Islamic Banking: How to Make a Profit on Interest-Free Loans

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BY: Trey Antley, Guest Contributor 

Editor’s Note: The Campbell Law Observer has partnered with Judge Paul C. Ridgeway, Resident Superior Court Judge of the 10th Judicial District, to provide students from his International Business Litigation and Arbitration seminar the opportunity to have their research papers published with the CLO.  The following article is one of many guest contributions from Campbell Law students to be published over the upcoming semester.

The term Islamic banking represents banking that is compliant with Sharia law.  Under Sharia law, certain techniques used by conventional banks are forbidden such as charging and paying interest.  Making up about twenty-three percent of the world’s population, 1.6 billion Muslims still look to financial institutions to help them buy homes and earn a return on their money.  Despite restrictions imposed by Sharia law, the global Islamic banking industry is valued at $1.1 trillion and growing.

Origins of Islamic Banking

Since Islam lacks a clear division between secular and religious life, the first step to understanding Islamic finance requires an introductory note on Islam.  According to the Islamic tradition, God (Allah) communicated to the prophet Muhammad a path towards salvation known as sharia.  After Muhammad’s death in 632, those revelations were systematically transcribed.

The written version of the God’s revelations to Muhammad became the Muslim holy book, the Koran.  Muslims view the Koran as the infallible word of God that instructs them in religious and daily aspects of life.¹   Hadiths constitute the sayings and acts of the prophet Muhammad.²   Interpretations of the Koran and the hadiths comprise what is known as divine law or Sharia law.³  Classical Muslim jurists and later Sharia scholars developed rules, known as fiqh al muamalat, concerning transactions in accord with Sharia law.

The first modern Islamic bank was founded in Egypt in 1960, but the Islamic banking and finance industry arose in earnest in the 1970s.⁴  With an increasing need for industry standardization, the Accounting and Auditing Organization for Islamic Financial Institutions was formed in 1990.⁵  In 2002, the Islamic Financial Services Board, an international standard-setting body of regulatory and supervisory agencies, was established.  The IFSB currently has 184 members, including regulatory/supervisory authorities, inter-governmental organizations, financial institutions, professional firms and self-regulatory organizations.

In order to guarantee compliance with Sharia law at the company-level, Islamic financial institutions have a Sharia supervisory board.⁶  Scholars compose the Sharia supervisory board and issue religious rulings or fatawas on financial transactions that are binding on the financial institution’s management.

Principles of Islamic Banking

The main principles of Islamic banking include sharing risk, prohibiting monopoly, making fair transactions, ethical investing, and most notably proscribing interest or riba.⁷  In financial endeavors, Sharia law mandates risk sharing and disallows speculation or gharar.⁸  This encourages many Islamic banks to form a partnership relationship or joint venture with their customers.  In a transaction, both sides must be fully informed and lack ignorance or jahala.⁹  Any profit from business and trade must be fair and legitimate or halal.  Additionally, banks are expected to pay an alms tax or zakat for the poor.  Zakat is usually around 2.5  percent and voluntary, but in some countries like Saudi Arabia, payment of zakat is obligatory.¹⁰

Sharia-compliant ethical investing excludes investing in companies or funds that earn income from pork-related products, alcohol, conventional financial services, pornography, gambling, tobacco, arms, and other illicit activities.¹¹  Beyond gambling in the traditional sense of casino games and lotteries, banking practices cannot cross the line into what might be considered gambling or maisir and qimar.¹²  Some Muslims question the propriety of insurance, such as that provided by the Federal Deposit Insurance Corporation, as approximating gambling and violating the ban of riba and gharar.¹³

According to Islam, money has no inherent value so one should not make money from money.¹⁴  This premise leads to the outlawing of the collection or payment of interest, which might promote other evils like usury or speculative transactions.¹⁵  Another purpose of barring interest is to prevent the accumulation of wealth in a few hands.¹⁶  The seriousness of this principle is underscored by the fact riba is a capital sin of Islam.¹⁷  Lending is distinguishable from riba, and the act of providing or receiving a loan or qard is not in itself contrary to Sharia law.¹⁸  Following these general principles, Islamic financial institutions have created a number of innovative Sharia-compliant products and methods.

Sharia-Compliant Financial Practices

One Sharia-compliant product is a sukuk, which is similar to an investment certificate or bond.¹⁹  The holder of a sukuk owns an interest in an asset rather than owning the debt as in a traditional bond.  Instead of interest, sukuk holders are paid a portion of the underlying assets revenues and the proceeds from the sale of that asset.²⁰  The reputation of the scholars who certify the sukuk’s compliance with Sharia law influences the sukuk’s valuation.²¹

An Islamic financial institution can offer benevolent financing in which the institution does not make a profit, a transaction called a qarde hasan.²²  Since even Islamic banks hope to make a profit, this type of loan is uncommon and considered charitable.  The individual or institution receiving such financing is only expected to pay back the principal and a small fee to reimburse administrative costs.

In the context of manufacturers and suppliers, Islamic financial institutions may provide commissioned manufacturing or istisna.²³  In istisna, the financial institution pays in installments for the service and necessary supplies to build a plant or equipment for the client.  The client then pays the financial institution in installments for the cost of manufacturing the plant or equipment plus a profit payment and fee.  This is distinct from deferred payment financing or bai bithaman ajil where only the material is purchased and not the service.²⁴

Under bai bithaman ajil, the financial institution buys assets as they are manufactured, and afterwards, the customer purchases the goods from the financial institution.  The customer can pay the financial institution the entire amount due or pay in installments.  The repayment amount includes a profit that uses interest rates as a benchmark.²⁵  This method can be used in home financing, but as a home product, bai bithaman ajil faces criticism because the financial institution does not share in the risk by retaining an ownership interest.

