Media reported yesterday on a local Muslim woman who had sought to interest New Zealand banks in offering mortgage products that met Islamic restrictions on the payment of interest. The article suggested that a Kiwisaver provider was interested in offering such products. There were some small lenders offering such products prior to the 2008/09 recession but they did not seem to survive.
I’ve long been intrigued by the ideas and practice of interest-free finance. My own Christian tradition for centuries banned, or regarded with intense disfavour, lending at interest. That drew first on Old Testament provisions, which prohibited Israelites from lending to fellow Israelites in need at interest (while allowing loans at interest to outsiders). The stance was reinforced by perspectives from Aristotle, rediscovered in the Middle Ages, arguing for the inherent sterility of money. Prohibitions on lending at interest were eventually removed but it remains a powerful vision for some (for me). Within the Christian community, outfits like the Kingdom Resources Trust in Christchurch try to put it into practice.
The injunctions against interest are apparently much stronger and more pervasive in the Koran. In his recent book, Beggar Thy Neighbour, Charles Geisst reports that “of all the prohibitions against undesirable activities in the Koran, usury is mentioned the most. Interest, or riba, is considered usury and no distinction is made between them”. This was a distinctly counter-cultural stance, as compound interest had apparently been common among Arabs before the coming of Islam.
If interest is prohibited, profit-sharing arrangements – equity finance, in effect – are not frowned on at all. They have a element of uncertain return – economic risk – for which some reward is appropriate. Predominantly-Muslim countries, and individual Muslims. have grappled with how to apply the prohibitions on interest in today’s world. The large Muslim minority in the UK and the large financial sector with global connections has led to considerable interest there. In his pre-crisis heyday, Gordon Brown wanted London to become the global centre of Islamic banking.
My interest in interest-free finance once got me a trip to Iran, as a member of an IMF technical assistance mission. This was shortly after the Iran-Iraq War and the death of the Ayatollah Khomeini, in an earlier phase of opening to the West. I got on the mission because of my (innocuous, non-US, non-UK) New Zealand passport. From my perspective, two weeks in Iran was made easier by the fact that I didn’t then drink alcohol at all.
I was (am?) a bit of an idealist, and went in fascinated to learn more about trying to apply the interest-free teaching in practice. And I like to think we offered them some helpful advice – monetary policy without interest isn’t particularly intellectually or practically difficult. But I came away somewhat disillusioned. We met a variety of people – bureaucrats, bankers, and even some theologians (we wanted to better understand what the permissible limits were). Some were more earnest than others, but the overwhelming impression I came away with was of people trying to devise instruments to the limits of the letter of the law (Koran), with little regard for the spirit. I’m not, for a moment, suggesting that that was the approach of individual devout Muslims across the country, but among the groups we engaged with the focus was on products that had the economic substance of interest, but not the legal or exegetical label of interest.
I’m not sure that that was, or is, unrepresentative of many Islamic banking products. Take mortgages as an example. A widely-used UK website , Islamic Mortgages, covers a wide range of sharia-compliant mortgage products.
In a nut shell how does an Islamic mortgage work for different types of purchases?
- you choose property, agree price, undertake survey
- bank enters into contract to buy the property from vendor
- bank sells property to you at higher price
- the higher price is paid by you in equal instalments over a fixed term, irrespective of what happens to Bank of England base rate
- choose property, agree price
- bank undertakes survey, buys property and sells it to you for the same price, in return for payments spread over fixed period up to 25 years
- in addition to monthly payments, you pay a sum for ‘rent’ – assessed annually in line with market trends
- you can overpay (as with a conventional flexible mortgage) to buy the house more rapidly
These are interesting products in their own right, but the first is simply economically equivalent to a mortgage with a fixed interest rate for the entire life of the loan. Neither the purchaser nor the lender will necessarily regard themselves as paying or receiving interest, but the payment streams over the life of the contract (“fixed term”) will be the same as those on a conventional table mortgage with a fixed interest rate for the same term. And the risks – credit, market, counterparty – seem very much the same.
An alternative type of product might be an equity-based housing finance product. In conventional housing finance markets, the purchaser puts up some equity, and a lender provides the balance. The lender receives an interest-rate and is exposed to the (hopefully small) risk that the borrower defaults and that the house can’t be sold for enough to cover all the outstanding debt. Any increases in the value of the house – whether changes in market prices generally, or as a result of improvements/extensions – accrue to the owner.
But it would be technically quite feasible to envisage a model in which the person wanting a house to live in, and the financier, became equity partners in a joint business venture to own the house. You, the, resident would presumably pay rent to the joint venture, some portion of which would be passed to the equity finance partner, and when the house was eventually sold gains and losses would be shared, proportionately, between you and the equity partner. You have risk, the equity financier has risk, and no one is paying or receiving interest – in form or in substance. It would be simple enough, technically, to structure the contract to allow the resident’s equity share to rise over time (instead of “principal repayments”, one uses the funds for equity repurchases from the JV partner).
I’m not sure if such contracts exist anywhere in the Islamic world. In the West, without the theological concerns about interest, there is good reason why they don’t exist.
If I’m a young person in the West buying a first house, a bank might lend me 90 per cent of the value of the house. Most mortgages are table mortgages and are repaid gradually, so that in time the owner’s equity share is large, heading for 100 per cent. All the Bank cares about after that is my ability to service the debt. And that depends largely on avoiding prolonged periods of unemployment. If house prices fall that poses a risk – banks can call in a mortgage if the value of the collateral drops below the value of the mortgage – but it typically only crystallises if the flow debt service isn’t being met, and if house prices fall so far that not all the debt can be repaid when the house is sold up. Within limits – quite wide limits – banks don’t care about or monitor the maintenance you do on your house. If you don’t do the maintenance, mostly it is your loss. And they don’t care at all about changes in market rentals in your neighbourhood, or for your specific type of house. Conventional mortgages are simple, easy, and cheap to monitor.
But equity-sharing contracts would be enormously costly to monitor and manage, especially in a country with such a variegated housing stock (rather than lots of high-rise uniform apartments). If you are only an equity partner in a house, your incentive to do maintenance is attenuated – and likely to weaken especially in periods of personal financial stress. So a financier providing a large equity stake would probably want to pre-specify maintenance obligations and standards (and would then need to monitor compliance). You’d need to negotiate all alterations and extensions. Rental rates vary, as do market values. Perhaps a real rental yield could be pre-specified in the initial contract, but any arrangement for the resident to gradually buy out the outside equity partner requires an agreement on market value at the time of the transaction. Transactions costs rapidly start to mount. They might work within a relatively closed community – say, a local church community where effective monitoring costs might be reduced, or a small mosque-based credit union – but it is difficult to see them being effective, and economic, more generally.
In their recent book House of Debt, the US academics Atif Mian and Amir Sufi, argued that equity-sharing contracts should become the norm for housing finance. They argue that such contracts would materially reduce the risk of financial crises, and that the main reason such contracts aren’t common is because of the tax system and the role of US government agencies. I’m very sceptical of both claims, and would post the note I wrote on why – but it would take 20 working days to get OIA clearance. This post is quite long enough, but if anyone is interested I can explain my scepticism in a later post.
UPDATE: The later post on equity-sharing mortgages.