Does Islamic Banking Truly Avoid Interest?
Usury is alive and well in shariah finance.
The Russian parliament has just approved Islamic banking in the country. Islamic banking purports to avoid usury, the charging of interest on loans. In any country with a sizable Muslim population, you can find an Islamic bank.
(In 2015, the Russian Orthodox Church even looked into starting a new banking system, drawing inspiration from the Muslims.)
Every major religion prohibits usury. Christians are traditionally banned from lending at interest. Jews are forbidden from charging interest to fellow Jews. And Islamic shariah law proscribes riba (usury), teaching that those who profit from it are condemned to Hell.
Islamic banking developed in the mid 20th Century among pious Muslims who sought to avoid usury. Shariah-compliant banks not only eschew interest, but also shun investments in haram (unclean) ventures like gambling or pornography. In general, Islamic banking seeks to be halal (clean) in its operations.
However, having studied and taught Islamic finance for the past three years, I find it to be the same as conventional banking. Legal ruses (hiyal) rebrand interest payments as “profit rates.” If a borrower fails to pay a mortgage, the consequences are the same. An Islamic bank that truly avoided interest payments would become insolvent.
To see this, I describe in this article the five main structures in Islamic finance: Mudarabah, Wadiah, Musharakah, Murabahah, and Ijara. I explain how some of these vehicles mask interest payments behind legal jargon. Then, I close by suggesting a way forward, towards a fairer banking system.
To be clear, my intent is not to malign pious Muslims, including those who started Islamic banking. I wish Christians took the Bible’s ban on usury as seriously as Muslims take the Quran’s. That being said, my view on Islamic banking is shared by some Muslim scholars.
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Mudarabah (Joint Venture)
Mudarabah is the type of financing you see on Shark Tank or Dragon’s Den. A fledgling business seeks money from a wealthy capitalist. The capitalist provides the money in exchange for partial ownership (i.e. equity) in the business. If the business fails, then the capitalist loses his money. If it succeeds, then the capitalist and entrepreneur share in the profits.
An example is seen in the following 10-minute video. This is not Islamic, but it follows the principles of mudarabah.
In the case of an Islamic bank, the bank would provide a business with money in exchange for an equity share. There would be zero interest payments. Provided the other rules of shariah are followed, mudarabah is perfectly clean and halal.
Yet, because it is risky, Islamic banks rarely offer mudarabah financing. To stay profitable, banks seek safe returns, which are unlikely in venture capital. Islamic mudarabah firms exist, but these are not banks, and operate exactly like non-Islamic venture capital firms. There is no real difference between the Shark Tank TV show and mudarabah.
Wadiah (Safekeeping)
Wadiah is when the bank charges a fee for storage and services. If you keep your gold jewellery in a bank’s safety deposit box, for example, the bank may charge you $20 per month for safekeeping. If you open a chequing account with a bank, then you pay the bank $5 per month to hold your money.
There is nothing usurious about this, but this model is not unique to Islamic banking. Conventional banks also charge transaction and service fees. There is no innovation here. This model is also difficult to scale up when it comes to risky loans.
Musharakah (Profit and Loss Sharing)
This is where Islamic finance has innovated - at least in theory. A musharakah contract involves the lender (the bank) entering a business partnership with the borrower. The two partners share in the losses and profits of the enterprise.
Typically this is done through a diminishing musharakah, in which the borrower gradually buys out the lender’s stake in the partnership.
The best way to explain this is through the example of a mortgage.
Suppose a house costs $1 million. In a traditional mortgage, the borrower puts a 20 percent down payment, and borrows the remaining $800,000 from the bank at the going rate of interest. The borrower agrees to pay the bank back over a length of time, the amortization period.
In the U.S., for example, a 30-year fixed mortgage has an interest rate of roughly 7 percent. This means that each month, the borrower would pay $5,300 to the bank. This would continue for 30 years, unless the borrower defaults or sells the house. If the client defaults, the bank can seize the property.
