Alternative Finance Models - Essay Example

?Alternative Finance Models The global financial crisis which took place in the summer of 2007 spread like virus to countries all over the world including Europe and North America. According to a study over 100 such financial crisis have taken place so far and many scholars are now starting to doubt the financial system that countries have been following for years(Stiglitz,2003). After the end of World War II there have been various innovations in the Banking sector and communication and technology have played a major role in aiding these innovations. The question is, however, whether the financial system that countries have been following is reliable or not. The system failed in the recent financial crisis and many countries such as Bangladesh are now finding alternative finance models such as Grameen Banking and the Gulf countries have now introduced Islamic Banking. Both of these models have certain attributes that differentiates them from the conventional Banking system. The choice of the system depends on the nature of the country and the series of policies being followed by the government. According to the World Bank estimate, around 1.3 billion people live on less than a dollar per day. Grameen Bank system was formed in 1976 by Muhammed Yunus, with a vision to eradicate poverty from Bangladesh. (Anon., n.d.) This Bank is designed especially for the poor who have no education, no credit history and no assets to offer to the Bank (Latifee, 2008). The bank also aims to empower poor women who are usually the bread earners of the family (Anon., n.d.). Women in Bangladesh are engaged in activities such as farming or raising poultry and they need small loans in order to meet their daily needs. Furthermore, women in Bangladesh are not educated and lack the basic knowledge about banking activities. The Grameen Bank was formed especially for women in the rural areas who do not have the finances to pay for their children’s education or to pay for basic necessities such as food and water. With the Grameen bank designed especially for the poor these women and men can now go to the bank and avail the financial services like any other individual residing in the urban area. For example women can get loans from the Bank and start up their own business. The loan can be repaid within a period of 3 months or 3 years depending on the amount. There are no requirements for getting the loan but members are usually required to memorize the resolutions proposed by the Bank. These resolutions include statements such as “I will use clean drinking water, I will wash vegetables with clean water, I will use contraception when possible” and so on. It has been estimated that the population growth in Bangladesh fell after the Grameen Banking system was introduced (Yunus, 1999). The concept of resolutions was Muhammed Yunus’s idea and he wanted to educate the women of his own country and help them improve their standards of living. His strategy has worked and over 5% of borrowers from the Grameen Bank rose above the poverty level and extreme poverty declined by 70% in a span of 5 years (Yunus, 1999). The Bank also serves the beggars though its struggling members program. The main features of this program are: The rules of Grameen Bank do not apply to these members and they can form their own rules All loans given to these struggling families are free of interest and they can pay installments in any way they are comfortable with The beggars are not asked to give up begging but they are asked to engage in other income generating activities. The main idea behind this step is to slowly move these beggars away from beggary and introduce them to other income generating activities. Such programs help the poor in ways one could not have imagined. Grameen Bank is probably the first Bank in the history of Banking which is 100% made for the poor and of the poor. The poor own the Bank; after a year of membership they can buy shares in the bank and become members. According to the founder Muhammed Yunus around 94% of the bank is owned by the members (Yunus, 1999). The Bank is now present in over 40 countries and it continues to grow all over the world. Over 40,000 people in Malaysia have been served by this bank and their repayment rate has been stable at 100%. The bank has also served poor families in Bolivia and has helped women form their own businesses to serve their families (Yunus, 1999). The pioneer of this project Muhammed Yunus has been given various Peace awards by the United Nations and he has helped in improving the life of thousands of people all over the world. How does the system work? One of the most astounding features of the system is that it is designed according to the needs of the poor and there are no ground rules which have to be followed. In other words the rules and regulations are made by the poor themselves who have their full trust in the bank. The beggars are exempted from even following the basic rules of the bank and they get to design their own rules that suit them best. The Bank shapes itself according to the needs and culture of the area and serves the consumers accordingly. For example it serves consumers in Malaysia differently than it does in Bangladesh because the needs and social structure of these countries differ. In Grameen banking system, the bank forms groups and these groups elect a leader amongst themselves. The leader is usually the one who has the leadership qualities and the ability to oversee the activities of all group members. Loans are then given to two members from each group and these loans range from $25 to $100 (Yunus, 1999). The payments need to be made in weekly installments and after these two members repay their loans, the next two members are eligible to apply for the loan. If however one member fails to repay the loan the line of credit