Feb 7 - 13, 20

Regarding an almost non-existent footprint of consumer finance, this scribe recently wrote:

"The consumer finance fiasco was more the result of a swiftly hiked interest rate and banking sector's greed that set a marketing trap for the uninitiated community of consumers without caring for the compliance of the cannons of prudent loaning, the syndrome that triggered US subprime mortgage catastrophe.

The size of consumer finance was in fact immaterial as it was simply negligible. It is the culture of underrating the importance of this critical segment of a developing economy that has stood in the way of an equitable distribution of national wealth. Consumer finance helps in creating assets, both tangible and financial which in turn play an important part in the social uplift of nations. The brief, bright moments of consumer financing era that our nation witnessed till the middle of 2008, brought a marked change in the lives of middle class people who, guided by a sense of prudence, improved their asset position by building a home or purchasing a car to solve their housing and transport problems."

The current high-interest-rate regime has seen further fading away of an already weak footprint of consumer finance. Unfortunately, our banking sector has ruthlessly destroyed the institution of consumer finance by fleecing the uninitiated and voiceless herds of low-income consumers. Exorbitant rates charged to the consumers and imprudent financing policies resulted in massive defaults driving the banks back to their protective shells. This resulted in an unannounced ban on consumer finance as banks found a new, wealthy, and risk-free borrower - the government - to take care of their copious liquidity. The attrition process is sustained and unambiguous, with the consumer finance percentage systematically tapering down from 5.7 per cent in June 2009 to 3.7 per cent in December 2010.


Total credit/loans 5,165 5,517 5,738 6,204
of which: Consumer finance 294 266 245 228
of which: Finance for cars etc. 78 69 64 57
Consumer finance as % of total 5.7 4.8 4.3 3.7

Car financing is a significant component of consumer finance accounting for a 25 to 26 per cent. The low-interest-rate era and excessive banks liquidity gave country's weaker sections of middle class population a chance to solve their housing and transport problems. Those were the times when leasing and modaraba sectors had not started to feel the pinch of liquidity squeeze. Banks and leasing companies infested the markets with their aggressive marketing teams to lure the low-to-average income families into signing car lease agreements that were heavily loaded in favor of the lessors. Beside unjust asset repossession clauses and high penalties in case of delayed payments, the banks and leasing companies took advantage of the complexity of IRR-based rental calculation under net present value concept and charged exorbitant rates to their customers.

The prospective lessees were usually fed with the normal rate, which was easy for them [lessees] to comprehend. The difference between the misleading normal rate and the effective IRR (Internal Rate of Return) used to be quite high giving banks and leasing companies a higher spread in comparison to other lending operations. This is illustrated here below with the use of an example:

One of the Islamic banks, like other banks, has tried to mystify a car lease transaction by spelling out certain "factors" for the calculation of monthly lease rentals. For example, the factor for a 5-year car lease against a car price of Rs500,000, on advance-booking basis, is 0.029146. When multiplied to the car price, this factor gives a monthly lease rental of Rs14,573 payable by the prospective lessee. A normal lessee, with basic and common knowledge of arithmetic, will proceed in the following way to determine the rate that is being charged:

Total payment by way of 60 rentals =60x14573 = Rs.874380
Interest/mark up portion =874380-500,000=374380
Interest/mark up per annum =374380/5=74876
Rate of interest/mark up =100x74876/500000=14.975 percent per annum

The rate is the nominal rate which the customers are usually fed with. It can be easily determined with the help of a financial calculator that the effective IRR in this case is 24.65 per cent, almost 10 per cent in excess of the normal rate. Besides interest cost, insurance charges, tracker fee, processing fee and delayed payment penalty are also there to increase the cost of car financing to an unmanageable level for people with average to moderately-high income. But, the most unfortunate aspect is that the lessees are usually not aware of the effective cost of borrowing for owning a car. This is time about our financial sector becomes honest to its customers by giving them a full insight into the structure of a car financing transaction. This will not only reduce the incidence of defaults but will also help their customers in making an honest assessment of their financial capacity to execute a car lease agreement.

A number of banks have spelled out their car financing schemes in sufficiently clear terms but none of them has made an attempt at being explicit about the rate of interest / mark up based on effective-IRR method. Islamic banks essentially write leases on operating-lease basis, which is Sharia compliant mode of financing. Other banks normally record the transaction on finance-lease basis. This is perhaps the only difference the Islamic banks can use to their advantage. On interest/mark up (or profit) issue, there is little that distinguishes Islamic from the conventional, as far as leasing and diminishing musharika are concerned. Islamic banks are yet to detach themselves from the market-based concept of mark up rate which is essentially industry driven. The yardstick for the banking industry is KIBOR (Karachi Interbank Offer Rate) which in turn is a near mirror image of SBP policy rate. Given the illogically high policy rate and banks' addiction to an 'inhumane' bank spread, car financing remains a taboo for the not-so-high income groups.