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I have been doing some reading on the differences between Islamic Banks and Western Banks lately and found that the main difference is that Islamic Banks do not charge interest when they lend out money and do not issue interest when they take in deposits.

Instead of interest they choose to have an agreement with the depositor or lender to share in the profits for which the money is used to generate. So if I am a borrower looking to say buy an investment property or start a new business, I would go to the bank and sign up an agreement to borrow the funds and pay back the principal plus X% of my profits after Y years. Similarly if I was a depositor I would take my money to the bank and sign up an agreement that after Z years the bank would pay me back my deposited funds plus W% of the profits the bank generated with my funds.

The thing I found strange was that the risk lies totally with the party lending the money (i.e. the bank as the lender and the customer depositing the funds). In other words if the borrower buying the investment property or starting a new business makes a loss during the agreed period then they can just walk away and all they have lost is their time, whilst the bank absorbs the full loss. Similarly if the bank makes a loss with the depositor’s funds then the depositor will absorb the full loss.

It seems that the Islamic Bank’s philosophy is twofold; to make profits and to be socially responsible, and they view the charging of interest to be socially irresponsible.

The first part of my question is: If Islamic Banks have no problems in making a profit (as without making a profit they would not be able to stay open and operate), why are they against charging interest? After all interest is basically compensation to the lender for the opportunity cost of lending the money.

The second part of my question is: If the lender is bearing all the risk in relation to the borrowed funds, won’t the borrower be enticed to start taking unnecessary risk in order to achieve higher and higher profits? And won’t this end up creating a bubble environment where the whole house of cards can come crashing down, causing the Islamic Banks to absorb all the loses and close down.

Mindwin Remember Monica
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Victor
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3 Answers3

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To answer your first part, its not an opposition to profit. It's an opposition to usury - the practice of charging excessive interest on loans. There are extensive passages in the Qur'an condemning the practice, and in many cases "excessive interest" is any interest.

To the second part of the question, these may well be more risky investments. But if you're trying to build a strong and thriving community financial spirit, one might expect there to be significant social pressures to use the loaned money responsibly. Additionally, while it removes some of the penalty for failure, it doesn't remove the rewards for success. The incentive is still there to succeed. It's merely the penalty for failure is no longer financial ruination. It may also temper the incentive for banks to give money to riskier borrowers, but rather to prudently invest in ventures with an acceptable amount of risk.

The question as to whether or not this is a "house of cards" likely depends on the questioner. Whether or not this is also true for the western banking system likely remains to be seen, but it hasn't exactly been doing a sterling job of convincing me it isn't true for the past decade.

Fomite
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I'm not sure of the theological basis against usury in sharia law. IIRC, sharia forbids excess compensation, and the modern interpretation of this includes interest.

Rules about banking are common in religious faiths. The Catholic church viewed interest as the "selling of time", and since time is a force controlled by god, charging interest was a heretical practice.

For private transactions, modern Islamic banking is a relatively new phenomenon that emerged in the postwar period. I don't think this method of banking is a "house of cards", it's just different. Some US states, like California, also subject lenders to higher levels of risk. (ie. borrowers can walk)

duffbeer703
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One of the principles of Sharia Banking is (Wikipedia):

Shariah prohibits what is called "Maysir" and "Gharar". Maysir is involved in contracts where the ownership of a good depends on the occurrence of a predetermined, uncertain event in the future whereas Gharar describes speculative transactions. Both concepts involve excessive risk and are supposed to foster uncertainty and fraudlent behaviour.

In other words risky investments are prohibited in Sharia Banking.

DJClayworth
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