Chapter 11: Investing the LARIBA Bank Deposits
As the LARIBA bank accumulates deposits, the most important next step is to employ that capital in a productive way to generate economic activity which in turn will generate profit, employment opportunities and more affluence for the community.
The investments department of the LARIBA bank can be looked upon as a finder of good investments for the purpose of enhancing the economic well being of the community leading to its financial independence.
The LARIBA bank investment officers (called loan officers in RIBA banks) can be looked upon as investment bankers and as development bankers.
In his/her capacity as an investment banker, he/she is responsible for finding investment opportunities for the owner of capital.
In this case he/she would match the risk level acceptable to the owners of capital and their investment objectives with investment opportunities available in the community.
This activity is rewarded in the form of a finders' credit.
The owner of capital would enter into a direct investment agreement with the owner of the investment idea and/or business person, Aamil, with the LARIBA bank acting as an intermediary (broker) and if agreeable as manger of that relationship.
In his/her capacity as a manager of the relationship the LARIBA bank would follow-up on the progress of the investment and the adherence of the Aamil to the conditions of the investment agreement, and can collect the profits due to the owner of the capital.
These and other services would be conducted by the LARIBA bank for a service fee agreed upon by the three parties;i.e. the owner of capital, the Aamil and the LARIBA bank.
The LARIBA bank can also act as a trustee on the deposited funds as well as a Mudarib of some of the deposits (only for depositors who allow Mudaraba using their deposits) and of the shareholders capital.
In this capacity the LARIBA bank would realize a service fee as well as participation in the profits/loss of the investments.
LARIBA FINANCING MODELS
1. Murabaha (Cost Plus)
In a Murabaha contract the client would approach the LARIBA bank to finance the purchase of a certain item.
Because the client does not have the funds, the bank would buy that item in response to the order of the client.
The title of that item transfers from the seller to the LARIBA bank.
Then, the LARIBA bank would have another sales agreement to sell the item to the client at a price which includes a profit element.
As a result of this sales step, the title transfers from the LARIBA bank to the client.
The total sales price (including the LARIBA bank's profit) would be paid back to the LARIBA bank over a period of time.
It is important to note that the sale price agreed upon between the LARIBA bank and the client is final.
Following are some questions about special situations which may arise in such dealings:-
1.1 How Does the LARIBA Bank Define its Profit?
The LARIBA bank, in its efforts to return an acceptable profit for its shareholders and investors, would study the market and the competition.
One important competition would be the RIBA banks and the products they offer for investors of capital.
For example, the interest rates paid by RIBA banks on certificates of deposit, savings accounts and money market instruments.
And because the LARIBA bank's objective is to return to its investors and shareholders a superior return (by 1.5-2%) over the interest paid by RIBA banks, this will define the opportunity rate of return expected by the owners of capital.
On the other hand, the LARIBA bank, in its effort to enhance its credibility with its customers, should advise its customers to shop around for the best available financing in the market.
This way, the LARIBA bank investment/finance committee would develop a range for the profit to be negotiated with the customer.
The LARIBA bank should make it clear in its negotiations that this profit is not of the same nature as that charged, in the form of interest, by the RIBA banks.
It should also be noted that the LARIBA bank officer should show the customer in dollars and cents the difference between the customer's cost of financing using LARIBA and RIBA.
Then comes the question to the customer: "what is your choice? You (the customer) have a choice between RIBA and LARIBA- the final decision is yours"
1.2.What If The Customer Wants To Accelerate His/Her Payments?
In RIBA banking, a time-value of money is applied.
Hence, if the customer wants to prepay, the time value is applied.
The customer pays less and maybe a prepayment fee.
In this case, the client can save some money.
This concept is not accepted from a Sharia (jurisprudence) point of view in LARIBA banking.
However, in case that happens, the LARIBA bank may include in the sales agreement a renegotiation clause to renegotiate the price in case of accelerated payments.
In addition, the time spent by the finance, the accounting and legal officers, in addition to any out of pocket expenses by the LARIBA bank should be charged.
1.3. What If The Customer Cannot Make The Payment and Honor the Contract?
This is the very unhappy situation in any financial institution RIBA or LARIBA.
The reason for the customer's inability to honor his/her contract may be one of the following:
1.3.1. The customer over-extended him/herself by expanding his/her activities and/or consumptive behavior beyond his/her means.
If this is the case, then it is the error of the LARIBA bank which was supposed to do an in-depth analysis of the customer's cash flow.
Of course, these situations can be specific and they vary from one customer to another.
However, the LARIBA bank should work with the customer and make a conscious decision as to how to help the customer meet his/her obligations.
May be this can be achieved through prolonging the repayment without charging any additional cost of money as is done by RIBA banks.
The only additional charges allowed are out of pocket expenses by the LARIBA bank, and the officers' time incurred in restructuring the contract.
If a person who has financed a car, for instance, repeatedly fails to make his/her payments then the car is re-possessed.
The car is sold in the market and if there is a credit due to the client, the money is paid back.
If there is a deficit, then the loss is LARIBA bank's loss.
1.3.2. The customer is faced with an unexpected calamity like, for example loosing his/her job.
In this case the customer is treated the same way as in 1.3.1 above.
The LARIBA bank, out of its good will, may decide to forgo any additional expenses and costs by donating the LARIBA bank expenses and officers time as part of its Zakah (Gharimoon- heavily indebted- category).
1.4 What If the Client was Found To Have Misrepresented Facts or To Have Given Incorrect Information ?
This is the time when the LARIBA bank has the right to withdraw the item financed.
The client is pursued to the fullest by the LARIBA bank in order to recover as much of the loss as possible.
Additionally, all out of pocket expenses should be charged to the client.
