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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.

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    FYI: they dont charge interest doesnt mean you can get money for nothing. I was under the same assumption and called up Shariah banks in US. Well, they dont charge interest but they charge fixed % of Rent on the property which was equal to the interest rate at that time. – Asdfg Jan 13 '12 at 1:01
  • I didn't say you "get money for nothing", I said the lender shares in the borrower's profits instead of charging interest, but if you make a loss then the lender absorbs all the loss. – Victor Jan 13 '12 at 1:06
  • @Asdfg: would the bank charge a fixed % of the gross rent or the nett rent (i.e. the rent before all expences or the rent after all expenses have been deducted)? – Victor Jan 16 '12 at 3:13
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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)

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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.

  • I understand that "excessive interest" may be seen as socially irresponsible, but why is "any" interest seen as bad? You could also say that in the sharing of profits between lender and borrower, if the lender is asking for a large % in profits, then that would be unfair or "bad" as well. – Victor Jan 13 '12 at 0:47
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    There's a few reasons why that might be true. One is tradition - it merely is because it has been, whereas an equity stake in the business is a fairly modern concept, and thus not defined. Some of it's likely practical - its impossible to charge too much interest if you can't charge any interest, and the % of profits is seen as less of a problem - everyone involved is still making money. It also should be contrasted with interest as a high % stake still involves risk, while interest involves none. – Fomite Jan 13 '12 at 1:21
  • Interesting way to look at it, however I still feel that the lender will be taking all the risk, being that if there are no profits but only losses, they take the full brunt of it. Do you know if the banks would thus apply tighter lending practices? – Victor Jan 13 '12 at 1:28
  • @Victor The whole idea is that all parties must share in profit or loss. The idea is that money is a medium of exchange, not a thing to be traded in it's own right. I don't think that an Islamic bank will necessarily be a tighter lender -- after all, they can agree to a razor-thin profit margin. You can say that in general, loans secured by collateral tend to perform better, but at the end of the day, underwriting matters. – duffbeer703 Jan 13 '12 at 2:49
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    This is a great answer. There is nothing against making profits, but everything against usury. Islam's outlook has always been very pro-business and pro-profit. – Spacey Jan 13 '12 at 23:42
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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.

  • But any investment has risk! Generally the higher the returns the higher the risk. A low return investment should have a lower risk, but it still does have risk, and the level of risk is subjective to the person taking the risk and how they manage that risk. Any start-up business will have risk. In fact any profit making activity has inherent risk, and Islamic Banks are not against making a profit. – Victor Jan 13 '12 at 23:45
  • Also, unless you have a time machine or crystal ball, all future events are uncertain. So any type of investment, whether it be speculative or in blue chip shares, in property or in business ownership will all have a level of uncertainty, which is why there is always risk involved, as risk is the uncertainty of future events. – Victor Jan 13 '12 at 23:50
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    @Victor It didn't say "risk is forbidden" it said "excessive risk is forbidden". – DJClayworth Jan 14 '12 at 21:56
  • as I have mentioned risk is subjective. What one person sees as risky another may see as not risky. Risk depends on many variables including the experience of the person taking on risk and the risk management controls put in place. – Victor Jan 15 '12 at 2:33

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