In this morning’s Dominion-Post their personal finance columnist Janine Starks has an introductory article about Islamic approaches to finance. The key, specific, dimension is the prohibition on interest.
That prohibition, in one form or another, was once common across Judaism, Islam, and Christianity. It is one of the few aspects of teaching where the Christian church has, pretty much universally, changed its teaching, and personally I’m not convinced the change was well-grounded. I’ve therefore long been intrigued by experiments with interest-free approaches to finance – some of which manage it in form not in substance, but others are the real deal. Once upon a time, having an innocuous New Zealand passport and some interest in the issue, I even participated in an IMF mission to Iran to advise them on the possibilities for a market-based monetary policy consonant with interest-free principles.
This morning’s article reminded me of a couple of posts I had written in the early days of this blog, starting from Islamic banking but focused primarily on the notion of mortgage products that did not involve an interest rate. The first was here and included these extracts
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.
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.
The follow-up post was here. It is hard to excerpt so I won’t try.
In the last few weeks there has been (understandably I guess) a lot of rhetoric about common values etc etc, but actually there are really important – and mutually inconsistent – belief systems in our world, or even our country. As I noted in something else I was writing earlier this week
In fact, the notion of (serious) shared values falls down quickly in the presence of anyone – secularist, Christian, Muslim – who takes their faith seriously, as a source of authority and rule for life. In some of these areas, serious Muslims and serious Christians have more in common with each other than either do with aggressive secular liberals. In others, not – after all, most of the aggressive secular liberals have grown up in societies still suffused with the legacy of 1500 years of Christianity, and the way it shaped art, literature, government, individual rights and so on.
The approach to interest, and finance more generally, is one of those differences.