Islamic Banks Could Be The Answer To America's Over-reliance On Credit And Risk

If second quarter results are anything to go by, America’s banks are recovering nicely. Most made respectable gains and have improved investor and public confidence in America. However, many people who advocate for changes in the banking system feel that just recovering from the financial crisis is simply not enough, and that serious changes must be made to avoid future banking meltdowns.

Put simply, the Great Recession was caused in part by banks that advanced credit to people who could not actually afford the repayments on their homes, which led to a housing bubble that eventually burst. Beneath the surface, the problems were toxic mortgages; financial firms acting recklessly and taking on too much risk; and a mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with concurrent systemic breaches in accountability and ethics at all levels, according to a report by the Federal Reserve.

However, nearly five years later, banks are still paying huge fines, and they are still subject to criminal and civil investigations from government agencies, so it’s hard to see what has actually changed in America’s banking system.

But don’t worry, there is an alternative.

Islamic banking is a growing option in America as various Islamic banks pop up across the country to service those who wish to preserve Shari’aa law or those who just want to use an Islamic bank. They welcome all customers, and there are some very interesting features that could make you consider turning to an Islamic institution before you take out that next loan.

The underlying principles of Islamic banking are fairness and shared responsibility. Traditional banks will lend you money if you’re creditworthy, with little concern about the actual thing in which you intend to invest. A house, for example, can either be a successful or unsuccessful investment, but when it loses value, you still owe the bank the same amount of money you borrowed in the first place, plus interest. Islamic banks, on the other hand, have more stringent rules and won’t help you invest in something they don’t consider affordable or a good investment for them. And that’s the key to these banks: the risk is shared.

This culture of shared responsibility and willingness to change the banking world for good has been a goal of Dr. Yahia Abdul-Rahman’s for 45 years.

Abdul-Rahman is currently the CEO of LARIBA, an Islamic-centric financial institution that offers interest-free banking, or as he calls it, RF banking, meaning Riba Finance or responsible finance.

For Lariba, every transaction is an investment that uses the lease-to-purchase model.

“We get the address of the house and ask for three live-market document estimates of how much would this house rent for if you were buying it as an investment, and the customer's finance officer does the same,” Abdul-Rahman said. “Then we use a proprietary model to calculate the rate of return on the investment using the rent estimates. If the rate of return on investment is higher than what the shareholders and investors of the house are expecting, then this makes it a very good investment, and we tell our customer that they’ve found a home that makes economic sense and we are going to invest with them and we’re going finance it.”

However, if the financial models show that the borrower is making a bad investment, the bank will tell them that it’s a bad economic decision and it will not invest with them.

The beauty of the model, says Abdul-Rahman, is that the bank will share the responsibility in the event of losses, so the borrower is not burdened with all of the bad debt if the house should lose value. For example, if you own 50 percent of a house valued at $100,000 and the bank owns the other 50 percent, but then suddenly the house loses 20 percent of its value, you will both lose $10,000 on your investment rather than you losing $20,000 and still owing the bank the original loan and interest. However, the strict rules in place and financial models mean that the bank rarely makes bad investments. The idea for the consumer is that they will slowly buy their house from the bank over an agreed-upon period of time at an agreed-upon price without paying any interest. On the downside for the borrower, however, is that the banks get a share of the profit, based, again, on the rentable value of the house before the borrower sells it.

If you’re in the housing business to make maximum profit and you’ve spotted what you think is a bargain, then this model may not be for you, but if you’re like the millions of people who lost money in the housing crash, this may be a much better and less risky model to consider that can get you on the property market with just a 5 percent deposit.

In addition, the bank will not be on your deed for the house, so if a worst-case-scenario happens to the bank, which seems to happen a lot to small banks in America these days, you don’t need to concern yourself or worry about what’s going to happen to the banks' partial ownership of your house. It's still your house and no one can force you to sell it.

The underlying message is that the borrower is in a partnership with the bank, so there are no hidden fees, and the consumer can buy the bank's share of their home at any moment without any penalty fees.

Abdul-Rahman came to the United States from Cairo, Egypt, in 1968 with $17 in his pocket, a fitting start to life in America for someone who likens himself to the protagonist of "It’s a Wonderful Life," which tells the story of a banker with a good heart who always tries to do the right thing for the community.

Abdul-Rahman started Lariba in 1987 but quickly expanded and bought the Bank of Whittier in California in 1998, which was, and remains, a small bank that only has two branches. It has been run with what Abdul-Rahman calls the American RF, which he says allows people to go out and participate in the "American dream" without over-indulging and renting money by paying interest through the abuse of "charge cards" -- credit cards and loans.

This approach has largely worked for Whittier and Lariba. As dozens of small banks failed during the financial crisis, Whittier spotted it early. In 2006, he began advising its underwriters to be extremely cautious and tight in its standards.

Islamic bank also offer Islamic bank accounts.

“We look at every demand account or checking account as a trust around our neck," Abdul-Rahman said. "We cannot use it in lending, it’s a trust. That’s why you’ll find 15 to 20 percent of our cash in the Federal Reserve, because these funds are entrusted in our hands by the checking account holders."