How Islamic is Islamic Banking?

“That is because they say, “Trade is [just] like interest.” But Allah has permitted trade and has forbidden interest. So whoever has received an admonition from his Lord and desists may have what is past, and his affair rests with Allah. But whoever returns to [dealing in interest or usury] – those are the companions of the Fire; they will abide eternally therein.”

(Holy Quran 2: 275)

Learning Objectives

Explain Islamic Banking with its objectives

Describes Various Modes of Islamic Banking

Explain whether these objectives are being fulfilled or not

Describe Various Eminent Scholars Opinions on Islamic Banking

Differences between Conventional & Islamic Banking

Definition of Islamic Banking

Islamic banking has been defined by OIC:

“An Islamic bank is a financial institution whose status, rules and procedures expressly state commitment to the principle of Islamic Shariah and to the banning of the receipt and payment of interest on any of its operations.”

Islamic banking has been defined by State Bank of Pakistan as

“Banking in consonance with the ethos and value system of Islam and governed, in addition to the conventional good governance and risk management rules, by the principles laid down by Islamic Shariah.

Islamic banking, the more general term is expected not only to avoid interest-based transactions, prohibited in the Islamic Shariah, but also to avoid unethical practices and participate actively in achieving the goals and objectives of an Islamic economy”

Islamic banking, also known as non-interest banking, is a banking system that is based on the principles of Islamic or Sharia law and guided by Islamic economics.

Two fundamental principles of Islamic banking are the sharing of profit and loss, and the prohibition of the collection and payment of interest by lenders and investors.

That is why Islamic banks are often known as PLS-banks.

Objectives of Islamic Banking

The aim was to provide banking opportunities that are compliant with Islamic Shariah (law).

The major objective was to provide Halal banking safe from Riba (interest).

Investment in business that deals with goods and services considered ‘haram’ is prohibited. Example: pork, alcohol, gambling, pornography etc.

Gambling or speculation has to be minimized.

Modes of Islamic Banking

A brief description is given below. Details can be obtained online from other websites. They claim to operate with objectives mentioned above.

Murabaha: 

Most common mode of transaction in Islamic Banks.

Let’s say, Ahmad wants to buy a car worth Rs.2, 000,000. He does not have the money to buy it. He approaches a bank. The bank buys the car at Rs.2, 000,000 and sells it to Ahmad at Rs.2, 200,000. Ahmad will pay Rs.2, 200,000 to the bank in fixed installments.

Ijara (Giving something on Rent): 

Under Ijara, the bank leases out assets like house, motor vehicle etc. for a fixed period of time and payment. Leasing is basically a contract between two parties: the owner of the asset (lessor) and the user of the asset (lessee). The user of the asset pays money to the owner of the asset. An example of leasing is a rental agreement, in which the tenant pays rent to the owner of the house.

Ahmad wants to buy a house but he doesn’t have the money to buy it. The bank buys the house and rents it out to Ahmad. Ahmad pays rent to the bank until full payment has been given.

In this case, just like in Murabaha, the final full payment is more than the original value of the commodity.

Islamic Investments: Mudarabah, Musharakah, Equity Bonds and Sukuk Bonds

Mudarabah:

In this, depositors provide funds to the banks. The bank invests the money into a business. The profit earned from the business is shared between the depositor and the bank in a pre-determined profit sharing ratio.

Musharakah:

This is similar to Mudarabah. Musharaka is an agreement between two or more partners to combine their assets, services, obligations or liabilities for the purpose of making profit.

Musharakah and Mudarabah are frequently used in the purchase of property and real estate, in providing credit, for investment projects, and to finance large purchases.

Equity Bonds

In an equity fund the amounts are invested in the shares of joint stock companies. The profits are mainly achieved through the capital gains by purchasing the shares and selling them when their prices are increased. Profits are also achieved by the dividends distributed by the relevant companies.

Equity participation means if a bank loans money to a business, the business will pay back the loan without interest, but instead gives the bank a share in its profits.

Istisna and Musawama

These are financing arrangements where customer seeks finance for manufacturing/ trading of goods and sets a future delivery date with transfer of ownership of goods to bank.

Bank then appoints the customer as its agent to sell the goods on behalf of bank (since ownership lies with Bank). Out of the proceeds bank keeps the investment (principle) plus profit at agreed rate.

Sukuk Bonds

A sukuk is an Islamic financial certificate, similar to a bond in Western finance. These are claimed to be alternate to conventional treasury bills/bonds.

So there is Sukuk Murabaha, Sukuk mudarabah, Sukuk musharakah which provide the relevant certificates.

