Sharia-Compliant Student Loans

Let me start off by saying that I know very little about Sharia (Islamic religious law) and how it applies to lending, except pretty much what I heard on this NPR Marketplace segment. But a concept in Sharia-compliant lending caught my attention, a concept that could be usefully applied to the student loan market: equitable risk.

From the Wikipedia entry on Islamic banking, the idea is described like this:

Mudaraba is venture capital funding of an entrepreneur who provides labor while financing is provided by the bank so that both profit and risk are shared. Such participatory arrangements between capital and labor reflect the Islamic view that the borrower must not bear all the risk/cost of a failure, resulting in a balanced distribution of income and not allowing the lender to monopolize the economy.

Or, as described in the Marketplace segment,

Islamic finance, the essence is not geared towards debt. It is more geared towards equity, partnership…So the future, we could see Sharia student loans that work like venture capital. The lender would get a cut of the student's future earnings. If the student does well, the bank does well. Equitable risk.

Currently, there is no risk to the bank unless a student fails completely in paying back their loan—until the student defaults. And even then, the student cannot discharge his debt in bankruptcy. There is no middle ground; either the student does well enough to pay the loan back, or the student fails and defaults on his loan.

And there is one party that is almost entirely absolved of risk in this situation—the institution. Currently, the price for an education is disconnected from its actual value in the marketplace. A college that does a good job of graduating students and placing them in jobs can easily cost the same or less than a college that fails to graduate a high percentage of students or has a low job placement rate. But those factors are not calculated into how much debt students take on for their education, leaving the student with nearly all the risk for the loan, and the lender and institution with little to no risk.

Say a private college graduates a student with $80,000 in loans and a declared major in journalism. The student will struggle to pay off the loan and pursue a career in journalism, but these struggles are no skin off the institution’s back—the institution has the money, even if the value of the degree wasn’t worth the debt load. But under a system of equitable risk, the debt available for the degree would be more closely pegged to the actual earnings of the student after graduation, potentially leading to a more rational pricing system.

Clearly, a national system like this would have big problems—institutions that did a good job of graduating journalism majors, even if the students were successful, would have less debt available to their students because of the lower salaries in that career path. This could hurt institutions whose primary mission is to graduate students into lower paying, public service careers—some form of government-financed debt and risk-sharing would still be critical to ensuring that students can get loan money to finance their education.

While an entirely Sharia-compliant system is unlikely to work in the U.S. student lending system, some of these concepts could help bring rationality to the current tuition-pricing system, and also ensure that student lending sticks its original purpose of helping students, not making big profits for banks or institutions.