Why we urgently need Islamic student loans

A major barrier to career aspirations among Muslims has been their inability to take on student (or any other) loans to fund higher study, as Shariah law prohibits predetermined interest rates.

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British Muslims are twice as likely to be unemployed than the national average – and the rate is even higher among young men.

A major barrier to career aspirations among Muslims – particularly with the introduction of university tuition fees – has been their inability to take on student (or any other) loans to fund higher study. Essentially, centuries-old Shariah law prohibits predetermined interest rates, treating it as a crime of “usury”. As a result, there’s a built-in sense of exclusion and a limit on any opportunities in a careers market set up to reward graduates.

With the ongoing concerns over radicalisation in the UK, new and active thinking is needed to ensure higher education (HE) is a genuine channel for social mobility and major, unnecessary blockages are removed. What’s needed is a specific system of Shariah-compliant funding for HE places. With its financial infrastructure the UK has the potential to have “first-mover” advantage in promoting an alternative to conventional student loans. The development would certainly be in keeping with the UK’s bid to be the predominant Western hub (and a competitor for Dubai and Malaysia).

One solution, which has previously received some backing from the UK government, is student loans linked to “Takaful”, the Islamic equivalent of insurance, where all participants contribute to a mutual fund used to finance students’ education. Graduates start to make repayments as soon they get a career job. These might be set at an average benchmark rate (known as “Wakalah mode”) or else tied to the actual earnings of a graduate (“Mudarabah mode”). A Takaful fund would be managed by a bank, which charges a fee. But Shariah scholars have criticised this approach, arguing that the “benchmark rate” is only a thinly-disguised interest rate, and against the moral hazards associated with management of the funds.

Our new proposal is for a student funding mechanism structured along the lines of an Islamic bond with equity participation (Mudarabah): applications would be invited from a large number of potential student participants. A syndicate (say, of the UK Student Loans Company, the government, a group of universities and an Islamic bank) would then establish a special purpose vehicle (SPV) to raise capital from institutional investors by issuing Graduate Dividend Notes (GDN).

The capital raised would be distributed to participating universities to cover the tuition fees of students who commit to a predetermined levy on their income over their working lives. The levies would accrue to the SPV and be distributed as dividends to GDN holders. As with corporate dividends, the amount paid would fluctuate with the financial success of participating students. Since levies on graduate income would closely resemble income taxation, the possibility exists of collection through the tax system. This is the current basis for collection by the UK Student Loans Company. Again, like an income tax, the levy could be structured in proportional, progressive and regressive forms. Pension funds would be the most obvious participants. Graduate students’ income (and therefore their levy to the SPV) would be inflation-linked, so that GDN holders would have inbuilt inflation-protection: a major attraction to investors at a time when real yields on index-linked Gilts are negative.

With longevity risk the prime reason for the near-extinction of defined-benefit pension plans, an important feature is the longevity component of GDN, since working lifetimes are set to increase in line with longer life expectancy. Although hedging mechanisms are beginning to appear, there is a very limited natural supply of longevity protection. GDNs have longevity protection embedded.

As a quick comparison with a flat rate levy on graduate income in excess of £21,000, the current student loan scheme makes a 9 per cent deduction for loan repayments. Under our scheme only a 7 per cent deduction would be required.

The approach could be expanded globally and be structured to cover student living costs as well as tuition fees. The risks and rewards of the funding mechanism remain with GDN holders and the attractions of inflation – protection and longevity-protection – would be considerable. With the right impetus from government, HE institutions and banks, the first wave of new Muslim students funded in this way could begin their studies in 2015, opening up a previously locked door to career opportunities and involvement with wider society.

Dr Vasilis Pappas is at the Gulf One Lancaster Centre for Economic Research, Lancaster University Management School and Professor Paul Dawson is at Kent State University