Takaful

Takaful is a type of Islamic insurance, where members contribute money into a pooling system in order to guarantee each other against loss or damage. 

Are these Objectives Being Fulfilled? (How Islamic is Islamic Banking?)

Questions have arisen about Islamic Banking:

Has interest been completely eliminated?

Has just the method changed of the end product: an increase in money over time?

Has interest (Riba) in reality just changed into profit?

Is it only a change in name?

Is there an actual difference between Islamic banking and conventional banking?

Scholars’ Opinions

Many learned scholars who are in favor of Islamic banking have also shown their concerns over what was prescribed by them and what is in actual in practise Islamic banks are following.

Mufti Taqi Usmani has been called “the granddaddy of modern-day Islamic finance

In March 2009, Sheikh Muhammad Taqi Usmani of the Accounting and Auditing Organization for Islamic Finance Institutions (AAOIFI), a Bahrain-based regulatory institution that sets standards for the global Islamic Banking industry, declared that 85% of Sukuk, or Islamic bonds, were “un-Islamic”.

https://www.arabianbusiness.com/most-sukuk-not-islamic-body-claims-197156.html

Because Sukuk underpin the modern-day Islamic financial system, one of its pre-eminent proponents arguing that the epicenter of the system was flawed sent shockwaves through the industry.

As al-Wahidi makes clear in Asbab al-Nuzul (1075 CE), riba, which literally means ‘increase’ in arabic, is the penalty assessed for the non-payment of a loan by a distressed borrower in his analysis of 2:275-6:

Aṭāʾ al-Khurāsānī  (752 CE) and Ikrimah ibn Abi-Jahl (636 CE) also said: “This verse was revealed about al-‘Abbas ibn ‘Abd al-Muttalib and ‘Uthman ibn ‘Affan who had lent someone dates. When it was time for the collection of the dates, the owner of the dates said to them: ‘If you take all of what is due to you what remains will not be enough for me and my dependents. Why do you not take half of what is due to you and I will double the interest that was initially agreed?’ They both agreed. When the term was due, they both asked the man to pay what was agreed. This reached the Messenger of Allah, Allah bless him and give him peace, and he warned them against going ahead with it.

As the context makes clear, riba was the penalty assesed for non-payment by a distressed borrower that the Prophet PBUH objected to, and not the initial interest rate charged for a loan. Similar definitions have also been give by:

  • Imam Shafi’i (820 CE)
  • Ahmed ibn Hanbal (855 CE)
    Tabari (923 CE)
    Ibn al-Arabi (1148 CE)
    RA

According to another veteran of Islamic economics, Muhammad Akram Khan, criticizes Islamic banking as professing to have “put its business on a basis other than interest” but in practice devising “a whole host of ruses and subterfuges to conceal interest.”

He said Islamic banking has evolved toward convergence with conventional banking “imitating conventional banks in product development” rather than establishing “a different type of banking which was aligned to fairness, equitable income distribution, and ethical modes of investment.”

Rice University’s Islamic Finance Chair Mahmoud Amin El-Gamal‘s book Islamic Finance Law, Economics, and Practice for an extremely harsh critique of the entire industry by a reputable academic Muslim source: 

https://www.cambridge.org/gb/academic/subjects/economics/finance/islamic-finance-law-economics-and-practice?format=PB&isbn=9780521741262

Mahmoud Amin El-Gamal, a professor of economics at Rice University (United States), has described modern Islamic finance as “Shari’a arbitrage” — i.e. what is prohibited in conventional finance becomes permissible when deemed “Shari’a compliant” despite having similar, if not the same, economic substance.

In an article in late 2007, Mr. Salman Ahmed Sheikh claimed that there is basically no difference in the Islamic and conventional modes of financing. In his opinion, the only differences are procedural, which are minor and do not change the nature of the transactions.

Sheikh Dr. Israr Ahmad Marhoom had this to say on Ijarah, Murabaha, Mudaraba when personnel of Meezan Bank came to him: that they are clear forms of interest by applying simple logic:

Sheikh Dr. Zakir Naik says he doesn’t know of any Islamic bank that is 100 % Islamic:

Sheikh Assim Al Hakeem on tricks Islamic Banks play:

Sheikh Imran Hussein, the famous Islamic Scholar with a Masters degree in economics, calls Islamic banking ‘back-door Riba’:

Engineer Muhammad Ali Mirza also states that there is no difference between conventional banking and Islamic Banking:

All Similar Recognizable Products with ‘Islam’ Added

The products that modern-day Islamic bankers have created are very similar to conventional products.

So similar, in fact, that to an outside observer they could be considered the same.

