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An edited version of this article was published in Islamic Banking and Finance Magazine, September 2004 edition.
At a conference in 2001 organised by the Riyadh Development Authority, I gave a presentation on the modes of home financing. At that time, the Saudi government was providing interest-free loans to Saudi nationals to finance the purchase of their homes but had become concerned the scheme was draining financial resources. The conference, therefore, sought to identify alternative funding sources. Needless to say, the banking sector was a keen participant.
My argument was: if the banks were invited to provide finance for home purchase in Saudi Arabia, they would simply create that money out of nothing and lend it to prospective home owners at interest. Why, I asked, could the government not create the same amount of money out of nothing and lend it to the people interest-free? I also pointed out that an increased reliance on bank finance within the property market would bring the boom-bust cycle to Saudi Arabia.
Genuine Islamic financing, and the monetary system that accompanies it, would produce an entirely different set of outcomes for the property sector and the wider economy. If a bank was to share the risk of a property price fall with its home-buying client, it would be more cautious before pumping money into the market. This alone would be a strong restraining factor upon property booms, whereas what we see today is a positive feedback circle in which newly injected bank loans send property prices higher, thereby making the sector an even more attractive target for lending.
To achieve this vision, certain fundamental changes need to be made in how we organise our banking and monetary affairs. That these changes will reduce the profitability of interest-based commercial banks is clear. If left to their own devices, the possibility also exists that Islamic banks and their regulators might in due course adopt the necessary reforms. Hence, the widespread encouragement from among the interest-based establishment for a form of Islamic commercial banking that does not challenge the conventional paradigm of lending newly created money at interest.
If interest rates increase significantly, the ijarah rental rate will likewise increase and the client could well find himself locked into the payment of lease rentals that he cannot afford. If Shariah requires that the price in a contract of sale be known, doesn't linking the price (in this case, the price of a usufruct) to an uncertain future value (LIBOR) defeat that requirement? Are Islamic bankers just mimicking the instruments of interest-based banking, floating rate mortgages included?
Furthermore, if the client decides that he can no longer afford the rent, the bank's mortgage contract requires that he must guarantee to repay the finance initially provided by the bank. In those cases where the house has to be sold to achieve this, the possibility arises that property prices may have fallen in the meantime and that the sale proceeds are, therefore, insufficient to repay the financed amount. The client will be required to make up any shortfall to the bank, and the prospect of negative equity arises. If the bank is renting the property to a customer, this can be only because the bank owns the property. How can it follow that the customer must suffer the consequences of a fall in the price of the property upon sale? Conceptually, it should be obvious that, if the ijarah mortgage product really is a rental, the client should not have to bear the risk of a fall in property prices. On the other hand, if the client is bearing the capital risk because he owns the property, then why is he paying rent to the bank? Perhaps the client and the bank both own part of the property, in which case both parties should suffer the capital risk but, under the dominant form of ijarah home financing contract, the bank owns the house in its entirety until the final payment on account is made by the client and only at that point is title transferred to the client.
The truth of the matter is that the core Islamic contracts of sale and rental have been mixed so that neither bears integrity any longer. The danger of such mixing should be obvious from a consideration of what would happen if an Islamic moneylender was allowed to combine a gift with an interest-free loan and a promise, all three of which are acceptable contracts in Islam. The client could simply be asked to promise to give the money-lender a gift on repayment of an interest-free loan. We know what kind of cash-flow that combination produces, and the scholars no doubt prohibit it on the grounds of legal trickery. So why does the reasoning not apply when the trick is played with promises and houses?
At a seminar in London in October 2003 given by a Shariah scholar to one of the big UK banks, the nature of the monthly payment made by the bank's Islamic mortgage clients was discussed. According to the scholar, the payments represented a combination of a rental (for use of the property) and a further amount in respect of goodwill (to confirm that the client will have sufficient funds to fulfil his promise to buy the property at the end of the rental term). When it was pointed out by a member of the audience that the bank's marketing literature used the word "downpayment" to describe what the scholar had referred to as "goodwill", the latter informed the audience that this language was invalid and had to be changed. Such a structure would constitute a combination of two sales in one - in this case a rental and a sale - something that is prohibited in Shariah. Apart from the point that this emphasis on labels makes no difference to the bank's cash-flow, there is another more telling fact that emerges from the story. Namely, that several months of product development may be of little use if the right questions aren't being asked.
Five hundred years ago the Church in Europe was faced with the dilemma of the contractum trinius, the triple contract. This was an invention of the merchants and the financiers who had together devised a way around the Church's usury prohibition. The triple contract was a combination of three contracts in one: an investment, an insurance contract and a sale of profit.
From the Church's perspective, all three components were permitted, but the outcome was a payment of interest on a loan of money and this was undoubtedly prohibited. Yet the Church was powerless to defend itself, for the principle of combining permitted contracts to achieve prohibited ends seemed beyond its ability to legislate.
Now it seems that the Muslims have invented their own triple contracts and given them such grand titles as "murabahah to the purchase orderer" and "tawarruk". We should not be celebrating these innovations, nor clapping their apostles to the conference podium. By these contortions, the Islamic prohibition of usury is now threatened with the same fate it suffered in Christendom.
Tarek El Diwany, September 2004.
