What it means
The central rule is that money should not earn a return simply by being lent. A return must be linked to a real asset, a real trade or a real share in risk, so an Islamic bank earns its income from profit on sales, rent on leased assets or a share in a venture's profit rather than from interest.
The most common structure for financing a purchase is the murabaha. The bank buys the asset the customer wants, then sells it to the customer at cost plus an agreed mark-up, which the customer pays in instalments.
The profit is fixed up front, so it does not change if market interest rates move. Other structures include ijara, which is a lease where the bank owns the asset and charges rent, and mudaraba and musharaka, which are partnerships in which the bank and the customer share profit by agreed ratios and, in general, losses in proportion to capital.
Sukuk are certificates of ownership in assets, often described as Islamic bonds, that pay investors from the income those assets generate. The rules also forbid excessive uncertainty and speculation, and investment in activities considered unlawful, such as alcohol and gambling.
Many Islamic banks employ a religious supervisory board that reviews products to confirm they comply. The practical result for a business is that the contract looks different, even if the economic cost can look similar to a conventional loan.
Finance staff should read the structure carefully, because the legal ownership of the asset, the accounting treatment and the consequences of late payment all differ from those of an ordinary loan.
In practice
Real-world examples.
Example
A bakery chain wants to buy new ovens but its owner prefers a structure without interest. The Islamic bank purchases the ovens from the supplier and sells them to the bakery at cost plus a fixed mark-up, payable in instalments. The finance manager records the asset and the liability based on the contract.
Example
A property company leases a warehouse under an ijara contract, where the bank owns the building and the company pays rent. At the end of the term the company has the option to buy at an agreed price. The rent is reviewed on the schedule set out in the agreement.
Example
A technology start-up raises funding from an Islamic investor through a profit-sharing partnership. The agreement sets the split of profits at 60% to the founders and 40% to the investor, and any loss is shared in proportion to capital. The founders report results to the investor each quarter.
Formula
Calculation
Murabaha selling price = cost to the bank + agreed mark-up
Suppose a company needs a machine that costs $80,000. The bank buys it and agrees a mark-up of 10%, which is 80,000 x 0.10 = $8,000. Selling price = 80,000 + 8,000 = $88,000. The company pays this in 8 equal instalments of 88,000 / 8 = $11,000. The price is fixed at signing, so the total does not change even if the company pays over a longer or shorter period under the agreement's terms.Case study
Seen in the real world.
Desert Bloom Trading is an illustrative, fictional import company. Its owner wanted to expand the warehouse but did not want a conventional loan because of his religious beliefs, and he was unsure whether an Islamic structure would be more expensive.
His finance manager asked an Islamic bank and a conventional bank for quotes on the same project. She compared the total payments, the fixed or variable nature of each structure and the consequences of late payment. The murabaha offer had a fixed total cost, while the conventional loan had a variable rate that could rise.
The owner chose the murabaha, partly for religious reasons and partly for the certainty of a fixed total. The illustrative lesson is that Islamic and conventional finance should be compared on total cost and contract terms, not on labels.
Watch out
Common mistakes.
- Believing Islamic banking is simply a conventional loan with a different name, when the contracts involve real asset sales, leases or profit sharing.
- Assuming it is only for Muslim customers, when many non-Muslim individuals and companies use Islamic products.
- Comparing products on the mark-up alone, when fees, late-payment terms and ownership rights can change the true cost.
Questions
People also ask.
What does riba mean?
Riba is the Arabic term for interest or any unjustified increase on a loan, and it is the main thing Islamic finance avoids.
What is a sukuk?
A sukuk is a certificate representing ownership in assets, and it pays investors from the income the assets generate rather than from interest.
Who checks that products comply?
Most Islamic banks have a religious supervisory board of scholars that reviews and approves each product structure.
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