In an Islamic musharakah mortgage, the borrower pays $200,000 to own 20 percent of the $1 million house, while the bank provides the remaining $800,000 to own the rest of it. The bank charges the borrower “rent” on the 80 percent it owns. In addition, the borrower gradually buys out the bank’s equity in the home until he, not the bank, owns 100 percent of the property.
If that does not make sense, watch this 3-minute video.
Thus, the borrower pays the bank a rent each month, plus an extra payment (the profit rate) to buy out the bank’s stake in the property. The bank can vary payments according to market conditions.
Islamic banks benchmark these payments at the market rate of interest. Manzil, an Islamic bank in Canada, bases its “profit rate” on 5-year conventional mortgages. In other words, Islamic banks practice usury.
(In reality, it is often worse. The “profit rates” which Islamic banks charge are higher than the interest rates of conventional banks. This is because Islamic banks are not as well capitalized, and may incur additional legal compliance costs.)
If you were to take out an Islamic mortgage, you would pay around the same monthly payment as a conventional mortgage — in the best case scenario. This is because Islamic finance hides interest payments under the guise of “rental payments” or “profit rates.” They are the same thing.
Murabahah (Cost-Plus Pricing)
Murabahah is just more legal trickery. It allows the bank to buy an asset, and then charge the borrower a markup on the asset to make a profit. The markup is a legal ruse to hide usury.
Let us again use the $1 million house example. As I describe above, a conventional 30-year fixed mortgage involves a monthly payment of $5,300 per year over thirty years.
In a murabahah contract, you pay the bank $200,000. The bank uses this, along with its own $800,000 in funds, to buy the house outright. The bank then “sells” the house back to you for $1,908,000, amortized over 30 years. In other words, your monthly payment would be… $5,300, the exact same as under a conventional mortgage.
(Again, in practice, this is often worse, due to Islamic banks’ low capitalization.)
Ijara (Rent-to-Own)
An ijara agreement involves the borrower paying rent to a trust for a set amount of time (the amortization period). After that period of time is over, the borrower owns the asset.
This 45-second video explains ijara financing.
In the best case, this is comparable to the existing rent-to-own model. In the worst case, ijara just mimics conventional banking, masking interest rates behind a profit rate.
Conclusion
A balanced summary of these issues is presented in this 20-minute video. I recommend watching at least the first minute of it.
Although I have only scratched the surface of Islamic banking in this article, it should be plain to most readers that shariah finance lacks any real innovation. It merely deploys cunning legal tricks to hide interest payments. Functionally, it is the same as conventional finance, and is thus usurious.
Islamic banks operate in a fractional-reserve banking system, in which most money is backed by debt. In other words, our economic system is inherently usurious. Islamic banking cannot survive in such an economy without adopting usury.
The only way to fix this is a global monetary reset. For a start, we must return to the gold standard, in which every dollar is backed by, and exchangeable for, physical gold. It is much harder to charge interest on tangible objects.
The gold standard cannot end usury entirely. Nor is doing so realistic. However, banks should be legally barred from abusive practices. For example, a bank which provides a loan is able to seize a borrower’s collateral if he defaults. If the collateral does not cover the loan’s balance, however, the bank should not go after the borrower’s other assets.
This may dry up liquidity, but it would also reduce the price of assets. If houses, cars, and land were cheaper and more affordable, then everyone would benefit. Innovation would continue to prosper. I am reminded of the fact that the Industrial Revolution did not rely upon financial capital. A less financialized economy gives room for the real economy to blossom.
This is a real possibility in the coming years. Previously, I wrote about how the BRICS (Brazil, Russia, India, China, and South Africa) alliance is pursuing de-dollarization, and what appears to a gold-backed digital currency. The BRICS nations also have real assets (gold, lithium, oil, etc.), and strong manufacturing ability. As a multipolar, de-globalized world emerges, it could give rise to several types of financial systems.
The West is dying. Perhaps Western banking will die as well. This would allow for new and exciting forms of financial innovation. God-willing, we will see a less usurious banking system emerge from the ashes.
This was fascinating and cleared up a lot of questions I had. Thank you.
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