Islamic banking: How to make profit under Sharia law

FINANCE
Margarita Poluektova

How do banks make profit? It is no secret that they benefit from interest rate received from loan repayments. However, assumption that every single bank operates in this way is not justified: indeed, Islamic ones do not charge interest rate at all. That is why the fact that Islamic finance has been growing rapidly over recent decades and its global assets are now estimated to be around $1.5 trillion across the banking sector makes it a real financial phenomenon.
 
The reason why Islam prohibits to profit from interest rates lies in the principles of Sharia law depicted in the Qur’an (the word of God) and the Sunan (teachings of Prophet Muhammad). Islamic finance is based upon the fact that money is solely a medium of exchange and has no intrinsic value, and anyone living in accordance with Sharia is not allowed to make any profit by lending or receiving money. To be consistent with these rules, charging interest, riba, is prohibited and has no application in Islamic finance. However, the Sharia-compliant banks have proved that there are alternative effective ways of making profit without violating religious laws.
 
Modern Islamic banking is based on buying and selling goods and services. Thus, banks can profit from trading using ijara or murabaha contracts. With a ijara scheme, the bank provides property or equipment on lease or rental basis. An example of this contract is purchasing a house for a customer and reselling it with management costs added. With a murabaha scheme, the bank purchases requested goods and profits by reselling them to the customer with a mutually negotiated margin added. This is considered to be a reward for the risk that is assumed by the bank. Another way to profit under Sharia is with a musharaka scheme. This is a joint venture, in which the bank and the customer contribute to the operating capital and share the returns and risks in agreed proportions.
 
The difference between the operation of non-Islamic and Islamic banks can be illustrated by the following example. When a customer wants to buy a car for £10,000, the non-Islamic bank calculates that at 4% interest rate £10,000 over the course of 5 years would be worth £11,049.91, so the customer will have to make the monthly payment of £184.17. The bank calculates the interest rate every month: first payment would be fully interest, and the last would have no interest in it. During the loan it is possible to delay a payment, refinance or pay partially or fully. Islamic banks, however, take a different approach. When the customer requests a car, under the murabaha scheme the bank gets it for £10,000 and suggests that the customer can buy this car from the bank for a higher price, for example, £12,000 (the price is usually higher than in a non-Islamic bank). For a course of 5 years, £12,000 would be split into the monthly payment of £200. During the loan, as opposed to non-Islamic banks, it is not possible neither to delay a payment nor refinance. However, if the customer pays a loan fully before the time it is due, most Islamic banks would pay an early repayment reward. In that case the profit would be reduced, but a bank would still gain from this transaction.
 
The success of Islamic finance is undeniable and impressive since on its emergence it could not have been predicted that the alternative ways of making profit would work as well as charging the interest does. Thus there is no surprise that it is becoming more and more popular around the world, and nowadays non-Muslim customers are also able to participate and benefit from Islamic banking scheme. In 2004, the Islamic Bank of Britain was established, and it operates entirely in accordance with Sharia law. It has branches in London, Manchester, Leicester and Birmingham and offers a range of Sharia-compliant financing deals.

Margarita Poluektova is a second-year Politics, Philosophy and Economics student at the University of Manchester