Islamic Banking: If no interest is allowed to be charged, how does the bank profit?

According to the latest figures there are an estimated 1.61 billion Muslims worldwide, which makes the concept of Islamic banking that much more attractive for so-called “western – banking” organisations. It is therefore not surprising that banks such as Citibank, HSBC and many others have created Islamic banking divisions within their own organisations. The question, however, has to be asked, if Islamic law does not allow for interest to be charged or received, then how does a bank operate or generate a profit for itself?

Islamic banking is based on the Islamic rules of transaction, which is also known as Fiqh-al- Muamalat. The most prominent of these rules is the rules relating to interest, which in essence entails the prohibition of paying or collecting of interest. The shariah, which is the precepts of Islamic law, also forbids engagement in economic activities involving speculation, which include interalia financial unknowns such as the buying and selling of futures. Islam further prohibits trading and investing in businesses and products, which are in anyway related to alcohol, pork or pornography. These principles apply consistently to individuals, companies and governments.

Perhaps the most far-reaching of these prohibitions is that of interest. The payment of interest and the taking thereof, as occurs in the conventional banking system, is expressly prohibited by the Holy Quran. Although the restriction against the use of interest might seem to be a binding constraint upon expansion, Islamic banks and financial institutions have in fact grown rapidly. It is estimated that Citigroup’s Bahrain based Citi - Islamic subsidiary has deposits in excess of $6 billion. According to the Islamic Banking and Finance magazine, there are $265billion in deposits that comply with shariah worldwide.

Whereas Islam prohibits the paying and receiving of interest, it not only permits “a rate of return” but also encourages it. In the interest free system sought by adherents to Islamic principles, people are able to earn a return on their money only by subjecting themselves to the risks involved in profit sharing, banks included.

Islamic banks are expected to undertake operations on the basis of Profit and Loss (PLS) arrangements or other acceptable modes of financing. Mudarabah and musharakah are two profit-sharing models preferred under Islamic law that is also used in Islamic transactions.

A mudarabah transaction can be defined as a contract between at least two parties whereby the financier entrust funds to the entrepreneur to undertake an activity or venture. In this type of contract the financier is not allowed to play a role in the management of the enterprise. Consequently, mudarabah represents a PLS contract whereby the return to the lenders is a specified share in the profit/loss outcome of the project in which they have a stake, but no voice.

For banking purposes, the mudarabah concept includes three parties: the depositors as financiers, the bank as an intermediary and the entrepreneur who requires the funds. In other words, the bank operates on a “two-tier mudarabah system” in which it acts as an entrepreneur on the saving side of the equation and the ‘owner of the capital’ on the investment portfolio side. Insofar as the depositors are concerned, the Islamic bank acts as an entrepreneur, which manages the funds of the depositors to generate profits, subject obviously to the rules of mudarabah. The bank then provides the various depositors’ monies, depending on the capital required, to the entrepreneur. Profits are then split until the initial funds of the bank are paid off. The bank is further compensated with additional funds based on the profits of the business in terms previously agreed upon between the entrepreneur and the bank. A percentage of the returns are also for the benefit of the depositor.

Musharakah is similar to mudarabah, in which an entrepreneur seeks funds for a business venture and pays the bank back with a ratio of profits, except in this instance the losses are borne proportionately to the capital amounts contributed. However, certain major decisions by the entrepreneur may be subject to the bank’s consent and the bank, as a partner, has the right to full access to the books and records and can exercise monitoring and follow-up supervision. To minimise risks, banks will often require a large down payment on goods and property or insist upon large collateral. It goes without saying that banks will also conduct a comprehensive feasibility study on the project in which they intent investing into.

Besides their own capital and equity, Islamic banks rely on two main sources of funding namely:

1. Transaction deposits, which are risk free but yield no return; and

2. Investment deposits, which carry the risk of capital loss for the promise of a variable.

In all there are four main types of accounts that exist in the Islamic banking model namely:

Currents Accounts:

Current accounts are based on the concept of the depositors being guaranteed repayments of their funds, but they do not receive remuneration for depositing such funds in a current account, because the funds will not be used in PLS ventures. Rather, the funds in the current account can only be used to balance the liquidity needs of a bank.

Savings Account

Savings Accounts operate on the al- wadiah principle. They only differ from current accounts in that the depositors could earn income. The money that is deposited by customers goes into a pool, which is then invested in a shariah compliant activity that is very low risk. The profits generated from these activities are then allocated to different sources of funds. Depending on the returns, the bank may decide to pay a premium, referred to as a gift, at its discretions to the holders of such savings account. The Islamic Bank of Britain estimates that profit rates on its savings account range between 2 and 3.75 % annually.

Investment Accounts:

An investment account operates under the mudarabah – al – mutlaqa principle. This is whereby the active partner (bank) must have absolute freedom in the management of the investment of the subscribed capital. The conditions of this account differ from the savings and the current account by virtue of a higher fixed minimum amount that a depositor needs to invest, a longer duration of deposits and the depositor may lose some or all of his funds in the event of the bank making losses. This is often regarded as a high-risk investment.

Special Investment Account

This type of account operates under the mudarabah principle and is directed to larger investors. The special investment account is related to a specified project and the investor has the choice to invest directly in a preferred project carried out by the bank.

The mudarabah and musharakah modes, as explained earlier, are the main conduits for the transactions that are carried out by Islamic banks. In practice however, the other methods applied by Islamic banks, to earn an income, are murabaha and ijara and ijara wa iqtina.

Murabaha seems to be the most commonly used method in the Islamic banking world. With this type of financing, the bank finances the purchase of a good or asset by buying it on behalf of its client and adding a ‘mark-up’ before reselling it to the client on a “cost plus” basis profit contract. The bank takes a risk on the transaction for the moment that it is the lawful owner of the goods.

Ijara and ijara wa iqtina is a mode of financing whereby the bank buys the equipment or machinery and leases it out to their clients, who may opt to buy the items eventually, in which case the customer’s monthly payments will consist of two payments i.e rental for the use of equipment and instalments towards the purchase price. Here is an example of how it this model works: Say the bank contributes 90% and the customer 10% of the purchase price. Over an agreed period the customers then pays monthly purchase instalments, through which the bank sells its share to the customer. The bank makes a profit by the customer paying the bank rent to live on the property and a portion towards his instalment.

There are a number of reasons why a non-muslim will consider choosing an Islamic bank as opposed to a conventional bank. Islamic banks attract borrowers who can offer security or collateral for a loan. This means that Islamic banks are unlikely to lend to sub-prime borrowers and should not, in the normal course, be hit by a large number of defaulting borrowers. There is also the factor that Islamic banks are more cautious and careful in borrowing money to consumers as they share in the risk with such consumers.

It is clear that although the Islamic banking model prohibits interest, there are other ways that Islamic banks generate a profit albeit in the form of the bank participating in the risk of a transaction and accordingly earning a profit there from.