In the UK and US, payday lenders operate successfully as they leverage off the financial turmoil affecting nearly half the population. Quick loans with high interest attract the financially weak and create burdensome debt. The Islamic financial system has to respond just as the Church of England has done. In this article, Rizwan Malik formulates a system that creates an Islamic financial alternative to payday lenders.
Payday loans have entered the national debate with aplomb. An English Premier League footballer recently refused to wear his club’s jersey as it was sponsored and carried the logo of a payday lender. When asked the reason, his response was that his religion does not support the idea on which the sponsor’s business is based. Similarly, another football team had to withdraw its plans to have a payday lender as a sponsor as more than 4,000 people signed a petition against the move arguing that the business was unethical. Add to this the recent criticisms from the Church of England, and one can see that payday lenders are not favoured by everyone.
So What is a Payday Lender or Payday Loan Company?
A payday loan is a short-term advance designed to assist a borrower until his pay is received, i.e., until payday. In the UK, the loan can be as small as £50 or up to £1,000 with an average loan reaching £300. More than half of the borrowers have an annual income less than £25,000. The industry has grown immensely increasing to $2.2 billion in 2012 from £900 million in 2009. So what is the problem when all these payday loan companies are doing is helping people in need by loaning funds?
Primarily, the high rates of interest charged meet the chagrin of borrowers. What is worse is that the payday loan industry is not regulated giving borrowers little protection. The Office of Fair Trading (OFT) recently released a report concluding that some loan providers do not follow good industrial practices. Borrowers are not sure of the exact amount they are going to be charged, and face difficulties when they want the loan amount to be rolled over to another lender. Competition among different lenders is based on how quickly the borrower can obtain the funds instead of competing on prices. Advertisement practices of such companies were also criticized as it was said such companies were promoting reckless lending when they advertise as “Guaranteed Cash”, “No questions asked”, etc.
Customers of such companies not only include those struggling financially but also people with a respectable credit history. Borrowers are usually looking for small amounts and hence the high street financial institutions are not interested in them, leaving them with no choice but to knock at the door of payday lenders. Such payday lenders can drag financially vulnerable people into further financial problems as once they take a loan, cumulated interest becomes very difficult for borrowers to pay off. Lord Freud, minister of welfare reform, believes that such loan facilities should only be used for essential spending, such as payment of bills and purchase of foodstuffs. Hence, there is a need for strict regulation to be in place otherwise the industry could become more onerous on the financially weak. The Public Accounts Committee (PAC) accused the OFT of being ineffective in its regulation of the market. It stated “the regulator has been timid rather than tough in its enforcement and has failed to proactively identify risks of malpractice”. Margret Hodge, MP, agrees with tough regulations and fining companies that are lending recklessly.
Unfortunately, regulations have been fairly relaxed. Companies are only required to state the Annual Percentage Rate (APR) they are charging. But, it was found that on average such companies charge more than 1,000% APR. Wonga, the largest payday lender, charged an extreme 5,853% APR. Wonga argued that such percentages mean very little because loans are given out for a very short period. They charge 1% on a daily basis for any amount lent and hence such annual APR percentages should not be taken into account.
Religious Condemnation
The Archbishop of Canterbury, Justin Welby, also condemned payday lenders. What was unique in his condemnation was that he offered an alternative: increase the profile of credit unions so that such payday lenders will be forced out of business. The credit unions will offer loans at lower rates comparatively.
The Archbishop’s comments continue a long tradition of the Church’s antagonism towards unscrupulous lenders. Religious interpretation once regarded charging interest as a sin, and money lenders were often punished. Although the practice continued surreptitiously through legal trickery and subtle circumventions, it was not until the protestant revolution that marginal charges of interest were accepted. Pastor John Calvin proposed a reinterpretation in the 16th century and argued that there is a difference between low interest and high interest. Only the latter is prohibited by scripture. Gradual acceptance of this interpretation led to the creation of banking institutions and, eventually, the proliferation of interest-based financial products.
