How do Islamic banks make money?

How do Islamic banks make money?

A young man chooses his career and decides to become a successful banker, just like his father. He wants to prepare for the role and asks his father “What should I do to become a successful banker just like you?” “Son,” says the father, “you must follow these three simple rules: first, do not lend money to those who have none; secondly, do not lend money to those who are in dire need of it; and third, most important, do not lend your own money.” Good advice in these troubled times. It is a pity that many of today’s bankers have either never received this sound advice, or have ignored it!

In a previous article, I made the argument that Islamic banking institutions have weathered the current financial crisis relatively well because they have been, or certainly should be, insulated from the disasters of the interbank market and turmoil in the derivatives markets. A number of readers have raised the logical question of how Islamic banks manage to stay in business without charging interest.

To summarize, one of the main principles of Islamic banking is the prohibition of riba (usury or interest). Until the 1980s, riba was generally interpreted as applying only to usury, but it is now accepted practice to apply to all interest. Other principles are based on simple morality and common sense, which are by no means unique to Islam. For example, usury is prohibited by both the Old and New Testaments. Even literary heavyweights like Shakespeare opposed this practice.

Islamic banking is also by no means a new phenomenon. The main practices can be traced back to the early parts of the seventh century. Some experts even claim that many of the concepts and techniques we know today were later adopted by European bankers. Its relatively recent re-emergence coincided with rising oil prices in the mid-1970s, thus providing parts of the Muslim world with significant financial resources. The other crucial element was the concomitant search for ethical values ​​in the management of their financial affairs, something that many of the traditionally Western financial organizations could not provide. As this is a trend not only applicable in the Muslim world, emerging Islamic banks are increasingly being adopted by non-Muslims who do not wish to invest or even deposit their savings in companies engaged in unethical and socially harmful activities such as trade in alcohol, gambling, pornography and tobacco.

The Islamic economic system is concerned with social justice to ensure that none of the parties involved in a transaction are exploited without at the same time inhibiting individual enterprise. Extended to the Islamic financial system, this means that the funds of individuals and/or companies exposed to risk share in the profits or losses arising from the enterprise. This concept of sharing the pleasure or pain of the business outcome is progressive. To paraphrase Charles Darwin: “It is not the strongest financial system that survives, nor the most intelligent. It is the one that is most adaptable to change.” Islamic banking promotes better management of resources, especially since direct speculation is not permitted by Sharia, ie Islamic law. Participants are up to date with sophisticated techniques and have developed products that are not only ethically motivated but also profitable.

Islamic financial solutions usually have Arabic names, thus scaring many potential buyers to say that everything is too complicated. At their core, most of these products are essentially the same as their conventional equivalents. The main differences are the lack of interest and the often complicated procedures to ensure Sharia compliance.

For example, in Islamic housing finance, the associated risks are shared between the bank and the borrower, rather than transferring the entire risk to the latter. The most commonly used contract is the diminishing musharakah (partnership) contract. In this case, the bank and the borrower form a partnership, with the bank providing up to 95 percent of the purchase price and the borrower 5 percent.

The borrower buys the bank’s share of the property, profiting from the rent paid by the customer for the share the bank owns. This happens over a period of, usually, 15 to 30 years.

If the borrower defaults on rent or principal, the bank may provide the borrower with an interest-free loan to allow him to continue his payments in the expectation that he will pay in full when he is able. The good news is that during this hardship period, the borrower keeps their home rather than facing eviction.

Having said that, Islamic banks still assess credit risk and are indeed more cautious about who they finance than conventional banks.

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