One of the more interesting areas of finance to me is interest-free lending.

This is usually associated with Islamic banking, although that’s not necessarily the case. There are a variety of (usually complex) structures that can support interest-free lending, but today let’s look at Time Multiple Counter Loans (TMCL for short).

The way TMCLs work is in principle like so: I deposit $100 at the bank for 100 days. This equates to 10,000 “dollar-days”, which is how I am compensated. I don’t get interest, just the right to borrow 10,000 dollar-days in the future.

On the 101st day, I withdraw my $100 and borrow $50 for the next 200 days ($50 * 200 days = 10,000 dollar-days) . After that period, I must begin to pay traditional interest or repay the $50 loan. Before you ask, this requires collateral, personal recourse, or both usually.

The reader who has already had their coffee this morning may note that this arrangement embeds a kind of interest rate swap. The depositor of today is the borrower of tomorrow, and is implicitly exposed to changes in interest rates. It’s a pretty good deal to be depositing while interest rates (and opportunity cost) is low, and then borrow when interest rates are high, since credits and interest accrue in dollar-days instead of USD.

Interestingly, Islamic banks are probably less exposed to this, since they’re prohibited from directly earning interest anyway, and must pursue workarounds more complex than just loading up on interest-bearing bonds and loans.

This means there’s all kinds of changes in the market that can gum up this arrangement, and carries at least as much execution risk as a traditional bank, even if the bank is not constrained by acceptable Islamic financial practices.

Probably the most prominent non-Islamic modern example of this is JAK Members Bank in Sweden. Members get “Savings Points” when depositing into different kinds of accounts. This allows for treating a dollar deposit in different products differently, so is an improvement over the simple dollar-days accounting above.

JAK also has some other mechanisms to improve member experience so you can borrow beyond your Savings Points accrued (usually by building up more deposits with them during the life of the loan).

In practice, JAK Members Bank has suffered from illiquidity in recent years. This is consistent with our prediction that in a rising rate environment, people cash in their Savings Points accrued over the last couple decades in a near-zero interest rate environment. The opportunity cost for depositing into JAK is also higher today than it was a decade ago, since interest is available elsewhere.

As a standalone structure, TMCLs are pretty limiting. You’re essentially servicing a market that consists only of current-day-savers-who-are-also-future-borrowers. In the modern person’s financial lifecycle, this is probably fits only a narrow window for most individuals where they are net savers but future borrower (concentrated mostly on the years prior to buying a home).

There are some interesting things you can do at the institutional and government level once you get central banks involved in TMCLs, but those deserve a separate post. Happy Saturday, everyone!