Islamic Banking Made Easy

[Muhaba]

As I study better when I'm teaching, therefore for revision of some of my islamic banking course, i have decided to summarize what I study and post it here, thus benefiting others as well.

Islamic banking is different from contemporary banking as there is no interest in islamic banking. The bank will neither charge you interest on loans nor pay you interest on deposits. However, since the bank needs to earn money to pay expenses and earn a profit, it does this through other ways, for example through profit-sharing, investing saving and investment account deposits and earning a profit, buying assets (such as a car or home) and reselling for a higher price on installment payment basis, or by charging for services provided.

some Islamic banking terms with explanation:

وديعة Wadee'ah (or wadi'ah) - wadee'ah refers to the money that is deposited in the bank by people or businesses for safe-keeping. The bank doesn't pay interest on wadee'ah. To pay for its expenses, the bank may charge a monthly fee for providing this service. Or it may charge an amount per service rendered (for example per check cashed or teller service, etc). some banks charge a monthly fee fro accounts containing low amounts of money (such as $1000) but not on accounts containing higher amounts of money.

in a wadee'ah arrangement, it is not allowed for the bank to pay interest to the account-holder. If a bank is known for providing gifts to its wadee'ah account holders that may also be interest as in islam it is not allowed for a creditor to take gifts from a debtor who is known to give gifts to his/her creditors as this becomes interest. and since the bank and checking (wadee'ah) account-holder relationship is that of a debtor - creditor, the bank shouldn't give regular gifts to its wadee'ah account holders.

Another type of account in the Islamic bank is the saving account.
What makes the savings account in an islamic bank different from saving accounts in contemporary banks is that the islamic bank saving account doesn't pay interest to the account-holder. Instead, it is based on profit sharing: Money deposited in the islamic bank saving accounts is deposited with the agreement that it will be used for investment purposes and thus earn a profit which is shared by the bank and the account-holder. Since the arrangement is that of an investment, it is possible that there is a loss and the account holder loses some or all of the money deposited in the saving account. However banks are careful about the types of investments they invest in, reducing possibility of loss. Additionally, the money in saving accounts is invested in low-risk investment with low probability of default. this is why the the profit percentage in such accounts is low, such as 3% or 5%. In the islamic bank saving account money may be deposited and withdrawn at any time without any penalty, like the checking (current) account. The only thing is that withdrawing money over a certain number of times per month may affect the profit for that month.

Investment account - this is a long-term investment account. money deposited in this sort of account cannot be withdrawn before the specified term (5 years or more) without a penalty. This sort of account is also based on a profit-sharing and the profit percentage is higher than the profit percentage of the saving account.

That's it about types of accounts in the islamic bank. Insha-Allah more islamic banking info next time.

[Mustafa2012]

Jazaak Allaahu khayr for sharing your findings.

When the recent recession hit most of the Western World, the countries that were using Islamic Banking like in the Middle East, Far East etc. were not affected as much as the West was.

As a result the West has now started to use principles from Islamic Banking as a survival strategy.

Studying Islamic Finance is very interesting because it opens up doors for business transactions that can be carried out in a Halal way.

[Muhaba]

That is so true.
I always intended to summarize the stuff I studied and even translate some of my course material. it is so interesting and helpful and gives you an insight into history of economics & business in the islamic world, which goes back to the first few centuries. Insha-Allah people showing interest might encourage me to do this sooner. I have books on islamic economics, islamic banking, history of islamic economics, etc. and I aim to summarize and translate them all eventually.

[Mustafa2012]

That is so true.
I always intended to summarize the stuff I studied and even translate some of my course material. it is so interesting and helpful and gives you an insight into history of economics & business in the islamic world, which goes back to the first few centuries. Insha-Allah people showing interest might encourage me to do this sooner. I have books on islamic economics, islamic banking, history of islamic economics, etc. and I aim to summarize and translate them all eventually.

Please do share more of your findings. You'll be doing the Ummah a big service.

:jz:

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[Muhaba]

insha-Allah very soon. But please everyone pray for me as I am facing some hardships.

[Independent]

What makes the savings account in an islamic bank different from saving accounts in contemporary banks is that the islamic bank saving account doesn't pay interest to the account-holder. Instead, it is based on profit sharing:

This is very interesting, I know nothing about this. How does the bank know what rate of return to quote beforehand if this is not guaranteed? Is not the case that there is no difference between a savings account and an investment account, as both are dependent on performance?

Also, how is the money invested? If it is invested in the stock market where stocks pay dividends, is that not also a form of interest?

[aamirsaab]

This is very interesting, I know nothing about this. How does the bank know what rate of return to quote beforehand if this is not guaranteed?