There has yet to be a statement from Islamic leaders on payday lenders but the Shari’a (Islamic law) is quite emphatic on this matter. Islam prohibits any interest charged on loans and does not differentiate between low or high interest. The Holy Quran exhorts “O ye who believe! Fear Allah and give up what remains of interest, if you are truly believers. But if you do it not, then beware of war from Allah and His Messenger; and if you repent, then you shall have your principal; thus you shall not wrong nor shall you be wronged.” (Quran 2;278-279) The word riba literally means addition, increase or to swell. There are two types of riba: riba al nasi’ah and riba al fadl. Riba al nasi’ah is the interest charged on the loans and riba al fadl is any type of unequal exchange between two people of similar commodities.
The reason for the prohibition of riba is not explained in the Holy Quran although it cryptically states “this is better for you if you understand”. Looking more holistically, Islam promotes social economic justice and the ongoing welfare of society. Exploitation is prohibited in Islam. The Holy Quran has emphatically instructed Muslims to avoid acquiring other’s rights wrongly. The socio-economic justice and equitable distribution of wealth is an integral part of Islam and so riba is prohibited because it promotes inequality. The poor would become poorer through making interest payments.
In fact, Islam takes a cautious view on lending itself. Professor Habib Ahmed from Durham University opines that in Islam money lending, although is allowed, is not encouraged and should only be used as a necessity. There are instances where the Prophet (PBUH) would inquire if the deceased is indebted and if so the family would be asked to clear the debt before the funeral prayers could start. Being in debt was not encouraged, but if unavoidable then the loaning of money had to be interest-free.
Islamic Finance: Helping Those Struggling Financially
There are a number of different ways Islamic finance can help such people in financial difficulty.
1. Murabaha Model
Islamic financial institutions need to assess borrower’s need and the purposes the money is used for. If it is being used to buy something, Islamic financial institutions can use the murabaha contract (cost + profit) to finance it. For example, if someone has run out of cash and there are still a few days before payday but he wishes to buy groceries, the Islamic institution can buy the grocery from the market and sell at a marginally higher price to the buyer (the profit in this instance cannot be too high).
2. Ballot Committees
Another Islamic finance model, which can easily replace the credit union model suggested by the Archbishop of Canterbury, is saving circles or ballot committees (BC). A savings system practised in
Asian, African and Latin American countries, it usually involves the gathering of people. Each member of the group of trusted friends, relatives or colleagues contributes a fix sum on a monthly, weekly or daily basis for the length of the committee (usually one year). Further,with the help of a ballot each member is allocated a number, which determines his turn to be paid. In that particular month the member would receive the total pool. This idea has long existed and the main aim was to use it as a hedging instrument against a problem, paying for children’s fees or simply saving. A similar saving plan is practised in India called a chit fund that after years of operating is being regulated at present. The company managing the BC can charge an annual fee to cover its administrative expenses.
3. Takaful
This BC model can also be taken to the next level by using a model similar to takaful, where each member makes voluntary contributions on a monthly basis to cover situations when they are facing financial difficulty. The premium can be divided into two different pools, one used to pay against any claims made while the other to be used for investments. Every time a member makes a claim, he is paid out from the claims pool, while the funds from the other pool are invested in a Shari’a-compliant manner. These funds can either be placed in profit and loss sharing investment accounts or invested in Shari’a-compliant funds. The company managing the fund can be paid out a percentage of the premiums contributed by the members.
The returns from the investment can be shared with the members of the policy in accordance with an agreed ratio. This makes it different from the general takaful model where the investment returns are kept with the takaful company (management company) and distributed among the shareholders.
4. Qard al Hassan
Another model, which can be employed, is the qard al hassan. Qard al hassan is a benevolent loan given to needy person for a fixed period of time. The members can come together and set up a pool of funds to be used by the people facing financial difficulty. Here the management company or person would manage on a voluntary basis, where funds are lent out to people with no expectation of return of principal with an additional amount. Shari’a encourages people to give qard al Hassan to needy people with the intention to help them without expecting a financial or non-financial return. As the aim of Islamic financial system is the welfare of the society, such practices would encourage equality, and social justice in the society. If the borrower is unable to return the funds in time, the Holy Quran encourages leniency and offer more time as mentioned in sura baqara (2:280) “and if someone is in hardship, then postpone until ease, but if you give charity, then it is better for you, if you only knew.”
