Islamic Banking

It was time for the weekly Skype session with Apurva and as promised I had to take her to the world where there is no concept of Interest Rates. “How is it possible that the banks would lend out money but would not charge interest on it, what is in it for banks then, how will they survive?”, the questions came like bullets from the machine gun. “Islamic Banking is a concept which works on the principal of Non-Interest”, I started explaining her.

Islamic banks work on the Islamic principles where it is not allowed to lend out money to others on interest. Does that mean that banks lend out this money without any profit? No, obviously not!! Every entity is required to generate profits for its survival and that is the prime reason for its existence. But generating profit through interest is not the only way of generating profit. Islamic banking also has profit generating mechanism but it is devoid of the interest component and certainly not the compounding aspect of it. To understand how Islamic Baking works, we need to first understand how the regular commercialize banking with interest and compounding works. Let us say, you want to buy a Tata Nano which costs Rs. 1, 00,000. You go to a Bank, say RBM bank and ask for money. If the interest on the car-loan is 10%. At the end of 2 years, you would have to payback Rs 1, 21,000([1, 00,000 *(1.1)]*(1.1)). The fact that component of 1.1 (1+10%) appeared twice in the calculation is because the interest gets compounded over the tenure of the loan which is two years in this case. You will have to pay a total interest of Rs. 21000 at the end of two years. Alternatively, RBM bank can give you option of making equal payment based on the predefined frequency of payment which can be either Monthly, Semi-Annually or Annually.  

The above method of lending is based on the principle of Risk Transferring. In the above case the ownership of the Tata Nano car is with you till the time you make payment to the bank as decided with the banks. In case you fail to make the payment, the bank will sell off the car and keep the amount with it to recover the loss. This type of lending also has inbuilt issue of money multiplication creating artificial money. Suppose RBM bank lends you Rs. 100000 @10% for 1 year. You find a borrower which is ready to pay interest of 12% but can’t finance his loan through bank due to compliance issue. You decide to take the additional risk for getting 2% on Rs 100000 (i.e. 2000). The borrower who agreed to pay 12% to you finds another borrower who is willing to pay 15%. Like you, he also lends money to him to get 3% on 100000 (i.e. 3000). Though the amount of money in the system is Rs. 1, 00,000 it has changed 3 hands causing money multiplication. The chain of risk transferring will be shattered as soon the last hand in the chain defaults causing entire chain to collapse. This principle of Risk Transferring was the prime reason was 2008 sub-prime crisis which we will discuss some other day. This is not possible with Islamic banking because money is always lent for buying real assets such as home, car, metal etc.

Unlike the commercial banking which works on the principle of risk transferring, the Islamic banking works on the principle of Risk Sharing. The Islamic banking allows charging the predefined fix profit percentage which does not get compounded.  There are different ways of lending under the Islamic Banking that includes Istisna, Musawamah, Murabahah, Musharakah etc. I would try to explain “Musharakah” which is the most used of all and how it is different from the conventional banking. Suppose your father wants to buy a house in which is worth Rs. 14, 00,000. He has Rs. 4, 00, 000 and needs financing of Rs. 10, 00,000.

Consider the case where your father borrows it from conventional commercial bank which charges 10% interest compounded annually. The repayment is to be done as 5 annual payments.

Commercial_Bank_Loan_Repayment_Schedule

The above diagram shows the calculations for payments for Rs. 10, 00,000 loan from the commercial bank.  As it can be seen that the yearly payment to be made to the bank is constant every year. The principal to be paid as part of that payment increases over the years while the interest component to be paid reduces over the years as per the principal outstanding. Bank does not assume any risk such as natural disaster and risk is entirely bared by the borrower. In case of default, bank has the right to sell off the property and recover the money.

Unlike commercial banks, Islamic banks work on the principal of Diminishing Partnership in which share of the bank reduces gradually till the time it is transferred to the borrower. It is based on the principal of risk sharing which in turn corresponds to sharing of profits or sharing of loss. As discussed it does not include interest and works on the basis of fix, predefined profit rate. Islamic bank typically have both internal and external Sharia compliance officer to ensure that the money is lent in accordance with the Sharia principals (e.g. Lending money for alcohol, arms is prohibited). The Islamic bank receives funds from the investors to lend out to which bank gives the expected profit rate. The rate to the investors in expected as it depends on the investment made by the bank to the customers in terms of landings.

Islamic_Banking_Repayment_Structure

The above diagram shows the similar housing loan and payment structure under the Islamic Banking. Borrower makes an yearly payment to bank like that of the commercial banks but the yearly payment made by the borrower reduces every year as with each passing year the borrower increases the ownership stake in the property owned. The part of the annual payment includes the equity payment made by the borrower to regain additional ownership in the property and other part includes the profit paid to the Islamic bank for the equity still owned by the bank). In case of natural disaster or any other issue the borrower forgoes only the part of the equity owned by him and banks bares the risk for part of owned by it. The borrower can sell off his ownership to other borrower who will then continue the payments to the Islamic bank.

“I now understand how Islamic Banking works!! On face of it looks like a better model of lending. I wonder what will happen when it will gain more popularity and entire world will work on the non interest principal”, said Apurva. “There is still long way to go for that, “Musharakah” that we discussed is just part of Islamic banking. We would cover the other parts sometime later.” we ended the Skype call on that note.