In the world of banking, where each bank is going double on giving 0.25% or 0.50% more interest than their competitors, to acquire more customers. There are a set of banks, spread over 75 countries, which doesn't believe in the concept of interest: Islamic Banks.
It is understandable why the world economy is not expanding at a rapid pace because those banks are not providing any interest on deposited money (sarcasm). However, Islamic banks are currently managing only 1-1.5% of the world's capital, but their growth per year, which is 16%, is much more than conventional banking.
But how do banks and their depositors make money, if they don’t charge or give interest? For understanding their revenue stream, we first need to understand the operating principles of Islamic banks. As the name suggests, these banks work of principle of Islam or Shariah.
Following are the fundamental principle of Islamic finance:
Money has no intrinsic value, which means the money can’t make money (interest in simple terms). It also counters the concept of the time value of money.
Money can’t be invested in sectors, industries, or companies that are providing goods or services, which are prohibited or considered haram in Islam. These industries are alcohol, nicotine, pornography, and prostitution.
Highly risky and speculative trades are also prohibited in Islam. Furthermore, the concept of selling before owing something (short selling) and buying a product that is yet to be produced (future and forward contacts) are also prohibited.
The main purpose of Islamic banks is to encourage entrepreneurship and liquidate the economy and not to make a profit. For serving their purpose, they usually provide different schemes, where people can deposit their money. Some of these mediums are Mushaarakahv (profit and loss sharing) and Ijarah Muntahia bittamleek (rental with eventual ownership).
The function of these banks is to work as an agent between corporations - which are not prohibited according to Islam - and depositors. Banks lend the money collected by depositors to a corporation, but not as a loan. The lent money will give banks partial ownership of the corporation and hence profit or loss made by that corporation is shared with the bank in the same proportion of their partnership. Which is further distributed to depositors of banks, and that is how depositors of banks earn money on their deposits.
This method of deposit is riskier than conventional banking (where interest rates are fixed), but more rewarding, sometimes, as well.
Renting with eventual ownership is something more interesting, where banks lend money to the person, who is willing to own a house. By doing this, banks again own a portion of that house. Hence the owner of the house will repay the money to the bank and increase his / her ownership. The repayment is divided into installments. Over and above the repayment, the person has to pay rent to the bank for living in a place, which is partially owned by the bank. The rent is nothing but the profit banks will make through this whole transaction. This rent is changing every year, as ownership of the bank in that property decreases.
An example will help to give more clarity. Assume, the price of a house is 10 lacs, but the potential owner has only 5 lacs to support the purchase. So he took out a loan of 5 lacs from an Islamic bank. Now, the bank owns 50% of the property. The repayment is decided to be 1 lac per year. So first see the variation of the ownership for the next 5 years, until that person owns the property completely.
Let’s assume the rent of the property is 10,000 per year.
In the 0th year, the bank is owning 50% of the property. So, the rent for that year will be 50% of 10,000, which is 5,000.
Similarly for 1st-year rent will be 4,000. It decreases with time and eventually ends up in complete ownership of the person.
In this scenario, the person would end up paying 5 lacs 15 thousand to the bank, 5 lacs which was borrowed, and 15 thousand as rent.
Many will argue that those 15,000 are in a way interest, which the person has paid to borrow the money. The same argument is raised by many banking professionals, which says the Islamic bank charges interest in the name of profit. After all, whatever you pay over the borrowed money, is interest. What do you think?
Jumping to the Indian landscape of Islamic banking, there is no functional Islamic bank in India. But former RBI governor Raghuram Rajan suggested starting some, so the people who are not investing or depositing their money in a conventional bank, due to laws of Islam, can also deposit their money and contribute to the Indian economy. However, it is contradicting the fundamental principle of the Indian banking system, which is changing and paying interest. So there was no progress on the same.
The middle point of this problem is to start an Islamic window, which will be a product based on laws of Islamic finance, offered by conventional banks of India. Because in the end the financial system of a country is as secure as it is diversified.
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