Accessibility links

Breaking News

Explainer: What Is Islamic Banking?

A woman walks past a branch of the Noor Islamic Bank in Dubai. Although there have long been many Islamic banks in the Middle East and Southeast Asia, they are now also spreading rapidly in the West. (file photo)
A woman walks past a branch of the Noor Islamic Bank in Dubai. Although there have long been many Islamic banks in the Middle East and Southeast Asia, they are now also spreading rapidly in the West. (file photo)
When Islamic banking was first developed in the 1970s in the Persian Gulf states, its customers were almost exclusively observant Muslims who wanted a banking system that complied with their religious values. These include prohibitions against lending money with interest, which is defined as usury, and investing in businesses deemed morally harmful, such as alcohol or pornography.

But today, Islamic banking is getting wider attention, including among non-Muslims. That is because Islamic banks, which are open to people of all faiths, have largely survived the global economic crisis intact. So far, none has had to receive substantial bailouts to keep them afloat, suggesting that they somehow offer a safer haven to savers than conventional banks.

Mohammed Amin, a London-based Islamic finance consultant, says that perception is partly true, and partly not.

In practice, he says, Islamic banks are often more conservative in their commercial activities than ordinary banks. Their prohibitions against interest-bearing loans, for example, meant they did not buy up the large quantities of bad consumer debt that now burdens Western banks and has threatened many with collapse.

But individual Islamic banks -- like any savings institution -- can still expose their customers to risk. And that is because, while they shun interest-bearing transactions, they still do many of the same things conventional banks do, only by different means.

Sharing Profits

Amin cites payments on savings accounts as one example. In conventional banks, a saver receives a guaranteed interest payment of, for instance, 5 percent in exchange for keeping money in the institution. In Islamic banks, savers can earn the same amount but instead of receiving it as interest, they do so by sharing in the profits of the bank:

"You put your money into that Islamic bank," says Amin. "It pools that money with all the rest of the money it has. It uses it to run its business, which is providing money to other customers. And at the end of the year it will reckon up its results and the likelihood is that it will pay you [for example] 5 percent, maybe a little bit more or a little bit less, unless the bank has had a really bad year."

He notes that in a bad year, the Islamic bank might not pay a profit share, whereas a conventional bank is contractually bound to pay customers the promised interest rate.

Like conventional banks, Islamic banks make their profits by loaning money to customers. But whereas a bank loans with interest, Islamic banks do so through buy-and-sell transactions.

"An Islamic bank will say, 'You tell us which car you want, tell us which showroom it is in, we will go and buy that car and we will resell it to you,'" Amin says. "So, an Islamic bank will buy that particular car for, say, $1,000 and sell it to the customer and they will sell it to the customer for say $1,150 payable in 36 months' time. So, the Islamic bank is making a gain on the sale of the car. It is not lending money; the contract is the sale of the car for $1,150."

Still Plenty Of Risks

However, just as with conventional banking, there is nothing about Islamic banking that by itself guarantees that its commercial transactions are risk-free.

Banks can still face problems when the parties to whom they provide money are unable to fully pay back the sums. And, if an individual Islamic bank's owners are high risk-takers, they can still make bad investment choices, which can end in bankruptcy for the institution.

Many Islamic banks try to guard against such pitfalls by setting formal limits on how much risk they take.

According to Sahar Ata at the London School of Business and Finance, that mindset comes from Islam's prohibition of "gharar," which roughly translates as "excessive risk taking." She notes that Islamic banks usually try to limit the amount of debt they will assume in amassing their own capital to no more than 30 percent. At the same time, individual Islamic banks report to councils of Shari'a experts, who monitor the bank's operations and advise when its activities stray from underlining principles.

Still, the fact that Islamic banks duplicate many of the operations of conventional interest-based banks causes some Islamic scholars to criticize them as disingenuous. They argue that the current model of Islamic banks will inevitably place them on the same trajectory Western banks have followed in assuming ever greater risks to make higher profits.

Tarek El Diwany of London-based Zest Advisory, an Islamic banking and investment consultancy, suggests that what the critics would prefer is to see Islamic banks eschew all forms of debt-based finance, where one person seeks to profit from another’s debt.

"An alternative to the current Islamic banking model would be a true profit-sharing model, more akin to an investment fund, where I invest in your business, you make a profit, I share it, if you make a loss I share it," he says. "Whereas what tends to happen in debt-based finance is I give you $100 of capital and whether you make a loss or a profit I want $110 back at the end of the year. That is seen as fundamentally unjust, why should I benefit if you don't?"

However, other Islamic scholars defend the existing Islamic banking system as being reasonably compliant with Islam's prohibitions on usury and, so far, the controversy has remained largely under the surface.

Today, Islamic banking still accounts for only a tiny fraction of the global banking industry. The amount of money held in Islamic banks totals about $1 trillion, or less than 1 percent of global financial assets. But in many countries Islamic banking is growing rapidly.

In the last seven or eight years, the United Kingdom has licensed five fully Islamic banks, Islamic financial institutions are operating in the United States, and there are plans to open others in Western Europe. That is in addition to the many that already exist in the Middle East and Southeast Asia.