How Do Islamic Banks Make Money?
Muslim banks (aka Islamic banks) are financial institutions that operate under Sharia law and regulations. On the surface, there is little difference between Muslim banks and other (more conventional) financial institutions. In fact, most people completely oblivious as to how these institutions work. However, following Sharia law has major implications for how these banks make money and keep profits flowing (i.e. many Muslim banks do not charge interest). This hub will hopefully add to your knowledge and help you to understand the quirks of this narrow but growing sector of the financial industry.
Biggest Difference Between Muslim and Conventional Banks
Even though this is oversimplifying things quite a bit, Muslim banks and related financial institutions follow three broadly specific conditions (constraints) that are based in Sharia Law.
1. Muslim banks and related banking institutions are not allowed to charge interest
This is probably the biggest constraint and the one big characteristic that most Muslim banks are known for. It is such a distinguishing characteristic that in some non-Muslim countries where Muslim banks operate, they operate under the broad term of "no-interest banking" instead of Muslim banking for marketing reasons.
The reason for charging no interest stems from an interpretation of Sharia Law that states how "one must work for profits," and that the act of simply lending money to someone in need does not count as work. In short, "Money cannot be used to create more money." Therefore, for a bank to be considered Islamic, it must always provide some kind of service in order to earn its money/profits.
2. Islamic finance does not allow for high levels of uncertainty, also known as "argharar", in business transactions
In order to comply with this constraint, Muslim banks are required to disclose all information to prospective investors and to request all information from potential business interests. An important caveat that follows from this rule is that an Islamic financial institution cannot sell something that it does not own. Selling something that you do not own outright is considered the highest degree of risk because the risk of unavailability is extremely high. Therefore, the selling of financial products such as derivatives or CDO's (collateralized debt obligations), products that brought the global economy to its knees a few years ago, are prohibited or considered "haram."
3. Islamic finance requires that you invest only in morally upright and ethical causes
Therefore, Muslim banks are prohibited from investing in certain vices and morally-gray business prices such as gambling, prostitution, slavery, or drug-trafficking.
Making Money On The No Interest Model
Since it is such a large part of Islamic finance, I wish to provide two examples of how no-interest banking affects business operations in Islamic banking situations. First, let's take the simple case of setting up an account at a bank. In many conventional banks, interest-bearing savings accounts are offered to customers. The interest rates are promoted and marketed as a way to get customers to invest and keep their money with the bank.
However, in Islamic finance, savings accounts are typically advertised or marketed according to some record or profit/loss. Profits from the Muslim bank's successful transactions are redistributed to individual savings accounts. However, losses from the bank's unsuccessful transactions can affect savings account as well.
Another example is how Muslim banks handle mortgages. Let's say you want to buy a house that currently goes for $350,000. If you were to purchase this house via a mortgage from a conventional banking institution. The bank would provide you with a loan of $300,000 (and you would put down the rest of the money). That $300,000 is lent to you at a specific interest rate (let's say 6%). By the time that you pay off that loan (let's be generous and say 30 years from now), you will have paid the bank a total of $647,514.00.
This is in stark contrast to a Muslim banking institution that doesn't believe in interest rates. In this case, a Muslim bank would get directly involved in the transaction by doing something like buying the house that you are interested in outright, marking up the selling price by an extra $60,000 or $70,000, and selling back to you. You would then pay this new price $360,000 in installments. In the end, you actually end up saving a ton of money.
Difficulties in Following Sharia Compliant Finance
Even though today, Islamic Finance as an industry has ballooned into a $2 trillion dollar mega-marketplace. The road to success has not been easy. The aforementioned rules that constrain Islamic finance have prevented sharia-compliant firms from engaging in many profitable activities that conventional banks salivate over.
Historically, Islamic finance and its practicing institutions have been sheltered in the Middle East and a few other Muslim countries for hundreds of years. Furthermore, many of them have been largely subsidized by wealthy nation-states or empires that were devoted to the cause of Islamic finance and Sharia Law.
Moreover, global growth and expansion have been particularly difficult because most places in the world lack the regulatory framework to govern (much less understand) Muslim banking transactions. Brief example, in the mortgage case that we examined earlier; the transaction would most likely be taxed twice in a non-Muslim country (once, when the bank purchases the house, and another time when the bank sells the house back to you).
Of particular concern are the worries that Muslim banking institutions won't be able to compete on the global stage efficiently. Having operated in heavily subsidized cultural environments for so long. there are legitimate worries that Muslim banks lack the tenacity and efficiency of their conventional counterparts. Of course, only time will tell if this is true or not.
Have you ever dealt with an Muslim banking institution? How was the experience?
Successes on the Global Stage
Despite many worries and misgivings, Muslim banks have had some great successes. The UK, for example, is quickly trying to establish itself as the premier western center for Islamic Finance and sharia-compliant financial transactions. As of 2014, Britain has six major Muslim banks; including The Islamic Bank of Britain (see picture above). Moreover, London has recently become the first non-Muslim location that issues Sukuk, the Islamic financing equivalent of a bond.
Meanwhile, in the world of microfinance, Muslim banking is fast becoming a popular option for both short term and long term loans. In developing nations like Ethiopia, where over one-third of the population identifies as Muslim, Muslim banking products are seen as safer and more in sync with local traditions.
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This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.