Islamic banks now offer Islamic mortgages, Islamic car loans, Islamic credit cards, Islamic time deposit and guaranteed return accounts, Islamic insurance and some even offer Islamic managed and hedge funds.

This point is conceded by Samir Alamad, Sharia, or Islamic law, compliance and product development manager of the Islamic Bank of Britain.

“The industry does not want to alienate its products,” he says.

“They have to be recognizable, produce the same outcome as conventional products, but remain within the guidelines of Sharia.”

Play Between Profit & Interest?

The core of Islamic economics is a prohibition of interest (riba).

This immediately creates a problem for Islamic banks, as conventional banks charge borrowers an interest rate through which they can reward their depositors and make some profit for being the broker.

With interest ruled out it is harder to make money.

The modern Islamic banker has found a way around this prohibition, however. Through intellectual manipulation, they have converted the interest into profit.

However, in many cases this “profit rate” is competitive with the conventional banking system’s interest rate for savers.

Interest in Islam is involved in any loan of money that includes a contractual requirement for more than the principal to be returned to the lender.

The related verse in the Quran, a Muslim’s primary source of jurisprudence, is the following:

“O you who believe! Observe your duty to Allah and give up what remains [due to you] from interest, if you are [in truth] believers. And if you do not, then be warned of war from Allah and His Messenger. And if you repent then you have your principal [without interest]. Wrong not nor be wronged.” (2: 278-279)

Although there are evolving markets in Islamic finance and new and innovative instruments being developed, they are often amount to ways of circumventing the intent of Islamic laws, while possibly adhering to the letter. Often the contracts amount to a traditional “western” contract, with a non-legally binding Islamic “contract” stuck on the front.

This has led many scholars to question the legitimacy of modern Islamic financial instruments.

Profit rate is based on benchmark similar to conventional banks. If we use interest rates / profit rates as a benchmark. Statistically they have been seen to be extremely similar. Example:

Murabaha is basically a loan which involves an asset. Conventional banks “buy” from the car dealer then sell it to customers at 7% interest. Islamic banks buy from the car dealer and sell it to customer at 7% profit. Is it just me or are these very similar contracts except one gains “interest” and the other “profit”.

It makes us feel that we were working under the same capitalist system by giving it a different name for our own satisfaction i.e. Islamic.

Examples are given in case of Murabaha and Ijarah dealings and the essence of the meaning of Riba and its types, with more arguments against Islamic banking:

The Logical Benchmark

A logical benchmark is the duck test. If it looks like a duck, walks like a duck, and quacks like a duck, then it is a duck. Similarly in Islamic finance transaction, if it looks like interest, works like interest, and profits like interest, then it is interest. If the transaction is a debt based transaction, then it is riba. No matter how many commodities we trade to show it as a trading transaction.

To the casual observer, a spade is a spade.

Whether the product is dressed up in Arabic terminology, such as Mudarabah, Murabaha or Ijarah, if it looks and feels like a mortgage, it is a mortgage and to say anything else is semantics.

But banking is banking. It is the taking of a deposit and then using it to finance a purchase or business.

Many argue that Islamic banking is a modern day scam taking advantage of an invented ambiguity around the arabic term riba

The lender pays the depositor compensation for the opportunity cost of his money, and the person borrowing the money “rents” it off the bank.

The same symbiotic relationship occurs whether it is conventional banking, ethical banking, Islamic banking or Presbyterian banking.

Monetary Benefits of Islamic Banking

Every bank wants people to own more cars and more material goods. Its activities are shrouded in the technical language of finance — derivative products, equity swaps, adjustable mortgages, etc. No one, including top financial experts, can figure out how much usury occurs in such a complex system where everything is interconnected. Sharia-compliant banking has added to the confusion with its particular terminologies. But profit is the real god.

If the owners and managers of ‘Islamic’ banks were genuinely moral people and concerned about sin, wouldn’t they pay themselves less? The lowest paid bank employee in a Pakistani bank — whether a Sharia-compliant one or otherwise — makes between 100-1,000 times less than his CEO, for whom a seven-digit monthly salary is perfectly normal.” (Facts coming from a liberal secular writer – Mr. Pervez Hoodbhoy)

They do not like to call it interest, but “profit-share percentage”. But the financial transaction is structured in such a way that it “behaves like interest.” What I mean by this is that the profit is front-loaded on a capital amount, much like interest is. Islamic Banks still makes money on credit risk, but they call it otherwise

Monetary benefits of conventional and Islamic banking are similar. The amortization table for both traditional Western banking and Islamic banking is virtually identical and I would not be able to tell the difference between the two. The only tangible difference that I could discern is that for Islamic banking the profit is fixed for a fixed period and thereafter negotiable (but not really negotiable because it’s at the discretion of the bank). Islamic banking allows you to negotiate the profit at yearly intervals and to buy extra shares in the item.

