Islamic banks (aka Islamic banks) are financial institutions that operate under Sharia law and regulations. On the surface, there is little difference between Islamic 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. Islamic 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 ISLAMIC AND CONVENTIONAL BANKS
Even though this is oversimplifying things quite a bit, Islamic banks and related financial institutions follow three broadly specific conditions (constraints) that are based in Sharia Law.
- Islamic banks and related banking institutions are not allowed to charge interest
This is probably the biggest constraint and the one big characteristic that most Islamic banks are known for. It is such a distinguishing characteristic that in some non-Muslim countries where Islamic banks operate, they operate under the broad term of “no-interest banking” instead of Islamic 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.
- Islamic finance does not allow for high levels of uncertainty, also known as “argharar”, in business transactions
In order to comply with this constraint, Islamic 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.”
- Islamic finance requires that you invest only in morally upright and ethical causes
Therefore, Islamic 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.