What is... | August 23, 2017

What is Islamic banking?

If banks or other finance providers do not charge interest or speculate with people’s funds, how can they make money?


Most banks make money by charging interest for loans, while charming savers to use their services by paying them interest. An Islamic bank, however, operates differently.

For the faithful, the Islamic tradition is to follow Islamic law – shariah – in all aspects of life and financial activity is no different. And the shariah prohibits earning money from money alone.

What’s the difference?
This is why paying interest (or riba in Arabic) is banned. Instead, an Islamic bank pools people’s funds, invests in tangible and real assets like buildings, land or commodities, encourages risk-reward sharing and entrepreneurship, at the same time emphasising the inviolability of contracts.

Gambling and speculation are forbidden – and any activity which may be considered bad for society such as pornography, alcohol or pork products.

However, all of this is not unique to Islam. The Jewish tradition also frowns on usury, as did the Catholic Church until about 500 years ago. In 1140, for example, the Church declared that anybody charging interest would be excommunicated (a move which induced Christians to use Jews as money lenders, since they were believed to be excommunicated already).

Serving the interests of faith
There are two basic ways to provide Islamic finance, considered by Islamic practitioners and scholars to be the most suitable methods for shariah-compliant products.

One method is ijara, an Islamic form of leasing in which a bank purchases an asset and then leases it to the customer for an agreed period of time. At the same time, the bank is paid rent, exercising all the lessor’s rights and obligations such as maintenance, insurance and repair.

A murabaha, on the other hand, incorporates a locked-in return. In this case the bank finances the purchase of an asset by buying on behalf of customers and then adding a markup to its sale price, which is paid by the client on a deferred basis.

Here’s how it works
In an Islamic mortgage, rather than lending a customer money to buy a house, the bank will buy the house itself. The customer can then either buy the house back from the bank at an agreed above-market value and pay back in instalments (murabaha) or they can make monthly payments comprising a rental fee and a piece of the purchase price until they own the home outright (ijara).

There is an Islamic equivalent for many financial products – but not for everything. For example, forward and future contracts is like “selling promises” – so it’s understood as a kind of speculation. Also, short-selling is not allowed, because it involves assets the investor usually does not own.

Practice what you preach
Not only have these Islamic finance offerings been popular with Muslims but Islamic banks also have many non-Muslim customers, partly because of their clear ethics-based approach to finance.

Among Islamic countries, only Iran and Sudan have imposed interest-free banking, with Pakistan showing some interest in taking this step.

But in places like Malaysia and Kuwait, Islamic banking is booming. Bahrain’s central bank issued the first sovereign sukuk, a type of bond, in 2001. And in June 2014, the UK became the first Western country to issue an Islamic bond. Its £200 million sale attracted orders of more than £2.3 billion – 10 times higher than the amount sold. 

Paving a path to heaven?
The path isn’t always smooth. Although Islamic finance has done well to reduce its costs and expand its product range, it has yet to tackle numerous other hurdles.

On one side of the coin, some are worried that the restricted implementation of shariah could possibly throttle growth; on the other hand some believe that Islamic finance is becoming so keen to drum up business that shariah itself will be twisted.

An early attempt by Goldman-Sachs to enter the Islamic banking market foundered amid claims its proposed sukuk did not comply with shariah. In 2017 an Abu-Dhabi listed energy company, Dana Gas, told investors it cannot make payments on its $700 million-sukuk bond as it had been deemed non-compliant with shariah under Emirati law.  

Such rows have led to calls for greater international standardisation – and the creation of entities such as the Islamic Financial Services Board, which issue both religious and prudential guidance, playing the same role as the Basel Committee does for “conventional” banks. 

Islamic banking is a way to combine faith and finance to serve people’s real-life money needs. But the success of the industry depends on fulfilling both principles even if the price of that is less growth and more inefficiency.

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eZonomics team
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