The profit percentage and interest rate is almost identical and both are based on the reserve bank rate. Such that if the home loan interest rate is 12%, the profit-sharing percentage is similarly around 12%.

‘Scholars’ Selling their Iman

This new generation of Islamic bankers had cut their teeth in the City and Wall Street, and were used to creating sophisticated financial products. They often bumped heads with the Sharia scholars who authorized their products as Sharia compliant.

However, these bankers had a way of dealing with this, as one investment banker based in Dubai, working for a major Western financial organisation explains:

“We create the same type of products that we do for the conventional markets. We then phone up a Sharia scholar for a Fatwa [seal of approval, confirming the product is Shariah compliant”.

“If he doesn’t give it to us, we phone up another scholar, offer him a sum of money for his services and ask him for a Fatwa. We do this until we get Sharia compliance. Then we are free to distribute the product as Islamic.”

This “Fatwa shopping”, which was carried out by some institutions, brings us back to the Sharia scholars. Getting a favorable ruling from a leading Sharia scholar is important for a product manager.

That is why the top scholars can earn so much money – often six-figure sums for each ruling.

Initially it was stated that global system is interest based system and we can’t just remove it and establish an Islamic system overnight. It was said we need a midway approach. A Murabaha structure was such mid-way structure wherein by carrying out certain steps, a debt transaction would be Islamized. Probably the Islamic scholars thought they were innovating but they were following in the footsteps of the Christian clergy who gave their blessing Contractum Trinius allowing Christian merchants/bankers to bypass Christian rulings against Usury.

https://en.wikipedia.org/wiki/Contractum_trinius

What is even worse that instead of being considered the mid-way, faulty, stopgap arrangement, Murabaha is now considered a standard uncontroversial instrument of Islamic finance beyond reproach. A more disservice to Islamic finance hasn’t been done.

The most creative scholars are the ones in the most demand, says Tarek El Diwany, analyst at London-based Islamic financial consultancy Zest Advisory.

“To date, most Islamic financiers have been looking at examples of financing in Islamic history and figuring out how to apply them to today’s financial products.

If, it turns out the investment product was un-Islamic, the Scholar would take the eternal blame and the bank has nothing to worry about. Islamic Banks essentially work with these decrees that absolve themselves of any wrong-doing from a Shariah point of view. The blame wholly and squarely lies on the Islamic Scholar.

This means if a financial product is offered that is non-Islamic/Riba (Interest) based, then the “sin” and responsibility of that flaw lies with the Islamic Scholar who issued the decree and not with the Investor or the Bank.

Similarly, we have sharia arbitrage wherein a product or service may not be sharia compliant, but enough lawyers and sharia scholars bang their heads together on it for a while (and the incentive of hefty of course) they will make it a sharia compliant product.

Other genuine reasons why some scholars might have unintentionally inadvertently got it wrong:

Mixed Conventional & Islamic Banks

In theory a islamic finance subsidiary has its policy directed by his mother company (the conventional bank), and they impact the accounts of each other. An Islamic subsidiary is an Islamic window within a conventional bank.

So funds can flow between a conventional and Islamic finance subsidiary.

An Islamic window means that the Islamic business is operating within and still belong to the conventional bank.

And banks, whether conventional or Islamic are controlled by you-know-who-controlled central/state banks (given ahead).

Another Problem: Fiat or Paper/Digital Money

Islamic banks are Islamic investment corporations that utilize Islamic transaction contracts. The settlement of such transactions, however, cannot be Islamic if the payment is done with common fiat cash because fiat is debt-based, and that debt is overloaded with interest rate being a primary variable in several of economic formulas such as money demand, forward exchange rates, and so on. So cash, as an instrument to settle a payment, spoils down the notion of Islamic finance altogether.

And banks, whether conventional or Islamic are controlled by you-know-who-controlled central/state banks.

This is discussed in detail in this article:

Sheikh Imran Hussein asks that if these banks were really Islamic, they would have asked for reversion to Sunnah money (Gold Dinar, Silver Dirham and barter trade): 

Malaysian President Mr. Mahathir Muhammad just did this in the Kuala Lumpur Summit and after:

Differences Between Conventional & Islamic Banking

People always try to compare an Islamic banking product with a conventional banking product, and it becomes critical when it has a fixed return embedded.

