Cafe of Broken Dreams by John scientific terrorist in action

Islamic Banking uses interest

“The concept of Islamic banking is essentially based on the idea that Islam prohibits riba, but permits trade and profit-loss-sharing arrangements.”  *1

I don’t no why, because there is no fundamental economical reason to prohibit interest. Actually an economy which prohibits interest could face to a serious troubles and that’s something what an Islamic scholars have realized and developed the ”Islamic version of interest”. But I will try to explain why is critics of  the west used interest concept needless and I will also point to a fact that the Islamic banking uses the same interest concept as the west banking system.

First, lets look what does interest mean:

“Interest is a fee paid on borrowed assets” *2

and Riba:

“The word “interest" by and large, is now understood as riba.

riba al-fadl: money is exchanged for money hand-to-hand, but in different quantities
riba al-nasiah: where money is exchanged for money with deferment.” *3

The word interest is most often used as a fee paid on borrowed money. But this is not necessary condition, because asset could be also for example some real estate. - interest paid on borrowed apartment is called a rent. (more about meaning of assets via wiki)

interest principle

The fee paid on borrowed assets is not constant. Rents in urban locations are usually very high compared to countryside rents. That’s because demand for estates in urban locations is bigger. The high rent is then a signal for investors about attraction of a locality. More attractive localities are naturally in aim of  developers who try to construct more estates in those regions.  (increase supply)

A fee paid on borrowed money is almost always expressed as a year percentage ratio (0,5%  - size of interest is derived from amount of available capital) and it’s called an interest rate. The reason why is used percentage ratio is purely practical because it allows easily accountability or comparison. International interest rates markets (like LIBOR) then provides a quick capital flow across the whole world. Islamic banking due to the prohibition of interest rate doesn’t have access to those interbank markets neither do have similar simple Islamic interbank market.

There is also no immoral aspect of a fee paid on borrowed assets which would say prohibit interest rate, because every lender has to invest some time to reach assets which he could borrow. He also has to keep value of those assets. (house lenders use rents to house repairs or increasing house quality, money lenders use money from interest rates to cover coasts or to find the best investments)

What’s then a difference between an Islam banking and a West banking loan:

Home loans

The Islamic banking use two basics products Musharaka or more modern Musharaka al-Mutanaqisa. An Islamic bank works as the middle man between a money lender and a money borrower.

basic model of a Musharaka contract

Islamic bank instead of loaning a money, will buy a house and resell it to the borrower with a profit (look at the definition of interest or riba above, this profit is charge for deferment, but this should be forbidden). Part of this profit is then shared with its depositors.

In a more modern  Musharaka al-Mutanaqisa contract a bank rent (rent - charge for deferment) house to a borrower, and the borrower is able to buy parts of this house. Size of the rent is based on the current equity share of the partnership. (Musharaka – fixed profit sharing, Musharaka al-Mutanaqisa – float profit sharing)

In order to protect against default, is used strict defined collateral like a house itself.

West banking use product called mortgage, it can have either fixed interest or float interest.

basic model of a mortgage contract

In the west banking model a bank lent money, borrowers will buy a house for them and this house is usually also used as a collateral.

The difference between the west and Islamic banking is not in interest usage, but in the fact that west banks use charges expressed by a percentage ratio and Islamic banking by absolute amounts.

West bank: you will pay loan + 0,5 % every year from your loan as a charge

Islam bank: you will pay a house value + 1000 USD as our profit

Where is then the difference? Nowhere, its the same thing expressed by two different ways. West banking uses unite interest rate system and Islamic banking system have for every kind of a loan some special model and special charge system.

Penalty for late payment is another criticized part, but there is again no moral reason for that. Just imagine if I rented a house for a one year, but used it for two years I should pay a rent for that second year too. That’s why in the western system exist penalty for a late payment, which still looks like a better option than imprisonment in Dubai debtors prisons (more info about escaping foreigners from Dubai here),

Those who still have some doubts about using interest in the Islamic banking can check SAMA website - “central bank of Saudi Arabia” there is a clear declaration that SAMA uses REPO operations as the key monetary policy action. Interest rates of those REPO operations is possible to see here.

Actually, the monetary and banking system in the Saudi Arabia is same as in the rest of world. Saudi banks accepts international Basel II Accord and keep some minimal reserves ordered by the central bank. SAMA website reports that minimal reserves are 7% which means banks must be immediately able to pay 7% of the customers’ deposits. But, I have checked a balance sheet of the Banque Saudi Fransi and their reserves were 6,22% in the Q4 2008 so it seems that SAMA either have not updated its websites or they do not care about it much. Second bank I have checked was the Arab National Bank  and their reserves were almost 13% so there were everything fine. Average value of all 12 Saudi banks were according to SAMA 11.48%. This is still relatively good – for example Eurozone limit is 2%.

So as we can see Islamic banking is nothing special and sticker Shariah Compliant is just common commerce in order to lure on as much Muslim customers as possible. Only one difference is then that an Islamic bank should not invest into the prohibited stuff such as alcohol companies or pork farms.

*1, 3 -  Islamic Financial Services - Islamic Economics Research Centre, Jeddah

*2 – Wikipedia – Interest