The Interesting System of a Islamic Finance

“Those who consume interest cannot stand [on the Day of Resurrection] except as one stands who is being beaten by Satan into insanity. That is because they say, “Trade is [just] like interest.” But Allah has permitted trade and has forbidden interest. So, whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allah. But whoever returns to [dealing in interest or usury] – those are the companions of the Fire; they will abide eternally therein.”

““O you who have believed, fear Allah and give up what remains [due to you] of interest, if you should be believers.”
And if you do not, then be informed of a war [against you] from Allah and His Messenger. But if you repent, you may have your principal – [thus] you do no wrong, nor are you wronged.
”

If you wish to hear the recitation of the verses, links are provided here: 2:275; 2:278; 2:279

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These three quite ominous verses sum up, succinctly and clearly, what grim fate Allah has planned for those who deal in interest. However, it might be more accurate to say riba (ربا), rather than interest. Indeed, it could be argued that translations of the verses above which keep riba untranslated are more accurate. (Truthfully, any version of the Qur’an in English could be classified as unduly westernized.) This Arabic word’s original meaning is something along the lines of “increase”, “excess” or “addition” but is now primarily used to refer to the practice of interest or usury.

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• Some defend that riba doesn’t apply to all interest but, rather, only to unusually high interest-rates: usury. There is a lot of Islamic literature which equates riba with interest and that claims that there is a consensus amongst Muslim scholars that this is so.

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There are many justifications given by religious scholars for the banning of interest by Allah, namely claiming that lending with interest is exploitative and that the lender/borrower relationship created undermines the spirit of brotherhood that should exist amongst Men. This religious ideal is not unique to Islam. Indeed, other Abrahamic religions have things to say about interest:

“Do not charge interest on the loans you make to a fellow Israelite, whether you loan money, or food, or anything else.”

Holy Bible – Deuteronomy [23:19]

Human beings’ innate fear of falling in eternally burning fires and our puzzling love for masochistic submission to an almighty father figure came together in the Muslim world to create a Sharia-compliant banking system commonly referred to as Islamic Banking. In broad terms, to be in accordance with Allah, Islamic banks must not receive nor pay interest and must not invest in or involve themselves with businesses which partake in haram (forbidden) activities, such as selling alcohol, pork, gambling, etc.

Now, the question lingering in everyone’s minds: “How do these institutions function?”

In Islamic Banking, the most common way of financing is what is called Murabaha. It is, essentially, a contract of sale in which the bank buys a good that its client needs and then sells it to him with a previously agreed upon mark-up cost. Say, for instance, that you need a new set of tables for your restaurant. The bank buys said set of tables from the table-maker at X€ and sells them to you at X+P€, an amount that you pay through deferred payments.

I don’t need a revelation from Allah to know that many of my esteemed readers are scratching their heads in utter confusion trying their hardest to understand how such a transaction amounts to anything different than paying interest on a loan. Is it just interest with extra steps? Indeed, this is a criticism which Murabaha-type financing receives in ample amount, implying, therefore, that it is not Shariah compliant. However, since this removes the much-frowned-upon aspect of “money generating money on its own” and involves specific commodities, supposedly, Allah is pleased. And so, in spite of its criticisms, Murabaha contracts are calculated to represent about 80% of total financing made by Islamic Banks.

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Another type of financing contract that exists in Islamic finance is called Mudarabah which, contrary to Murabaha agreements, is broadly accepted as Shariah compliant. This method, which closely resembles venture capital financing, is a type of contract in which an agent provides the capital (called the rabb-ul mal (رب المال), literally “lord of money) to another agent, who invests it and operates the investment (called the mudarib). The mudarib has complete authority in operating and managing the investment. Profit after the repayment of the borrowed capital, when it exists, is split amongst both parties in a previously agreed-upon manner. On the other hand, if the project fails, the losses fall entirely on the rabb-ul mal, who will lose his invested capital.

Due to the very high risk that the rabb-ul mal faces, Mudarabah contracts contain covenants which protect him from negligence by the mudarib. However, the viability of this method of financing still suffers heavily from structural agency problems: the mudarib does not suffer from losses nearly as much as the rabb-ul mal. For the financier to be willing to take projects with higher risk, he will demand a higher profit share. However, this, in turn, diminishes the incentives that the borrower has to generate profits. And so, mechanisms that better align the incentives of both parties, like the ones used to align the incentives of shareholders and managers (for example shareholders voting to elect a Board of Directors), need to be incorporated to actually make this a practical way of financing.

A similar type of contract exists, called Musharakah, but where two or more parties pool capital for an investment and divide profits according to it.

There is a hadith in which prophet Muhammad says:

A dirham of riba which a man receives knowingly is worse than committing adultery thirty-six times.

Assuming that this is true, and that people, in general, don’t like adultery, then, it is no surprise that Islamic Finance continues to grow, with global assets exceeding $2000bn. However, its growth is not restricted to Muslim-majority countries. Many financial companies, like J.P.Morgan, now offer Sharia-compliant financial services and the United Kingdom is at the forefront of this industry’s growth in the west. With about 5% of its population being Muslim there are already 5 different, completely Islamic, banks operating in the U.K.

This is a topic whose surface I was only able to scratch in this article due to its surprising complexity. But, surely, its relevance will only increase as Islamic Finance evolves and migrates from the Muslim-majority countries to the rest of the world.