Conventional Banking Islamic Banking The Reality  
Money is a commodity besides medium of exchange and store of value. Therefore, it can be sold at a price higher than its face value and it can also be rented out. Money is not a commodity though it is used as a medium of exchange and store of value. Therefore, it cannot be sold at a price higher than its face value or rented out. The items (car, house etc) are eventually sold at a higher price than the face value
Time value is the basis for charging interest on capital. Profit on trade of goods or charging on providing service is the basis for earning profit. Items are sold at a higher price over time Name has just been changed from INTEREST to PROFIT
By entering agreement with the customer, banks avoid all the risk and effort involved in buying the asset, transportation, finding a customer (i.e.: market risk, since customer has already agreed to buy the asset). In this way profit margin is not justifiable. Same. Banks bear no risk Same. Banks bear no risk. They only share the profits of a business venture
Interest is charged even in case the organization suffers losses by using banks funds. Therefore, it is not based on profit and loss sharing. Islamic banks operate on the basis of profit and loss sharing. In case, the businessman has suffered losses, the bank will share these losses based on the mode of finance used In reality, only the customer bears the losses. Banks bear no loss. Any claims are rarely factual

I say the difference is theoretical, because legally speaking an Islamic Finance Loan works exactly like a conventional loan, with the exact same paperwork, but charged at a higher interest rate.

Overall, our results suggest that conventional and Islamic banks are more alike than sometimes assumed and Islamic banks are not likely to be the solution to financial crises:

Overall, our results suggest that conventional and Islamic banks are more alike than sometimes assumed and Islamic banks are not likely to be the solution to financial crise

Avoid the Doubtful

If still in doubt, then Islam also says to abstain from things that are doubtful and keep to things that are clear;

Famous Hadith of the Holy Prophet (PBUH):

On the authority of Abu ‘Abdullah al-Nu’man bin Bashir (RA) who said: I heard the Messenger of Allah(PBUH) say:

“The halal is clear and the haram is clear, and between them are matters unclear that are unknown to most people. Whoever is wary of these unclear matters has absolved his religion and honor. And whoever indulges in them has indulged in the haram (Sahih Bukhari and Muslim).

And as narrated by Hazrat Umar (RA) concerning doubt about RIBA:

Hazrat Umar bin Al Khattab (RA) said: The last verse to be revealed was on riba, but Allah’s Prophet (PBUH) was taken away from us, without having expounded it to us; so give up not only riba (usury), but also reebah (whatever raises doubts in the mind about its rightfulness)     (Ibn Majah, Darimi)

It is like a shepherd who herds his sheep too close to preserved sanctuary, and they will eventually graze in it. Every king has a sanctuary, and the sanctuary of Allah is what He has made haram. There lies within the body a piece of flesh. If it is sound, the whole body is sound; and if it is corrupted, the whole body is corrupted. Verily this piece is the heart.”

Conclusion

No need to repeat the Quranic verses here but the essence of Quranic injunctions is that debt should be interest free or non-profit transaction. If you want to engage in profitable transactions, do trade which entails taking equity stake.

That was the argument at the prophet’s PBUH time that both trade and lending for profit are the same i.e. if you treat money as commodity, there is no difference between trading and interest based lending in letter of the law. However, Quran forbade against lending and approved trading. I like to think of it as difference of spirit of the law and letter of law.

Real Islamic Banking

Islamic finance is not a radical concept. There is a paper by Irving Fisher called Chicago Plan which takes you in the direction of islamic finance. Islamic finance is already being recommended as zero fractional reserve banking in the West.

www.quora.com/What-is-Islamic-banking-about-What-are-the-ethical-legal-and-religious-nuances-attached-to-it

The best product that fulfills the criteria of Islamic finance and has been in existence for ages is operating lease. The bank owns the equipment (there is no lending of money at all, no rotation of commodities). The bank leases/rents the equipment for its use. At the end of lease term, the bank gets the equipment back.

This is close to what Dr. Israr Ahmad Marhoom has described here:

The bank takes the risk in any increase in demand for the equipment or excess depreciation in the value of the equipment. Whereas Islamic banks and central banks in Islamic countries may look down on such transactions, banks in the west have their operating lease arms as well as operating lease portfolios in their books. As such, it is not like Islamic banks are being asked to do reinvent the wheel.

Also read this final column:

And Allah knows best!

References

https://blogs.tribune.com.pk/story/194/is-islamic-banking-really-islamic/

https://islamqa.org/hanafi/qibla-hanafi/34403

http://blogs.worldbank.org/allaboutfinance/islamic-banking-can-it-save-us-from-crises

https://www.investment-and-finance.net/islamic-finance/tutorials/difference-between-mudaraba-and-musharaka.html

https://www.coursehero.com/file/p4une8jb/What-are-the-differences-between-Musharakah-and-Mudarabah-contract-and-the/

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