Common Questions About Islamic Finance (Part 2 of 5)

This week…
— Don’t Islamic banks simply change labels, by replacing the word “interest” with “profit”?

Last week…
— There was no Islamic bank during the Prophet’s (Allah bless him and give him peace) time, so how can there be Islamic banking now? Sounds like a bid’a. (Click here to view)

Coming up…
— Why does Islam forbid interest when money is just another commodity that comes at a price?
— Where should I keep my money? Islamic banking doesn’t adequately address the inflation problem and you say interest banking is forbidden.
— Stocks are like gambling, but Islam permits stocks and forbids gambling. Why?
— What’s the difference between an ordinary lease and an Islamic lease (ijarah)? They look the same.
— If Islam forbids fixed-income interest, what’s wrong with floating-rate interest? Doesn’t it also rise and fall like profit?
— I don’t have enough money to buy factory equipment (or a car, a home or pay for an education)? How do I avoid interest and still fulfill my short-term financing requirements?
— Is there a secondary market for Islamic instruments?

Don’t Islamic banks simply change labels, by replacing the word “interest” with “profit”?

Some Islamic banks do just that. And here is the easiest way to find out the truth: ask them if the profit amount (not the percentage amount) is fixed, or if the customer profit is declared before the bank’s actual profit is announced. If either of these is the case, their “profit” is just another kind of riba.

Interest, the additional charge over the loan principal, is the “cost” of using money, and is strictly forbidden in Islam, whether given or taken, at a low rate or a high one, to or from a Muslim or a non-Muslim, whether in Muslim lands or not. The problem with exchanging one amount of money for a larger amount of money at a later date is that there is no underlying asset or service transacted.

Profit, rent and mark-up, on the other hand, are asset and service backed, and permissible in Islam. Profit is earned on the sale of goods and the provision of services.

Rent is charged on the usufruct of property. Mark-ups are added to the cost of an asset. Among the most common financing products that an Islamic bank will use in order to earn profit are musharakas (partnership finance) and mudarabas (investment finance).

In a musharaka, two or more partners (even thousands of shareholders) commit risk capital and share profit based on an agreed upon percentage, enduring loss in proportion to their invested capital. Modern corporations, like those listed on the New York Stock Exchange, are a kind of musharaka.

In a mudaraba, an investing partner brings capital and a working partner brings time and effort to share in profits and losses agreed upon beforehand. Venture capital firms, such as the ones that financed much of Silicon Valley’s growth, are a kind of mudaraba.

Unlike with interest, which is charged on a borrower whether the business succeeds or fails, in a musharaka and a mudaraba the investor profits only when the business profits and therefore the investor fully shares in the business risk. Some might argue that an interest-based lender also shares risk: the risk of whether his money will be returned or not. But this is not a business risk, it is a credit risk. The difference is substantial: a business risk only risks the business; a credit risk will risk both business and borrower (by forcing repayment, in extreme cases through personal bankruptcy).

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