Over the past few years, the world economy has struggled to recover from the 2008 financial crisis.
Fresh issues like the current global banking system and its link to increasing household debt keep throwing hurdles to prosperity. To address the issue, the Citigroup’s chief economist Willem Buiter in an interview declared Islamic banking as the best solution for the household debt problem.
The Concept of Mortgage in the West
Before we explain what the household debt problem is, it is crucial to understand what mortgage is and what place it occupies in Western societies.
Suppose you want to buy your own house. But you’re short of cash. Therefore, you approach a bank and ask for a loan to get the house. The bank purchases the property for you. However, the title to the house is in the bank’s name unless you pay back the loan.
A mortgage is a legal agreement that allows you (the home owner) to transfer the ownership of the home to the creditor (your bank), until you pay up the debt with interest.
Usually people in the West move out of their old homes when its time to start their own families. To manage this, they apply for a mortgage on a new house with the help of a bank.
Mortgages are very common in the West. And one of the issues behind the household debt problem.
What is the Household Debt Problem?
In a conventional banking system, the bank provides a mortgage to its customers. Buiter considers this ‘poor financial design’.
Households are the last entities that should take on debt. They should take on equity-like stakes. They have two big assets: human capital, which is not ‘collateralisable’, and the property, itself, which is illiquid and hard to realise. – Willem Buiter
Simply put, this means that houses are not suitable for taking on big debts.
This is due to the increasing and piling amounts of interest that banks charge on the debts. This also makes it difficult to people to gradually purchase a share in the home. Hence the term household debt problem.
There is a solution to this. And Mr. Buiter believes that it lies in Islamic finance.
Islamic Mortgage is the Solution
Buiter has studied Islamic financial banking and he considers it as the best solution to the household debt problem.
According to him, in a Islamic mortgage, the bank owns the house in the beginning. As a customer of Islamic mortage, there are two payment streams involved here that can let them buy the house from the bank.
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.
Basically, Mr. Buiter says that there’s less financial risk involved in Islamic mortgage than by taking on a huge loan from a traditional bank and paying off the interest off it.
How Does Islamic Finance Help Here?
The biggest benefit of this solution is low financial risk. This is due to the fact that Islamic financial law prohibits charging of interest so the owner of the property only charges the fixed rent and allows the borrower or tenant to gradually purchase equity (share) in the property.
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.
Buiter further explained that such a solution extends far beyond Islam and it can be practically implemented in any country. This is a good step in places where housing is unaffordable.