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.