CMHC report on Islamic home finance

The Canadian Mortgage & Housing Corporation (CMHC), the Canadian national housing agency commissioned a study a couple of years ago, which has recently been completed by law firm Gowlings Lafleur Henderson LLP. The CMHC reiterates at the beginning of the report that "CMHC Insurance business has no plans to insure Shari'a mortgages, nor is CMHC making changes to legislation or administrative practices". The prominence of this disclosure is probably, at least in part, a reaction to the small but loud reaction from critics of Islamic finance when the study was announced.

The study describes how Islamic finance works and in particular how Islamic mortgages work. The report provides one of the most comprehensive and detailed overviews of the Islamic mortgage markets in a number of countries including Western secular democracies, secular republics with Muslim majorities and Islamic republics.

The most interesting section of the report, of course, is the focus on Canada. This section, however, begins with an interesting observations:

"Little empirical evidence based on a sound methodology assumptions exists to accurately project what portion of the Canadian population would be interested in [using] Shari'a-compliant financing"

This point is relevant beyond just the narrow focus of the Canadian report because there is little evidence about what factors--either within Muslim populations or within the Islamic finance industry--lead to demand for Shari'ah-compliant financial products. This is clearly a much larger issue than I can cover in this short blog post, but it suggests a promising area for research about what issues in Islamic finance matter for Muslim consumers of financial products.

Returning to the Canadian market, the market structure of the market has limited the ability to provide Shari'ah-compliant home financing to those Muslims who demand them. The market has for most of the past 25 years, been dominated by small cooperatives reliant upon member's investments to finance new home purchases. UM Financial entered the market in 2005 and used mudaraba financing from Credit Union Central of Ontario for $120 million, which has been used to finance home purchases and refinancing. Until UM receives addition financing, which it has reportedly been working on, it is limited in the financing it can provide. As the CMHC report notes, of the Canadian banks and other mainstream financing institutions, which represent 60% of the mortgage market, "none of them have actually offered Shari'a-compliant housing finance, not even on a pilot-project basis".

Whether these banks enter the market on their own or through specialized Islamic home finance companies, there will continue to be a limit on the availability of Islamic home finance in Canada. This problem is accentuated by the lack of certain numbers on the size of the market in Canada. While there are expected to be between 0.98 million to 1.30 million Muslims in Canada by 2011 and between 1.23 million and 1.78 million Muslims by 2017 according to Statistics Canada, there is no clear estimate about how many of these will be homebuyers and of those buyers how many will opt for Shari'ah-compliant mortgages over conventional alternatives.

The study does cite one statistic that probably impacts the rate of Muslims who choose Islamic mortgages rather than conventional alternatives. They cite a story in the Financial Post from May 2007 which said that Shari'ah-compliant mortgages are between 100 and 300 basis points more expensive than conventional mortgages (versus a similar spread of 40 to 100 basis points in the United States). Whatever a study of Muslims in Canada would say if one were conducted, the cost of the mortgage will make the difference between whether the indifferent consumer will choose one over the other. Muslims are often subdivided into three groups (not necessarily of equal size): those that only use Islamic finance, those that would prefer Islamic finance if the cost is equivalent (or close) and those who will not use Islamic finance. The middle group will be the group that determines the size of the market in Canada for Islamic finance.

The reason I raise this issue is that the market structure in Canada is not necessarily conducive to significant growth in Islamic finance without something different that opens up capital for new Islamic mortgages. In the U.S., this roles is played by Freddie Mac (and to a limited extent Fannie Mae). There are legitimate criticisms of how Freddie Mac operates to provide capital to Islamic mortgage companies, however, the cost premium in Canada is likely due mostly to the lack of a similar provider of capital.

In Canada this is likely to be assumed by one or more of the big five banks. This study could provide the foundation for Islamic finance products to be placed on equal footing in tax and regulatory treatment to conventional mortgages through changes in laws. It has also been reported that there are several Islamic bank applications that have been held up pending the completion of this report. Their approval would add to the pressure for the Canadian government to reform tax and regulatory laws (probably in line with changes made in the past decade in the UK).

The broader points that this report raises is that Islamic finance (particularly retail Islamic finance) is limited if: 1) it is not competitive in price with conventional alternatives; 2) regulatory uncertainty; and, 3) significant uncertainty over the size and characteristics of demand for Islamic finance.

These limitations can be reduced if: 1) Islamic financial institutions have greater access to capital; 2) regulatory and tax restrictions that add cost are removed to put Islamic finance on equal footing with conventional finance; and 3) the factors that determine whether the marginal Muslim financial consumer will opt for Islamic or conventional finance is better understood.