Supporting the Local Finance Providers
The Archbishop’s stance against payday lenders was weakened when it was found that the Church has indirectly (through funds of funds) invested in the largest payday lender, Wonga. However, the resulting criticisms were blown out of proportion and do not take away from his overall message. The Church has an investment portfolio of £5.5 billion; only £75,000 was invested in Wonga. It was found that the indirect investment was within the overall strategy of the Church which restricts direct investment in companies which generate more than 25% of the revenue through institutions charging high interest. Out of the total investments £3.25 billion is invested in UK and overseas securities, property £1.71 billion, loans to clergy £125 million and £96 million to woodlands. The whole investment process of Church of England is overlooked by an ethical investment advisory board which is designed to prevent the Church from funding businesses deemed against the Christian principles.
The investments in the socially responsible industry show that the Church is concerned about deriving profits only from industries that provide ethical value. In fact, Socially Responsible Investments (SRI) can be said to originate from Christian practices. The Quakers Philadelphia Yearly Meetings in the 18th century prohibited members from participating in the slave trade – then a lucrative industry – while Methodists managed money in the USA using social screens for more than two hundred years. Investments help companies grow, and for Christians, it was better to invest in companies that had social benefits.
The Islamic financial system also promotes
SRI/ethical investments. The Holy Quran states, “And when thy Lord said unto the angels: Lo! I am about to place a viceroy in the earth, they said: wilt thou place therein one who will do harm therein and will shed blood, while we hymn Thy praise and sanctify Thee? He said: surely I know that which ye know not”. A vicegerent is meant to be taking care of society and preserving what is there for generations to come. Shari’a prohibits investment in companies, which are involved in activities considered forbidden by the divine law. These activities are very similar to those prohibited under SRI with theaddition of conventional financial institutions- prohibited under Islamic financial system due to their involvement in interest-based transactions. These prohibited activities include tobacco, arm manufacturers, production and sale of alcohol, adult entertainment (including pornography), gambling, defence and conventional banks, etc. Both SRI and Islamic finance share a common objective – invest in activities that are beneficial to humanity.
For the Islamic alternatives to payday lenders to work, investment has to be made in companies offering the models previously mentioned (only models 1, 2 and 3) as it increases capital from which to shore up the pool of funds. The Islamic financial system has tools by which the investor can partner with the company. The investor partner extends the funds, while the company manages it. In this contract, the profit is shared at an agreed rate while the losses are borne by the capital provider. Here an indirect relationship is formed between investors and those in need of money. The Islamic financial system is ultimately founded on the principles of partnership and cooperation, a system, which promotes equity partnership and risk sharing. Hence it is a community-focused system promoting the expansion of real assets and services.
The investment coming from the capital providers can be small, but if there are many investors the amount of the pool can be very large. Equity crowdfunding is a perfect way of achieving this. Money from individuals from across the world is pooled to invest in the formulation of new businesses such as the Islamic payday lender alternative.
An excellent example of an alternative to the payday lending model already exists in Pakistan in the form of Akhuwat, a not-for-profit organisation operating in the country. It has been offering small interest-free loans to the people in the lowest stratum of society. The model has also been successful in liberating hundreds of individuals and families from the shackles of loan sharks. There is a need to develop an alternative model in UK, taking implications from the Akhuwat model.
Conclusion
To summarise there is an opportunity for both Islamic financial institutions and social enterprises to develop alternatives to people currently using payday lenders. These lenders are exploiting those that are struggling financially, and the regulatory system has not been able to protect them. Islamic finance offers alternatives, but these alternatives have to be considered as part of a larger ecosystem in which there are socially conscious investors. Payday lenders shore up their capital through shareholdings and advertising. Islamic financial alternatives have to consider these lines too in order to create sustainable, local financial providers.