They'll give an expected rate.

Is not the case that there is no difference between a savings account and an investment account, as both are dependent on performance?

The difference is the investment account has a higher rate of return (and also your money is 'locked' into the account - you'd have to pay a fee to take it out early).

Also, how is the money invested? If it is invested in the stock market where stocks pay dividends, is that not also a form of interest?

1. Dividends are not the same as interest.
2. Islamic banks aren't allowed to invest in haram organisations i.e alcohol, fire arms, pork etc.

As a side note; conventional and Islamic banking are actually very similar. Like 80% the same thing - essentially the same products, same kind of basic facility etc.

[Independent]

They'll give an expected rate.

OK. In that case the end result of this for consumers is probably very little difference. Western banks are actually investing the money in the same way, although this is packaged to the consumer in the form of a pre-determined rate of interest. So long as the expected rate is fulfilled it's the same. The only difference would be that an Islamic bank would require a high level of regulation and transparency, to ensure that they really do pass on all the profits and don't charge unfair fees.

How does it work with borrowing - for consumers or businesses? How can you borrow without being charged interest?

[جوري]

It is called bayet el-mal.
All the state money goes into it. You don't pay it back with interest, I am not even sure you pay it back at all. it is what is owed you from the wealth of your ummah for being born Muslim!

best,

[Muhaba]

The main difference between islamic banks and conventional banks is that islamic banks deal with assets while conventional banks deal with money.
For example, if you want to buy a house, a conventional bank will lend you the money and charge you interest on the loan.

on the other hand, an islamic bank will not lend you the money. It will buy the house then resell it to you at a higher marked up price and you pay this amount in installments. In islamic banks, the amount of the markup should not change with time. for example, it shouldn't matter whehter you will pay the amount in 1 year or 5 years. the mark up should be the same. if it differs, it means the bank is actually charging interest.

for example, you want to buy a house which costs 100000. you go to the Islamic bank and request them to buy the house (take ownership) then resell it to you. After conducting credit checks, the bank agrees to do this, tell you that they will resell the house to you for cost + 20,000 totalling 120,000. you agree to pay this amount in 4 years.

now suppose, another customer goes to the same bank and asks to buy a house costing the same amount but wants to pay in three years. if the bank tells him/her that they will pay 15000 over the cost of the house, it means that the bank is actually charging interest as the amount of the mark up is changing with time. however, if the bank tells the customer that the markup is 20,000 whether they pay in 1 year or 5, then it won't be interest.

This is called the بيع بثمن عاجل bai' bi thaman aajil contract, which means deferred payment sale.
A similar contract is the مرابحة (moraabaha) contract which is a resale contract. in a مرابحة contract, the cost and amount of profit / mark up is known to the buyer.

i hope that explained the difference between how conventional banks do business and how islamic banks do it.

[aamirsaab]

OK. In that case the end result of this for consumers is probably very little difference. Western banks are actually investing the money in the same way, although this is packaged to the consumer in the form of a pre-determined rate of interest. So long as the expected rate is fulfilled it's the same. The only difference would be that an Islamic bank would require a high level of regulation and transparency, to ensure that they really do pass on all the profits and don't charge unfair fees.

See what I mean by the two banking methods being basically the same? :)

How does it work with borrowing - for consumers or businesses? How can you borrow without being charged interest?

This is the tricky bit. Strictly speaking, what I borrow from the bank is exactly what I owe. Unfortunately, this is not an ideal world and some do charge a handling fee or manager fee (they don't actually call it interest); which is essentially back door interest. Not all Islamic banks mind you but some.

Under Islamic teachings, there's no justification for the interest charge in the first place (whether I pay you now or "later" has no bearing on the amount I owe you bar inflation, although that's a different topic altogether). So with this in mind, it becomes difficult to see a loan as a product a bank can offer (and subsequently becomes difficult to see how you can even have an Islamic bank in the first place - which is the greatest conundrum of all but we can talk about that at a later date.) - that's because it isn't supposed to be a product that profit can be made: it's simply a loan.


I'll have to read my notes on the business borrowing/lending. It's been a while since I looked at them.

[Mustafa2012]

insha-Allah very soon. But please everyone pray for me as I am facing some hardships.

May Allaah make things easy for you.

Whatever it is you are going through, try to have a good opinion of Allaah and make du'aa to Him and have the best expectation of a response.

Remember the words of the Messenger (peace and blessings of Allaah be upon him): “How wonderful is the affair of the believer, for his affairs are all good, and this applies to no one but the believer. If something good happens to him, he is thankful for it and that is good for him. If something bad happens to him, he bears it with patience and that is good for him.” (Narrated by Muslim, 2999).

