I had some interesting correspondence recently for a reader, which led to me explaining the concept of "adverse selection" to him.
I used the correspondence as the basis for my December 2018 column in the magazine "Islamic Finance News."
A reader recently asked about progress on the UK implementing the promised Shariah compliant student finance scheme I have previously written about. After discussing the long implementation delay, our correspondence moved on to wider issues.
Some students had said to the reader that they could not see the difference between the proposed UK’s Shariah compliant student finance scheme and the UK’s conventional student finance scheme.
I reminded my reader that it was essential for the UK government that any Shariah compliant student finance scheme should have identical economic characteristics to the conventional scheme. The Shariah compliant student and the conventional student should make identical payments on identical dates if their other circumstances were the same.
The conventional student finance scheme involves a loan which is uplifted for interest and inflation, with the student, after he leaves university, repaying at the rate of 9% of his income over £25,000 a year, with the loan being waived after 30 years if not previously repaid.
The Shariah compliant scheme is based upon a takaful model, where the student makes the same payments as with the conventional scheme. The repayments being identical was not an accident; it was a fundamental design requirement for any UK Shariah compliant government student finance scheme.
Shariah scholars have signed off upon the proposed takaful based scheme as Shariah compliant, and ultimately Muslim students will need to decide for themselves whether they regard the scheme, when eventually implemented, as being religiously acceptable.
My reader went on to ask why private-sector Islamic financial institutions do not themselves offer an alternative student finance scheme. In particular, they would not need to replicate the economics of the conventional student finance scheme. Instead, the financier could, for example, pay for a student’s university education in exchange for, say, 5% of the student’s future earnings. Such a scheme would get away from any implications of interest being charged on loans as the financier would have a simple equity interest in the student’s future earnings.
While apparently attractive, I considered that such a proposed scheme is very unlikely to happen because it creates unacceptable risks for the financier. Even if we assume that the contract could be made legally enforceable, there is a very serious likelihood of “adverse selection.”
Students who expected low future earnings would sign up for the scheme, undertaking to pay a percentage of all future earnings in exchange for the student finance.
However, students who expected high future earnings, for example future Islamic investment bankers, would never sign up to a contract where they had to pay a percentage of their future earnings without any upper limit. Instead, they would sign up for the conventional (or Shariah compliant when available) UK government student finance scheme since under that, once their liability is cleared, all payments cease.
Our discussion illustrates a point that often comes up. Islamic finance as practised by real Islamic financial institutions normally mirrors conventional finance for very good reasons. Both systems seek to address the same real-world financial needs, and face the same real-world risks and constraints.
Conversely, solutions that are apparently “more Islamic” than real-world Islamic banking are in most cases not implementable due to those risks and constraints.