Tuesday, May 6, 2008

Letters Edition #1

Quote of the Week:
'Arguments are to be avoided: they are always vulgar and often convincing.' - Oscar Wilde

Commentary for the Week (Letters of the week edition):

Dear Friends,

Welcome to our first 'Letters Edition' where we publish thoughts and submissions from our subscribers. I trust that you will find it enjoyable. The commentary will be back next week.

Letter No. 1:

Dear Jawad,

Comparing the bank's interest income of $50 from $1,000 with your wife's of the same amount from $100 is not comparing like items:

a) The bank is taking an additional risk on the $900 of loans that it does not have covered by her deposit.
b) Very importantly, the bank is facilitating enterprise, or even mere survival, to 10 borrowers who would otherwise remain incapacitated for lack of those funds.

Item (a) - compensation for risk - must surely also be factored into any determination of cost of capital.

Your Dear Friend,

Letter No. 2:

Salam alaikum,

The problem with your analysis of the banks' profitability from the $100 deposit is that you ignore the countervailing consumer surplus generated by 10 loans instead of one. If your wife loans you the money and makes $50, you are worse off by $45, but presumably still better off in a pareto sense, or else you would not have fixed your car. When the bank makes 10 loans to earn the same $50 owned by your wife, it is presumably making nine other people better off, so overall welfare is increased manifold. Even if the bank makes the same absolute profit as your wife, its share of the increased welfare is much less in a relative sense and the net increase in social welfare is presumably on the order of 10 relative to the one transaction with your wife.

Best wishes,

Mohammad Fadel
Assistant Professor of Law
University of Toronto Faculty of Law


My response to Letter No. 1:

Dear SK,

As you show little mercy, I respond thusly:

a. There is no $900 ... there is $1000 that only exists as debt owed to the bank, and there is a $100 deposit. The former does not exist as pre-existing wealth or deposits. The only part that is 'capital' and the bank is on the hook for to the depositor is the $100. Furthermore, if the $100 is in a chequing account, the bank would not even be paying out interest to the depositor. This is actually a very key point - the $1000 is not 'capital', the $100 deposit is. The $1000 exists only as debt owed to the bank, not as somebody's deposit that it has to manage judiciously. Of course, any repayment of the $1000 loaned out and the interest charged is profit. I hope that helps because the key to this whole picture is that the capital risk you speak of is intrinsic to the bank's use of leverage in operations, not a result of the fiduciary management of someone's deposits.

b. This is indeed quite a valid observation - something that has been brought up by another honourable genius such as yourself. He probably beat you to opening the email. Unfortunately, you will have to wait until next week for a response. This point is too important for us not to share with everyone...

Point b is quite similar to Dr. Fadel's and is addressed below:

My response to Letter No. 2:

Although I responded to Dr. Fadel's critique privately already, his astute and wise observations deserve wider readership .

As he states, the efficiency gains from having a lower prevailing interest rate are not insignificant. Indeed, if the only loans available were at 50% interest, much of what passes for commerce in today's economy would come to a halt. My wife's $100, left in her own hands it seems, would make for a poor lubricant to the wheels of Progress.

Where I disagree with the good professor however, is on whether efficiency is our only ultimate goal. One of the central problems or tradeoffs that exists in economic decision-making is whether to devote precious resources towards making gains in efficiency or towards those that enhance economic equality, which is a moral standard (I refer you to the work of the economist Arthur Okun). Whereas Dr. Fadel's critique is informed by the imperatives of efficiency, my argument was made more from the perspective of morality. Lowering the prevailing interest rate from 50% to 5% is a gain in the efficiency of the system, not necessarily its morality. What he also reminds us, of course, is that if we could figure out a way, 0% rates would not just be moral, but be exceedingly efficient as well. Again, I don't believe that either of us fundamentally wrong, just that we are not entirely Right either.

I thank Dr. Fadel for allowing us to learn from his wisdom and expertise. For those of whom that do not know of him yet, he is an active, respected and sharp contributor to debates within Islamic Finance. I am honoured to be guided by him and I look forward to many more exchanges, agreements and disagreements with him in the years to come.

Thank you to all who wrote back with their views. A special thank you to people that asked me to get married to someone that charged less interest - I thought that their concern was very touching. The word of the week is 'Hypothetical'.

Finance News:

1. A very timely story for what we have been discussing here ... if you get a chance to read a book on finance this year, try Satyajit Das' 'Traders, Guns and Money' ... it is both funny and insightful. This interview is a good introduction ... http://www.reportonbusiness.com/servlet/story/RTGAM.20071124.r-takingstock24/BNStory/robColumnsBlogs/?cid=al_gam_nletter_maropen

2. A very interesting development in the mining sector has been the recent proposed buyout of Rio Tinto by BHP Billiton ... I encourage you to try and follow this story because there is something deeper going on ... First, at around $150 Billion, it is not a small buyout. Second, the shareholders refuse to accept $150 Billion because they know that what they have in the ground (minerals) are worth more than the dollars (paper) they are being offered today ... http://www.theglobeandmail.com/servlet/story/LAC.20071203.RBHP03/TPStory?cid=al_gam_globeedge

3. Who watches out for investor interests in Canada? The ROB discusses whether they are doing an adequate job ... http://www.reportonbusiness.com/servlet/story/RTGAM.20071203.wimet1204/BNStory/robNews/home

Economic News:

1. How the Subprime loan mess is related to the credit crunch and how that is related to the US $ ... http://www.atimes.com/atimes/Global_Economy/IK16Dj02.html

2. Think you know the Price of Oil ... I mean the Real Price of Oil ... http://www.atimes.com/atimes/Global_Economy/IK22Dj02.html

3. How the wealth of the world has shifted towards the East, and how the new centres of power are behaving relative to the old ... http://www.mckinseyquarterly.com/Economic_Studies/Productivity_Performance/The_worlds_new_financial_power_brokers_2084

Middle Eastern / Islamic Finance:

1. S&P begins to question legal ownership in some 'Islamic' structures ... http://www.zawya.com/story.cfm/sidZAWYA20071126121542

2. How much is the slide in the US $ hurting OPEC? ... http://www.economist.com/finance/displaystory.cfm?story_id=10191717


1. Ever thought about having solar power? ... Here is some inspiration for you ... http://www.theglobeandmail.com/servlet/story/RTGAM.20071203.wlsolar03/BNStory/lifeMain/home

2. The economist rediscovers that the Middle East has more than Oil ... http://www.economist.com/daily/news/displaystory.cfm?story_id=10235761&fsrc=nwl

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