to the entire group gets suspended. Therefore all groups are usually punctual and the repayment rate is therefore between 96% and 100% (Yunus, 1999). After the repayment of 50 installments the borrower then has to pay the interest which is a little above the going interest rate. The meetings of these group members take place in the villages they live in and officials from Grameen also visit these meetings in order to see how activities are faring. The bank primarily lends to women because they are mostly responsible for nutrition and education of their children. Men usually spend all the money on themselves and are not as careful as women. It was noted by the World Bank that nutrition and education level of rural areas in Bangladesh improved ever since the Grameen Program was introduced (Yunus, 1999). The other Banking model followed by countries all over the world is Islamic Banking. Islamic Banking is a system which is governed by the rules and regulations laid down by the Islamic Shari’ah (Anon., n.d.). In other words, it follows the principles laid down in Islam and believes in interest free Banking. Transactions that take place are based on tangible assets and real services. This is because according to Shari’ah interest hurts the purchasing power of people, increases poverty and also increases the gap between the rich and the poor. It is based on the concept of risk sharing and one individual does not bear the loss of a transaction alone (Ahmad, 2008). The system is based on morals such as justice and equality and aims to prevent greed that arises out of individuals. It is designed for the greater good of society and the economy and does not encourage profit maximization. It is due to this reason that Islamic Banking aligns money with real assets so that the profits and losses are shared by all and not just one individual. Islam believes in risk sharing and this principle ensures that banking institutions monitor the risks of every transaction very carefully. The financer and the entrepreneur both share the risk equally and therefore any loss that arises out of the transaction is shared by both. This also prevents excessive lending by Banks which occurred during the global financial crisis of 2008. This principle will only work if the demand depositors are also actively involved with the financial institution and monitor the progress. The demand depositors do not get any return in Islamic banking but they get a guarantee of their deposits. This Islamic practice is just like buying shares of a company and then redeeming them later. The profits and losses are shared by all shareholders and everyone is a part of the transaction. By following this technique Islamic banks are able to get depositors who actively monitor their deposits and keep a close eye on the activities of the bank. Hence a bank that engages in risky activities and lends out excessive loans is not preferred by the depositors (Chapra, 2008). According to Islamic Banking, equity financing is the most desired way to finance and should be followed whenever possible. A Harvard professor Mr. Rogoff believes that in an ideal world equity financing and direct investment would play a bigger role (Rogoff, 1999). Despite the advantages of equity financing, debt financing continues to play a major role in the banking system because at times it is not possible to make parties amenable to equity, especially government and other institutions. It is due to this reason that Islamic Banking allows the creation of debt through the sale or lease of financial assets and the lease based modes of financing are murabahah, Ijarah, Salam, Istisna and Sukuk. There are certain conditions which need to be followed before debt is given out. This is to ensure that there is no excessive expansion of debt by the bank. The conditions are: The asset sold must be real and not imaginary. The nature of the transaction is a trade transaction where both parties hold the intention of giving and taking The goods being sold or leased must be possessed by the seller (Chapra, 2008). The first condition ensures that the banks do not engage in the practice of gambling and do not give out excessive loans. The practice of giving out excessive loans results in social tensions and an unregulated system (Sharma, 2002). The second condition ensures that the seller does not pass on the trade transaction to a third party and engage in speculative activities. Many at times the risks are passed on to a series of users and the loss becomes greater than the size of the economy (Chapra, 2008). These speculators are nothing more than rapacious speculators, who borrow heavily to beef up their belts (The Economist, 1998) and (Edwards, 1999). The last condition ensures that the seller takes part in risk sharing so that the burden of loss is shared by all and not just one individual. All of these conditions make Islamic banking quite unique and stronger than the conventional banking system. Islamic Banking believes in creating regulations that are understood by all parties and these regulations are not imposed. Imposing regulations do not guarantee that the bank will not engage in profit maximizing activities. Therefore users of this system not only know about Islamic regulations but understand their implications and the basic purpose behind them. Each Islamic product aims to maximize the welfare of society and those who understand this principle usually take part in Islamic banking. According to (Khawaja and Mian, 2005) Banks favor firms that are connected politically and do not favor the poor. This goes against Islamic principles whose main aim is to maximize welfare for all, regardless of age, income, political background and ethnicity. One factor that governments need to keep in mind is that Islamic Banking does not encourage excessive borrowing from the central Bank. Due to the recent financial