How does Islamic banking work without interest?

In a previous article (HERE), we looked at the basics of Islamic Law (Shariah) and then we looked at what is involved in Commercial Law (HERE) for Islamic banking. In that article, we looked at how interest (Riba) is not allowed in commercial transactions.

NOTE: this is intended to be a brief article, not a detailed one. Not everyone is able or willing to read a 5,000 word article.

Simply put, I am unable to provide a loan to someone and charge interest. I can not ask for more money back than the initial loan I provided. If I lend £100 to someone, I can only ask for £100 back. I can not ask for a single penny more, as this equates to interest (and Riba). This is not allowed under any circumstances.

Now, this gives rise to some obvious questions that I often face:

• “So when I go to an Islamic bank, I can get a loan and the bank can not charge me interest?”

• “Because Islamic banking does not charge interest, it must be cheaper to get a loan from an Islamic bank than a normal (conventional) bank?”

• “Will an Islamic bank give me a credit card and never charge me interest? So, it’s all free credit?”

The answer to all the above is, of course, no.

So, this begs the obvious question – how on earth does an Islamic bank operate if it can not charge interest?

Remember, the bank is also banned from paying interest. So, if I place a deposit with a bank, it can not pay me interest on that deposit.

All the above will lead most observers to scratch their heads and wonder what is going on.

This is not like any banking system anyone is familiar with.

The first thing we must understand is this – Islamic banks are involved in exactly the same activities as conventional banks:

• They accept deposits

• They provide loans to customers, such as personal loans

• Car loans

• Home loans

• Credit cards

• The provide loans to corporate clients

• The provide trade finance loans

They do other things too, but I think we get the gist here.

They do activities (and lots of them) that are exactly the same as conventional banks. Of course, in each of the above products, the conventional banks charge interest. The Islamic banks can not.

So what gives?

The answer is quite obvious – the Islamic banks find ways to be compensated when they give us a loan. They can not charge interest but they can earn some “profit” from the fact that they are giving us a loan.

In many cases, this profit is a result of buying and selling assets. They buy assets from us or sell assets to us (but not at the same time). One of the main contractual forms that banks use for providing finance is a Murabaha contract. I have written several articles that discuss different types of Murabaha contracts in detail.

A Murabaha Contract

In simple terms, a Murabaha contract is a sale contract where one party buys the goods and the other party sells the goods. In this case, the seller discloses to the buyer how much he (the seller) had paid to acquire the goods in the first place. It is this disclosure of cost price that results in this subsequent sale transaction being a Murabaha transaction.

I will not explain any further here about Murabaha, because this would make the article too long. As I say, this contract is covered in lots of detail in several other articles here.

Leasing

Another method that banks use is to lease assets to their customers. For example, if the customer wishes to buy a car, they lease the car from the bank instead. The same can apply to home financing. The bank purchases the house from the vendor on the market, and then leases that property to the customer. The bank is the landlord, and the customer is the tenant.

At the end of the tenancy (or the finance period), mechanisms exist whereby the customer can purchase the property from the bank.

Credit Cards

For credit cards, banks can not charge interest but they recoup fees from customers in other ways. Some banks charge higher fees to credit card holders, to cover for the fact they can not charge interest.

Other banks charge profit via Murabaha transactions to make some profit (as opposed to charging interest).

Conclusion

So, in summary, Islamic banks can not charge interest, but they do not offer money for free. But what they definitely do, is to provide finance. They provide loans.

They find other ways to be compensated for the act of providing finance. These contracts often involve real assets that are bought and sold, or leased from the bank.

In all cases, the amount of profit received by the bank is broadly similar to the amount of interest charged by conventional banks. In most cases, it is, in fact, higher.

For a more detailed presentation of the kinds of contracts used, and how they work in practice, please take a look at my other articles on this blog.