital or its right to enjoy just return. The abolishing of interest in Islam is because in capitalism a predetermined fixed return on capital is without sharing the risk of the business contrarily Islam entitles capital to a return based actual productivity. Islamic economy is primarily an equity based one, not riddled with debts. Collective Actions.---The financial crisis has shown a unique unity among the US, European countries and all developed countries who have determined to resolve the financial crisis collectively. The French Prime Minister, Fancosis Fillon said only collective action could solve the financial crisis as the world is on the edge of the abyss because of an irresponsible system. British Prime Minister, Gordon Brown said only by global action can we fully restore the confidence that is needed and build the international financial order. Chinese Premier Wen Jiabao said overcoming the crisis requires global action and a joint response. Contrary to this if we look at the issues confronting to Pakistan in particular and Muslim Ummah in general, such as terrorism, right of self determination of people of Kashmir, Palestinians and in other parts of the world, the Muslim countries have not taken united stand to fight against these injustices. Since the cataclysm of 9/11, has radicalized the western perception of Islam and the Muslims. A religion of peace and tranquility that Islam inherently is in its pristine sense is, regrettably, associated with violence, bloodletting and terrorism, Islam, today, is stuck in the western mind as religion which has a zero tolerance for other religions and their followers. It is the high time that we all Muslim countries collectively and united, have to let world know clearly and categorically that western perception of Islam and Muslim is not correct. We have to establish our values transparently and remove confusion about them. -In fact the present Jihadi Group's activities are the reaction of the aggression and occupation with force of Muslim countries by the Western countries. The Muslim countries should collectively insist the. West to change these aggressive and unjust policies against Muslims which will bring lasting peace in the world.