2. Leasing (Ajara)
Here, the LARIBA Bank would own title to the item financed.
At the request of the client, the bank would purchase the item and lease it back to the client for a predefined term.
Here one needs to differentiate between financial leases and capital leases as defined in RIBA financing.
In LARIBA financing, the lease would de defined by a certain period, usually 3, 5 or 7 years depending on the nature of the project or item leased.
At the end of the lease, the contract may stipulate that the client may have the option to buy the item at fair market value or the item would revert to the LARIBA bank to sell it in the market.
In practical terms, the lease profitability is defined by asking the client to shop around for competitive leases in the market.
In most leases the LARIBA bank, because of its lower overhead and lower loans losses, would be able to compete and lease the item at a lower rate than what the competition charges.
3. Lease/Purchase - Ajara/Imtilak
In this model the LARIBA bank would enter into a joint agreement with the client to buy an item.
For example the LARIBA bank would own 75% of the item and the client 25% of the item.
The lease rate is defined as the market dictates.
The 25% portion of the lease payment due to the client can be paid to the LARIBA bank to reduce the banks equity and increase the client's equity, such that after a certain time the client owns the whole item.
4. Joint Venture - Musharaka (Direct Investment/Equity ownership)
In this model the LARIBA bank or its investment subsidiary enters into direct investment in equity form with the other parties or clients.
Profit and/or loss would be assigned to each joint venture according to a well defined distribution formula.
5. Money Management - Mudaraba
Here the LARIBA bank itself can act as a money manager through its investment banking finance/investment advisory board.
The bank can also delegate that function (as a Wakeel) to other money managers.
The Mudaraba contract would stipulate the responsibility of the bank as a Mudarib (money manager) or as a Wakeel (representative with discretionary authority) of the client to find a money manager who will meet the risk level defined by the client and his/her other investment objectives.
Ultimately, the LARIBA bank, as it matures, would be involved in Mudaraba business in most of its businesses.
In the Mudaraba agreement the LARIBA bank can act in one of two capacities.
The first as a representative on behalf of the client (depositors).
In this case it would charge a small fee as a remuneration for its servicing the account.
The other would be as an active Mudarib (money manager).
Here the LARIBA bank can invest its own capital along with the capital of the clients.
Here the bank can participate in the profit/loss through its capital participation.
However, it can also participate in the profit realized from the client portion of the investment according to a predetermined formula.
In case of loss, the LARIBA bank would incur losses on its capital participation but would not assume any of the losses due to the client, assuming that the LARIBA bank has done its due diligence and evaluation of the venture.
The LARIBA bank, however, can charge a service fee to the client to pay for the cost of servicing the account.
6.Advanced Purchasing of Future Production - Futures - Baii Salam
In this model the LARIBA bank would come to an agreement to buy the production of an orchard, a farm or an item like equipment or automobiles, ahead of its production at an agreed upon price.
The money is paid in advance to the producer.
The producer, in turn, would use the money as a working capital to purchase the basic services, pay wages and buy raw materials necessary for the production.
In this model the bank would help in the growth of the economy by providing the liquidity necessary for economic growth.
THE STEP-WISE APPROACH TO RISK MANAGEMENT FOR A LARIBA BANK START-UP
It is important here to stress the importance of risk management for the LARIBA bank.
It should be stressed that the credibility and performance of the LARIBA bank are not only professional duties but also an Islamic requirement.
The simple fact is that a LARIBA bank should not be allowed to fail or loose people's money.
If that happens, then the dream will die for the next 3 to 4 generations.
We simply cannot and should not allow this to happen.
Areas of risk management are:
LARIBA model used in the financing. Diversification by client Diversification by sector Diversification by geographic location 1. Risk Management By Applying The Proper LARIBA Financing Model
As indicated above, Murabaha (cost plus) represents the least risky of the LARIBA financing model.
It is true that the profitability may be limited, and that the Murabaha model itself is not accepted by some quarters in the LARIBA financing field, but it offers a lowest risk type of investment.
The risk grows as we move from Murabaha and then to Baii Salam.
It is recommended that the LARIBA bank, in its infancy (first 5-7 years of operation) uses Murabaha and Ajara leasing as its primary models of financing with the intention of slowly moving forward to joint venturing (Musharaka), and Baii Salam (futures contract).
During these first 5-7 years, the LARIBA bank management should set aside sufficient reserves to allow it to progress towards the other forms of LARIBA Financing models.
This way, the risk is minimized.
2. Risk Management Through Diversification by Clients
Here, the LARIBA bank management should do its best to spread its financing activity throughout the community without concentrating the financing into a small number of already successful business persons.
This way the LARIBA bank activity would be dispersed throughout the community which may result in more clients on the investment side.
On the other hand, the probability of failure is distributed over a larger number of clients.
3. Risk Management Through Diversification By Sector
This is what will create the unique character of the LARIBA bank.
It is advisable to recruit a viable board of directors for the LARIBA bank which represents the business sectors to be financed by the bank.
It is also important that the LARIBA bank, through its analysis of the economic activity as well as political, financial and monetary developments, formulates an investment position on a quarterly basis.
In this analysis attractive sectors should be identified as well as non-attractive sectors.
This way the Credit Policies Committee of the LARIBA bank would devise an investment "pie" allocating how much of its funds should be invested in each sector.
The allocation would be dynamic and would change as the economic projections change.
4. Risk Management Through Diversification By Geographic Location
A close watch should be exercised by the LARIBA bank on the locations which it is interested in.
For example, if one is in the U.S.>, risk factors should be assessed for different states and major cities to allocate how much of the capital should be allocated in each location based on that risk factor.
If the bank is investing world-wide then the allocation would be by country and on the basis of the risk-reward of investing in that country.