We often hear Muslims claim Islam is not just a religion but rather a complete way of life. A way that has been established by the Almighty to incorporate all matters which governs society, including financial dealings.
In the Australian Financial Review, Citigroup’s chief economist talks about the need for Islamic finance.
Few economists would look to religion for the solution to a growing household debt problem, but Willem Buiter says Islamic finance is an unlikely future source of much needed innovation.
A traditional mortgage – which is the core offering of a traditional bank – is “poor financial design,” Citigroup’s chief economist tells The Australian Financial Review.
Overlooking New York’s Hudson River, he says from his office:
“Households are the last entities that should take on debt. They should take on equity-like stakes,”
Households, he explains, have the least amount of collateralised wealth, which they can pledge against a loan – making them ill-suited to take on large amounts of debt.
“They have two big assets: human capital, which is not ‘collateralisable’, and the property, itself, which is illiquid and hard to realise.”
The solution, he says, is an Islamic style mortgage. The faith outlaws the charging of interest, so to skirt this restriction “financiers” instead charge rent and allow the borrower or tenant to gradually purchase equity in the property. The motivation may be to adhere to religious codes but the result is a less risky financial arrangement for the household than a standard home loan.
“A classic Islamic mortgage is a dual equity mortgage where the bank owns the house to begin. I buy the house from the bank with two payment streams. One is a rental stream related to the [rental] market. As long as I keep up that payment I won’t be affected,”
“But the second is discretionary: for example you buy 5 per cent from the bank each year.”
Less financial risk
The benefit of the arrangement is there is less financial risk assumed by the tenant than would otherwise be incurred by a large loan.
“If you have disruption in your employment you can stop buying equity in the house or even sell back what you have already bought – the chances of eviction and dispossession are much lower.”
As Buiter explains these arrangements extend beyond Islam and have proved practically useful in places where housing is unaffordable.
“Stanford University does this. It’s too expensive for an assistant professor to buy a house [in Palo Alto, California] so they go 50-50 with the university. If you make tenure you buy out Stanford and if you don’t they buy you out. So it turns into equity.”
The Islamic mortgage is a rare example, Buiter says, of “good financial engineering” rather than attempting to avoid paying tax or skirting regulation.
To know more about Islamic finance and why it can indeed be a solution for the world debt, click here.
“…But perhaps you hate a thing and it is good for you; and perhaps you love a thing and it is bad for you. And Allah Knows, while you know not.” [Qur’ān | 2:216]