Applying the Concept

One fifth of the worlds 6.5 billion inhabitants are Muslims. That’s 1.3 billion people. And like all religions, there are vast differences in the way it is practiced. The most observant of the faithful adhere closely to the Islamic Law, or Shari’a. This divine law, revealed in the holy book of the Islamic religion called the Qur’an, forbids a number of activities including gambling, smoking, drinking of alcoholic beverages, eating of pork, and payment of interest.

The challenge is that interest payments are the foundation of the modern financial system. It is the price the borrower pays for the credit extended by the lender. And, as we saw at the beginning of Chapter 3, financial and economic developments go hand in hand. Without interest payments, it is hard to imagine the modern economy we see around us.

Because they are prohibited from paying or receiving interest, people in the Islamic world have found alternative mechanisms for promoting the flow of funds from savers to investors. They have developed banks that engage in financial transactions that are in compliance with Shari’a. The primary things that set Islamic banks apart from their traditional, Western equivalents are (1) that the banks cannot offer a guaranteed return on the use of deposits so they cannot pay interest; and (2) that they are banned from involvement industries considered sinful, such as cigarettes, alcohol, or pork production.

In place of interest payments on deposits and interest charges on loans, Islamic banks enter into an alternative set of agreements with their customers. On the liability side, banks accept transaction and investment deposits. The former are available on demand, have a guaranteed nominal value, pay no interest, and may require the depositor to pay a maintenance fee. Investment deposits, which are the principle source Islamic bank funding, carry no guarantees and do not pay fixed returns. Instead, they represent shares in the profits or losses of the bank. In servicing its investment accounts, an Islamic bank operates much like traditional mutual fund managers distributing profits in that are proportional to the size of the investment deposits.

Lending is governed by the same principles of risk sharing. The two most important types of loans are called mudarabah and murabaha. Mudarabah is a profit-sharing agreement where, in exchange for lent funds, the bank receives a previously agreed upon fraction of the gains from the borrowers activities, in much the same way that a stockholder receives dividends. In a murabaha contract the bank purchases goods on behalf of a customer and then resells them on a deferred basis, adding a profit margin. That is, the bank is making the purchase on behave of the customer, and then the customer pays for the goods in a series of installments.

The prohibition against the payment of interest has led devout Muslims to develop financial institutions that engage in transactions based that comply with Islamic Law. The result is a growing system of more than 250 financial institutions with several hundred billion dollars in assets operating in nearly 50 countries. While they may be somewhat different character, Islamic banks serve the same basic role as traditional banks do: They channel funds from savers to investors.* [578, including footnote]

* Some financial economists believe that Islamic banks are more stable than traditional banks that pay and charge interest. The latter face a risk from the fact that they tend to make long-term loans but have short-term deposits. As a result, interest rate increases drive up the payments traditional banks make to their depositors without increasing the revenue they receive from their borrowers. This “interest-rate risk” is described in more detail in Chapter 12, beginning on page 304. By contrast, Islamic banks operate in away that is analogous to mutual funds, so the risk embodied in the assets flow through to the depositors who own shares in the profit-sharing investments.