How Islamic banks make money

How Islamic banks make money

A young man makes his career choice and decides to become a successful banker, just like his father.

Rudi Prenzlin

Monday, February 23, 2009

A young man makes his career choice and decides to become a successful banker, just like his father.He wants to prepare for the role and asks his father: “What must I do to become a successful banker, just like you?”

“Son,” says the father, “you must follow these three simple rules: first, don’t lend money to those who don’t have any; second, don’t lend money to those who need it badly; and third, the most important, don’t lend your own money.”

Sound advice in these troubled times. It is a shame that many of today’s bankers either never received this sound advice, or ignored it!

In last week’s article, “Credit crunch opens doors for other possibilities” I argued that Islamic banking institutions were weathering the present financial crisis comparatively well as they are insulated from the disasters in the interbank market and the mess in the derivatives markets.

A number of readers raised the logical question of how Islamic banks manage to stay in business without charging interest.

To recap, one of the basic principles of Islamic banking is the prohibition of riba (usury or interest).

Other principles are based on simple morality and common sense, which are by no means unique to Islam. For example, usury was also prohibited by the Old as well as the New Testament.

The Islamic economic system is concerned with social justice to ensure that none of the parties is being exploited without inhibiting individual enterprise.

Extended to the Islamic financial system, this means that the funds individuals and/or companies put at risk share the profits or losses resulting from the enterprise. This concept of sharing the delights or pain of the outcome of business is a progressive one. Islamic banking encourages better resources management, in particular as outright speculation is not permitted by Shariah ie Islamic law.

The participants are keeping pace with sophisticated techniques and have developed products that not only are ethically motivated but also profitable.

At their core, most Islamic financial products are essentially the same as their conventional equivalents. The main difference is the absence of interest and often complicated procedures to ensure compliance with Shariah.

For example, in Islamic housing finance the risks involved are shared between the bank and the borrower, rather than transferring all the risk to the latter.

The most commonly contract used is the diminishing mazurka (partnership) contract.

In this case the bank and the borrower form a partnership, with the bank providing up to 95 percent of the purchase price, and the borrower 5 percent.

The borrower buys out the ownership share of the bank which makes its profit from the rent paid by the client for the share the bank owns. This happens over a period of, usually, 15 to 30 years.

Should the borrower default on a rental or principal repayment, the bank may advance the borrower an interest- free loan to enable him to continue the payments in anticipation that he will pay in full when he is able to.

The good news is that during this period of distress, the borrower retains his home rather than face eviction.

Having said this, Islamic banks still appraise credit risk, and indeed are more cautious about who they finance than conventional banks.

Rudi Prenzlin is the chief financial officer of the Hong Kong Islamic Index



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