What It Is and What It’s Not [I]: Islamic Banks
Islamic banks utilize legitimate contracting methods to take deposits and give financing. These contracting methods are based in the Shariah and do not take the form of a loan with interest. These contracting methods are legitimate because they allow the Islamic bank to profit in a Shariah-compliant way.
I praise Almighty Allah’s name and convey my choicest salutations to Muhammad and all of the guided prophets of Allah.
This is the first in a three-part series where I will attempt to simplify the concept of Islamic banking, Islamic insurance and Islamic capital markets (Islamic securities). While finance is a technical discipline, I hope to explain it in language and length that is digestible by the reader.
Before we can understand how an Islamic bank works, we need to know how a normal bank works, a conventional bank.
Conventional banks take deposits from customers such as through current (checking) or savings accounts and use those funds to give loans to regular customers (retail customer) and to businesses (commercial customers). When you deposit your money in a bank you are lending to the bank. The bank is in turn obliged to give you your deposit upon your demand — which why they’re technically called demand deposits.
Furthermore, when a bank finances a home or vehicle purchase, or essentially any other financing it gives to retail or commercial customers, it’s done on the basis of a loan which earns interest. Other facets of a bank include the money required to start a bank — the initial equity capital. Such capital is paid up by shareholders who are also owners of the bank. This capital is what is used to start the banking business. Furthermore, banks are legally required to keep some reserves called statutory reserves to be able to meet the withdrawals of depositors. That is all there is to a bank really.
Some quick terminology
There is one more set of terminology we need to nail down to be able to better imagine how a bank works: assets, liabilities and equity.
◙ Assets are something of value such as your house or car. They can be financial in nature such as a check which hasn’t been deposited yet. They can also be a receivable such as money that you’ve lent and expect to receive. Hence, assets are anything of value and that can generate cash flows somehow. Put differently, an asset is something you can sell or rent, or otherwise, to receive cash flows. A bank’s main assets are the loans it gives to people and expects to be repaid (think future cash flows to the bank). We also mentioned the reserves the bank keeps; that’s also an asset too since it’s cash that the bank owns. There are other assets banks hold which are not relevant now.
◙ Liabilities are things which you have to pay to someone else. So a utility bill or rental payment, once they come due, are liabilities. Bank liabilities are primarily the depositor’s money since we said earlier that the bank is obliged to pay its depositors on demand. Banks have other liabilities which are not directly relevant to the current discussion.
◙ Finally, equity is the difference between assets and liabilities. It represents the true value (net worth) of an individual or institution. A bank’s equity is its total assets, mainly loans, less its total liabilities, mainly deposits. The difference between the two gives the true value of the bank. The owners who had contributed the capital to start the banking business are valued at this ‘equity value’ since if all loans are repaid and all deposits are withdrawn, essentially you would have only the true equity or value remaining for the owners.
What an Islamic bank is
An Islamic bank takes deposits and gives out financing just like a conventional bank. It requires capital to start operations and has owners by way of equity. So what distinguishes it from a conventional bank?
✔ Islamic banks utilize legitimate contracting methods to take deposits and give financing. These contracting methods are based in the Shariah and do not take the form of a loan with interest. These contracting methods are legitimate because they allow the Islamic bank to profit in a Shariah-compliant way.
✔ An Islamic bank may sell an asset, lease an asset or fund an asset or business through equity as a form of financing. Both deposit-taking and financing observe these legitimate contractual methods and their related principles.
✔ To demonstrate how Islamic banks give financing to their customers, an Islamic bank may buy an asset which the customer seeks, then it sells it to the customer for installment payments; this is a sale (bay’). An Islamic bank can buy an asset which the customer seeks and then lease (rent) it out to the customer. The customer will pay rental payments until the value of the asset has been paid in full after which the bank will grant it to the customer or sell it for a small price; this is an ijarah. Alternatively, the Islamic bank may engage customers directly in their business through giving them cash capital (called mudharabah/musharakah). This makes the Islamic bank a partial owner of the business. In all such forms, the Islamic bank profits legitimately.
✔ What about deposits? Deposits utilize deposit contracts in Islam such as wadi’ah. Deposits may also take the form of a loan (qardh) in which the customer loans money to the Islamic bank. In both cases, the Islamic bank will utilize those funds, and in both cases, the Islam bank is required to pay back the funds to the customer upon demand.
✔ What about the owners that contribute capital/equity to initiate the Islamic bank? Such owners also contribute capital directly to the bank and are considered owners through an Islamic equity contract called musharakah. All that means is that the initial contributors of capital become partners of each other and owners of the Islamic bank. They further appoint management to manage the operations of the Islamic bank on their behalf.
What an Islamic bank is not
✘ An Islamic bank does not borrow and lend to generate profits. It engages in accepting deposits and offering financing of assets/venture through direct involvement in the assets or business of the customer.
✘ An Islamic bank does not take profits on loans if they are used (we mentioned earlier that Islamic banks may use a lending contract to accept deposits).
✘ An Islamic bank observes some other restrictions such as the absolute transparency of its transactions, some of which are not observed by conventional banks. As a brief allusion, gharar and maysir are two elements of transacting which give rise to extreme uncertainty and are prohibited by the Shariah. Furthermore, Islamic bank are cautious not to engage in accepting deposits from and financing activity viewed to be unethical by the Shariah.
✘ An Islamic bank technically does not use leverage. Leverage is when you buy with more than what you have. What that means for an Islamic bank is that it does not give money (financing) which it does not have (from its deposits or reserves). The actual practice is a bit different, but more on that in another piece.
✘ There are other philosophical differences such as the core objectives of Islamic finance that an Islamic bank adheres to, but they are not elaborated here due to their somewhat technical nature.
This is essentially what an Islamic bank is and what it’s not. Now I know that you may still have lingering question or burning to desires to learn more. Questions like: why an Islamic bank? What are the primary differences between the theory and reality of Islamic banking? Why is there so much controversy surrounding the practice of Islamic banks today? Since I promised to keep these pieces short I will leave off answering those questions to another post. However, please feel free to post your questions and let me know what I should explain next. Until then, peace and blessing of Allah be with you.
