Islamic Financial Intermediaries

by Bakri Musa
Malaysia in the Era of Globalizat​ion #80
Reform in Islam
Chapter 9: Islam in Malay Life

Trade had been flourishing for centuries in Arabia, immediately before and after the prophet’s time. All that buying and selling, together with the caravan expeditions, could not have taken place without there being a satisfactory financing mechanism. There must had been a system for connecting the owners of money (savers) and the users of cash (investors and traders). Yet despite that flourishing head start and seemingly workable system, Islamic finance later went into decline. It is instructive that the decline in Islamic economics parallels the decline in Islamic civilization.

Today Western financial institutions are preeminent. Western banks and other financial intermediaries did not develop overnight. They have been refined, modified, and strengthened over the centuries. The process continues to this day. Today’s banks are a far cry from what they were a century earlier. The essential ingredient to the success of banks is the faith people have in them. Absent that, not even the strongest institution could survive. All the regulations and innovations in banking serve only one purpose: to strengthen that faith and confidence.

Bank failures and runs on banks were common in America during the depression. Those events are thankfully rare today, in part due to the diligence of the Federal Reserve System and the Federal Depositors Insurance Corporation (FDIC), the regulatory agencies of the federal government, together with strengthened prudential rules on reserves, heightened fiduciary responsibilities, and improved auditing. These refinements have been incremental, each in response to specific problems and crises. Banks still fail today, but thanks to the FDIC, depositors (at least the retail consumers) simply transfer their accounts to another bank without any hitch. The system is by no means perfect, as was painfully demonstrated by the massive Savings and Loans scandal of the 1980s.

The spectacular economic achievements of modern societies are attributable to the efficacy and efficiency of their financial intermediaries. Countries that have efficient and stable financial systems advance; those that don’t, decline, as demonstrated by Thailand, Indonesia, and a host of Third World nations. To many thoughtful analysts, the Asian economic crisis of 1977 was in essence a crisis of the banking system.

Within the last few decades, Islamic-based financial institutions are trying a comeback. As with everything Islamic, the concept sells with Muslims. America now has mutual funds and mortgage companies run along Islamic principles. Even venerable Western banks like Citibank are entering the fray. Academic papers and conferences proliferate. Harvard’ Institute of Islamic Finance and Information Program (HIFIP), with intellectual contributions from its renowned business and law schools, has been organizing annual conferences for the last few years that brought in luminaries from all over.

Much has been said of Islamic banking in which supposedly no interest is charged. This is purely semantics. Sure these banks do not charge interest in the usual sense; instead they tack on “service” fees and points. In the final analysis there is still a cost for the loan. I can give someone a 0% percent loan but charge exorbitant points, commissions, or fees to recoup the cost (interest) of my capital. The end result is the same; the borrower pays a price and the lender gets a reward.

There are American finance companies that cater specifically to Muslim homebuyers who are squeamish about mortgage interest payments. To obviate this, the prospective homeowner goes into partnership with the company to buy the house. The homeowner pays 20 percent of the price and the company the other 80, as in a traditional mortgage. But instead of paying the mortgage as in a traditional loan, the homeowner pays a market rent to the company for use of the house, with 80 percent of the rent payment going to the company and 20 percent credited to the homeowner. Every few years the house is reappraised and when the total payments cover the cost of the house based on the latest appraisal, the house would then be transferred exclusively to the owner.

If the rental market declines, the homeowner will pay less every month, which would be to his or her advantage. But if the market appreciates, as it typically does, so will his rent, and he will end up paying more cumulatively. Not only that, the company gets to reap the bulk of the benefit (80percent) of the gains on the house’s price appreciation. So the consumer gets bilked twice, once in his higher monthly rent and second, in not getting the full benefit of the price appreciation. This is also an inherently a bad system as it creates a perverse economic incentive for the homeowner not to keep up or improve the house so its value would drop, and his payments would similarly fall. That is no way to run a modern economy! In addition, there are all those costs of the appraisals that are being borne by the homeowner.

In reality what these companies are doing is nothing than more an equity-sharing scheme. This has not caught on in America precisely because of the perverse economic incentive. A more popular variation of equity sharing is where the homeowner goes into partnership with a friend or family member to pay for the down payment and then together they would secure a traditional mortgage. When it is time to resell the house, the profit would be shared based on their contributions towards the down payment. With this scheme, there is still the issue of interest payments on the mortgage.

With a traditional mortgage in America, if the borrower is unable to keep up with the payments, he could sell the house and whatever is left after he paid off the loan balance is his to keep. But if the value of the house were less than the amount owed (as had happened in declining markets), and the bank forecloses on the home, the borrower would not be saddled with the outstanding balance. This is because all home mortgages have a “non recourse” clause. The borrower would lose only what he has paid into the house (his equity). So if the concern of the Islamic groups that borrowers would be saddled with debt payments forever, than there could be a similar “non recourse” clause in selected loans like study loans and loans for one’s primary residence.

Similarly if the borrower is unable to repay the loan because of a legitimate reason like illness or death, the loan contract could be designed to cover such eventualities. Many loans now have mandatory disability and life insurance policies attached to them to cover such calamities. But insurance too is anathema to traditionalist Muslims, but I will come to that shortly.

I have a traditional home mortgage and I am quite comfortable with paying the interest on it. I rationalize the interest I am paying as being the rent for the house, and the principal as the payment towards the house. Technically this is correct as the bank has priority over me to the title of my house.

Most of the activities carried by Islamic “banks” are really not the proper purview of traditional banks. Thus leasing (Ijaara), another common service provided by Islamic banks, is done in America by finance companies or directly by the dealers and manufacturers. Islamic bankers also make a big deal on the supposed difference between leasing, which is halal because there is no interest, and traditional loans and mortgages, which are haram because of riba. But this is a meaningless difference. I could easily convert my mortgage into a long-term lease with the same terms, and at the end of the “lease” (mortgage) I would have an option to buy my property at an agreed upon nominal price. One could just as easily calculate the imputed interest rate on all leasing arrangements. Similarly, the profit sharing and “equity participation” lending that Islamic banks partake are properly the function of mutual funds and venture capital firms rather than banks.

By using the familiar term “bank” to describe activities that are properly the purview of other non-bank institutions, proponents of Islamic banking are misleading consumers. All these deferred sales, service charges, and lease payments are nothing but euphemisms for the cost of borrowed funds, more commonly referred to as interest. As Islamic banks do not function like a traditional bank, they should not use the label “bank.” Instead they should use the more generic term, Islamic Financial Institutions (IFI), so as not to mislead the public. I would not however, recommend the acronym “iffy!”

Next: Islamic Financial Intermediaries (Cont’d)