[Independent]

now suppose, another customer goes to the same bank and asks to buy a house costing the same amount but wants to pay in three years. if the bank tells him/her that they will pay 15000 over the cost of the house, it means that the bank is actually charging interest as the amount of the mark up is changing with time. however, if the bank tells the customer that the markup is 20,000 whether they pay in 1 year or 5, then it won't be interest.

Also very interesting. In effect this is equivalent to a western bank mortgage that's charged at a fixed rate of interest for the entire duration of the loan. Once again, from the point of view of a consumer there is little difference (apart from excluding a wide range of other mortgage products like variable rate loans but that's not fundamental).

How does an Islamic bank justify charging more for the value of the property in the first place? Clearly, if the bank charges a different amount for different loan durations, it makes it even more like an interest based arrangement.

Secondly, how does a business borrow money? Does the bank take equity in the business?

[Muhaba]

^It is different because the bank is reselling the asset at a higher price. It is not charging money for a loan.

a business may get money from an islamic bank if the bank decides to invest in the business. This may be done in two ways: 1. the bank provides all the funds and the enterpreneur manages the business without investing any money in it. here the two share profits based on an agreed ratio while any losses incurred are borne by the bank. The bank cannot ask the enterpreneur to return any of the money it invested. This is known as modaraba مضاربة .

2. the second way for someone to get an investment in their business from an islamic bank is by entering into a partnership شركة (sharika) with the bank. Here both the bank and the businessperson invest money into the business. The amount each invests may or may not be equal. Profits are shared based on an agreed ratio while losses are according to the share in investment. So if one party invests 40000 while the other invests 60000, profits may be divided 40:60 or 50:50, etc. But losses have to be 40:60. This form of company is مشاركة musharika. how the business owners decide to divide profits is based on whether the partners invest only funds, share in management functions, or one invests funds while the other invests and manages the company. If one of the partners works for the busines, he/she may get a salary instead of a higher percentage of profits.

A third way you can get required assets for your business without borrowing money is through a lease agreement. The bank buys the asset you need (say equipment or machinery) and you lease them from the bank. The lease may be a simple lease agreement or it may be a hire-purchase agreement الإجارة منتهي بتمليك (lease that ends in the transfer of ownership of the asset from the lessor (bank) to the lessee) after a specified time-period. The transfer may be free or for a small charge. In such a lease the ending sale of the asset is binding on the bank/lessor but purchase of the asset is not binding on the lessee.

So how does a bank decide whether it will invest in your business? If you are starting a new business, you will need to show the bank a viable business plan containing information about your business, suppliers, customers, demand for your product/service, supply of your product/service, your competitors in the area where your business will be located, your assets along with costs, your revenue and expenses, cash-flows for several years, as well as pro-forma financial statements. If you need funding for an on-going business, then you will the financial statements of past years as well as forecasts for the future. The more comprehensive your business plan is, the more likely it is that you will get funding from a bank. (Note: in the business plan, you don't have to show a net profit for the first year. But you only need to show that the business has potential. if you have a gross profit then it's considered a good sign. (Gross profit = sales minus cost of goods sold).

Another thing you should have on your business plan are financial ratios.

[Independent]

It is different because the bank is reselling the asset at a higher price. It is not charging money for a loan.

I suppose this depends on how much extra they charge than the 'real' value of the house. If it's a couple of percent, you could call that the cost of doing business. If it passes 5-10% it starts to look like pure profit. If it reaches, say, 50-60% over a 20 year loan, then surely that is an interest charge by another name?

In other words, is there a charge being placed against the access to capital itself (even if it's not called that), rather than just an administration charge? And if the charge is indeed just for administration, how do banks raise enough capital to operate?

Also, doesn't this lead to a slightly confusing picture of house prices? I mean, if you make a cash purchase from the vendor, it will be much less than the price you would pay to a bank for the same house, which buys it on your behalf?

As for the business loans you describe, in many ways they are similar to western arrangements. I suppose the key difference is that with both the private and the business finance, an Islamic bank takes direct ownership of the asset (a house, machinery etc) while you have the use of it (in a sort of hire purchase agreement). But since a western mortgage, or a business loan, is also usually secured against an asset (the house) then once again this seems like the same thing by another name.

I'm not sure that hire purchase and interest are so very different underneath it all. As a matter of fact, in the UK and the US hire purchase was often used specifically by those people who for one reason or another couldn't get access to credit. (For example, buying clothing through a mail catalogue). ie hire purchase is often used as another form of interest. Instead of borrowing money to buy the item, they get the item straight away but pay back in installments (but with an interest charge disguised within the price).