In order to attract capital that it can later use in a financing product, Islamic banks employ creative devices.  One such device is paying a discretionary reward or hibah to depositors.²⁶  Sharia law does not obligate the bank to pay a fixed return, but Islamic banks often award hibah to compete with commercial banks.

In addition to hibah, Islamic banks might use a venture capital approach or mudaraba to draw depositors.  The bank invests the customer’s deposited funds and collects a fee for serving as the customer’s agent or Mudarib.  Alternatively, banks might give capital to a client who only provides management and expertise.  In this arrangement, the financial institution will receive a percentage of the profits but carries all the risk of economic loss. Mudaraba was practiced in the time of Muhammad and had his approval.²⁷

A similar way Islamic banks might entice depositors is using a profit and loss sharing scheme similar to a partnership called musharaka.  Banks can use musharaka in two distinct ways.  The bank can invest a customer’s deposited funds, and both the bank and customer share in the profits and losses from those investments.  The other way banks use musharaka is by providing capital to an entrepreneur who also puts up capital.  Both parties share in the profits and losses as well as the decision-making.  The client typically contributes management and expertise.²⁸

In the context of home financing, musharaka is similar to mortgage financing, but it has some notable differences that make it Sharia-compliant.  Musharaka is sometimes referred to as a declining balance co-ownership program or diminishing partnership.  The customer and financial institution own a proportionate interest in the home to the amount they contributed to its purchase.  If the client misses a payment, the financial institution cannot charge a late fee other than to cover its administrative costs.²⁹  To ensure the fee is appropriate, the financial institution might have a third party estimate the cost of collecting a late payment.³⁰  The profit payment is generally competitive with prevailing interest rates.  The financial institution might get external funds corporations like Freddie Mac.  In order to stay Sharia-compliant, Freddie Mac takes a co-ownership stake in the properties and creates securities in the co-ownership assets that comply with Sharia law.

In the case of default, the financial institution can foreclose on the property.  The proceeds from the sale of the foreclosed property first pay off the principal and any other amounts owed.  No interest can be charged for the missed or late payment and the surplus goes to the customer.  Some Islamic financial institutions use a non-recourse clause to protect the customer’s other assets and steer clear of the Sharia law prohibition of profiting from another’s financial distress. If the customer sells the property while the institution still has an ownership interest, the customer must use the proceeds from the sale to buy out the institution.  Then, solely the customer assumes any gain or loss in the property.

In addition to Sharia law, musharaka practices in the United States face issues with state and federal law.  Even though musharaka complies with Sharia law, Islamic financial institutions must use the term “interest” in disclosures to satisfy United States regulations and statutes like the Truth in Lending Act.  Although state laws vary, the financial institution is usually a co-owner on the title of the property.³¹  However, only the customer is responsible for paying the property taxes.³²  To comply with the general requirement of private mortgage insurance for people with down payments of less than twenty percent, financial institutions may increase the profit payments by an amount equal to the cost of private mortgage insurance.³³

The most common asset-backed loan products that comply with Sharia are murabaha and ijara.³⁴  Murabaha is similar to a conventional secured loan.³⁵  The murabaha technique is a cost-plus arrangement where the financial institution purchases an asset for the customer.  The customer then pays the bank the asset’s purchase price plus an agreed upon profit over a period of time.  Instead of interest, the profit is considered compensation for the risks, like damage, destruction, or non-acceptance by the customer, that the bank assumes by owning the asset.³⁶

The customer who defaults is not liable for any interest or additional fees beyond the principal and administrative costs.³⁷  Due to these risks, financial institutions should deal only with trusted clients or those with sufficient collateral.  Observant Muslims might use this technique to purchase a home, which results in the bank owning real property.³⁸  Although this might appear to conflict with the general prohibition of the National Bank Act of 1864 against banks owning real property, the Office of the Comptroller of the Currency (OCC) concluded the murabaha does not violate the Act because murabaha is essentially the same as a mortgage.

Ijara represents another common technique for financing a home in accord with Sharia law.  Ijara is similar to a sale/leaseback arrangement where the bank purchases the asset and leases it back to the consumer.  At the end of the lease, the customer usually has the option to purchase the asset.³⁹  Although a lessee can buy the asset at the end of the term, the lessee is not bound to make the purchase.  The lease starts when the asset is delivered to the client instead of when the contract was signed.  If the asset is destroyed, the customer does not have to pay the full rent.  As with the murabaha, the OCC resolved the apparent conflict with the National Bank Act of 1864 by deeming ijara to be the functional equivalent of a mortgage.

Conclusion

Islamic banking offers creative approaches to serving the financial needs of customers who value the principles embodied in Sharia law.  As the market for Sharia-compliant financing and banking grows, the value of at least a basic understanding of Islamic banking will increase.  Of course, the regulators and lawyers involved in these transactions and related litigation must obtain a much higher proficiency in the topic and more in-depth research into the intricacies of Islamic banking is needed.

Trey Antley is a 3L student and will graduate from Campbell Law School in May 2015. He may be reached by email at md**********@em***.edu.