crisis there banks have become risk averse and they have been lending excessively to the governments and not to consumers. This is because governments do not default as much as consumers do. Although this is true, this practice by the banks has lead to an increase in profit maximizing activities and concern of the consumer is not kept in mind. This again goes against the principle of Islamic banking which aims at providing banking services to benefit the consumers. The first Islamic Bank was the Dubai Islamic Bank (DIB) which was formed in 1975. It operates in over 48 countries and offers home, auto and personal finance products. This bank offers higher returns than conventional banks and has a variety of other products that help in maximizing economic prosperity. There are various differences and similarities between Grameen Banking and Islamic banking. One of the basic differences between the two finance models is that Islamic Banking is based purely on Shari’ah and follows all Islamic rules and regulations (Ahmad, 2008). Grameen Banking is designed especially for the poor and follows the conventional banking system (Elyas, 2001). Grameen banking does not demand higher interest on its loans from the poor but nevertheless some kind of interest has to be paid by the borrower after 50 installments have been made and so on (Yunus, 1999). There is no concept of equity financing in Grameen banking and most of the borrowing and lending is not backed by real assets or services. This is because the main objective of Grameen banking is to help the poor who have no assets or services in their possessions (Yunus, 1999). The element of interest rate can be avoided in Grameen banking by providing microfinance hybrids (Eagle, 2008). If this works out then both the Islamic Banking and Grameen Banking will become more similar than ever. The basic principles on which both of these systems rely are the same and their basic values are quite similar as well. For example Islamic Banking believes in extending loans to the poor and demands equal treatment of all regardless of age, color or ethnicity. Similarly Grameen banking is designed especially for the poor who have no access to banking institutions and who need loans more than anyone else. In this regard both models aim at maximizing the welfare of society and do not believe in individual loss sharing or gain sharing. For example in Grameen Banking system there are groups of 5 people who can borrow and lend from the bank and if one of the member defaults the entire group suffers as a result. Similarly in Islamic banking the loss is borne by both parties and not just the individual. This not only improves relations amongst peers but also helps in reducing risks. Users of Islamic banking ensure that there is transparency in the system and users of Grameen banking ensure that all of their members repay the loans. This way the society benefits and the economies do not create a loss that cannot be borne by them. Both of these banking systems have their advantages and disadvantages. Islamic banking is the fastest growing banking system in the world today and should not be overlooked. In order to benefit the most from Islamic banking, Islamic Banks should offer micro financing which can be availed by the poor. (Eagle, 2008). Both Islamic Banking and Grameen banking aim to eradicate social injustice and provide equal opportunities for all. The recent financial crisis could have been controlled by firms if Islamic Banking had been adopted (Chapra, 2008). This is because Islamic banking does not believe in giving excessive loans to the borrowers without any backing in the form of equity. In other words Islamic banking aims to promote equity financing by creating debts through sale of real assets and services. The losses of these transactions are then shared by both parties. This principle not only prevents excessive lending by banks but makes borrowers and lenders more prone to risk. The major reason behind the recent financial crisis was the fact that Banks were giving out loans to the public and these loans were not backed by any real assets. The result was that majority of the banks faced severe liquidity crisis and most of them had to close down. This would have been prevented if Islamic Banking was used. Grameen Banking would also have helped control the financial crisis by providing loans to the poor and ensuring that their needs were met. In US Grameen banking system is not so apparent because of the high labor costs prevalent in the country (Yunus, 1999). Nevertheless Grameen banking can be adopted to suit the needs of the region and the poor can then benefit from this banking system. Both Grameen Banking and Islamic Banking have their advantages and disadvantages. These banking models are unique and quite different from the conventional banking system. In the recent years there has been an increase in financial crisis and globalization has made the world into one global village. A financial meltdown in US can reach the entire world within seconds and the success of the banking system is seen by how vulnerable these systems are to the financial crisis. According to various analysts the conventional banking system has not been able to withstand the financial calamities and there is a need for an alternate system. There are various models which have been proposed b y scholars and one of the models is the merger of both Grameen banking and Islamic Banking. This is been proposed by Dr.Linda Eagle, keeping in mind the various similarities between the two banking systems. The success of this new system depends on the extent to which the system is willing to accommodate the poor and how far it goes to meet the needs of different countries. If successful, this new system can change the dynamics of world banking within years. 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