Inflation has become a fact of life in nearly all countries, but it is a very serious problem in the developing countries. As far as commercial banking is concerned, it erodes the value of the depositor's savings as well as that of the bank's loans. Yet the banking system does not seem to specifically address this problem. This book makes an attempt at finding a way of compensating for the loss suffered by capital due to inflation.

Identifies the transactions in the commercial banking business that are affected by inflation, considers several possible ways of counteracting the adverse effects, and then presents one approach as most suitable for implementation. The method presented here is a general one, universally applicable to all lending-borrowing operations, to neutralise the effect of inflation on such transactions. It is simple and straight forward, but requires the Central Bank to play a pivotal role in its implementation.

The method has especial relevance to interest-free banking. For whereas in a conventional system the interest paid to the depositor may fully or partially compensate for the loss, and the bank may include it in the interest they charge the borrowers, in an interest-free system the depositor will have to bear the full loss. Therefore a method of compensation for the loss becomes even more urgent. It is on that account that this forms the third of a series of three books which, taken together, are expected to provide a comprehensive banking system that addresses the concerns and needs of Muslims today. The other titles are: Interest-free Commercial Banking and Participatory Financing through Investment Banks and Commercial Banks.

Written lucidly in simple English, it is suitable for reading by professional and academics as well as by the general public.

ISBN 90-802354-3-2, 1997

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Table of Contents

Chapter 1 -- Introduction

Chapter 2 -- Inflation
2.1 -- What is inflation? (Causes of inflation, Loss of value and compensation)
2.2 -- How is inflation measured? (Construction of a food price index)
2.3 -- Real-life price indexes (Published indexes and inflation rates, Consumer price index, Gross domestic product (GDP) and GDP deflator)
2.4 -- Conclusions

Chapter 3 -- Capital Erosion due to Inflation
3.1 -- Magnitude of erosion
3.2 -- The rate of inflation (Purpose, Consumer price index, GDP and GNP deflators, Investment component of the GDP deflator, Other indexes)
3.3 -- Common defects of popular indexes (Appropriateness, Uniqueness, Consistency, continuity and reliability, Timeliness, Legal and general acceptance)
3.4 -- Required characteristics of a good index
3.5 -- Conclusions

Chapter 4 -- Measuring Inflation on Capital
4.1 -- The price of wealth (Some recent events, A traditional scenario, Some other events, Inferences)
4.2 -- Price determination
4.3 -- Application to lending and borrowing (Bank loans and deposits, Person to person transactions, Advantages)
4.4 -- The new measure (Appropriateness, Uniqueness, Consistency, continuity and reliability, Timeliness, Legal and general acceptance, Costs)
4.5 -- Conclusions

Chapter 5 -- Commercial Banking in the Presence of Inflation
5.1 -- The time-line
5.2 -- Deposits (Application under conventional and interest-free systems, Advantages)
5.3 -- Loans and advances (The cost of borrowing)
5.4 -- Services
5.5 -- Financing
5.6 -- Government finance (Treasury bills, Government bonds)
5.7 -- Computing capital erosion due to inflation
5.8 -- Conclusions

Chapter 6 -- Some Finer Points
6.1 -- Accounting without gold units
6.2 -- Interest and compensation revisited
6.3 -- Other factors affecting CoB

Chapter 7 -- Summary and Conclusions
 

Appendix A -- A general model of commercial bank lending
A1 -- The basic model
A2 -- Components of the model (Cost of services, Cost of overheads, Profit, Risk premium, Interest paid to the depositors, Compensation of inflation)
A3 -- The basic model in mathematical notations
A4 -- Special cases (Conventional or "inflation-free" model, Interest-free model, Risk-free model, Free-service model, Inter-bank rate, Non-profit model, Person-to-person loans)
A5 -- The credit multiplier (Factors affecting CM, Computing INT, Computing CI, CM and CoB)
A6 -- The general model (Computing SERV, Computing OVRH, Computing profit, Computing RP, The complete model, Special cases)
A7 -- Implementation (Parameter estimation, Parameter variation and comparability)
A8 -- Conclusions

Appendix B -- Applications to Interest-free Commercial Banking and Participatory Financing
B1 -- Inflation in interest-free commercial banking
B2 -- Inflation participatory financing

Bibliography

Index