Islamic Banking Is Not Islamic
Islam forbids interest loans. This is
clearly stated in the Holy Koran 2:278 and 279:
“O ye who believe! Fear Allah and give up what remains of your
demand for riba, if ye are indeed believers. If you do it not, take
notice of war from Allah and His Messenger. But if ye turn back, ye
shall have your capital sums. Deal not unjustly and you shall not be
dealt with unjustly.”
I believe that in those days as in some third world countries today,
loans impose a backbreaking burden on the rural poor. The reason is
that there are usually one or two wealthy individuals (usually a
powerful landowner) in a village that can lend money. Eventually, the
borrower is reduced to serfdom because he cannot repay the debt.
There is an interesting description of wealthy landlord cum
moneylender in VS Naipaul’s book, “India: A wounded
Civilization”. He wrote:
“And in these villages, interest rates were so high, ten percent or
more a month, that debts once contracted, could never be repaid.”
The man he described was practically the master of the village, a kind
of feudal lord, more important to the lives of the villages than the
central authorities. His house was always full of grain. This gave him
power. Villages who cannot repay became his indentured labor. The
villages had a deep reverence for this man.
Nothing moved in the village without his blessings. Yet he was a kind
man who provided his villages with food during shortages. But a less
kindly man can easily abuse his power. To repay debt, villagers in
some parts of the world have been reported to sell their children into
Thus the original prohibition against usury does have its
justification and wisdom. But for those of you who refuse to accept
anything redeeming about Prophet Mohammed, you can easily find another
less honorable motive. Perhaps he was trying to find recruits from
among the impoverished indebted class by playing Robin Hood or Mao Tse
As the Indian central government sometimes find these
landlords/moneylenders to be obstructions for their development plans,
the Prophet too may have found his plans thwarted by this group of
men. He may not have liked having to share power with anybody. Take
your pick of motives. But whatever the original reason, this
prohibition against interest is clearly out of date.
The root cause of the problem is that there are very few lenders. They
are thus able to lend at high interest rates. The nearest bank or
village may be far away and even then nobody may be willing to lend to
the needy villager. Villagers may be illiterate and unaware of other
sources of financing.
But in the modern world, there are many lenders. If a bank charges too
much, you go to another. Money flows across continents from lender to
borrower at the touch of a computer button. The interest rate you pay
is very competitive and not jacked up artificially by a monopolistic
Yet Muslims still struggle to satisfy the conflicting demands of
modernity and their faith. The result is the rise on Islamic Banking
which started in Dubai in 1975 and is today a $200 billion industry.
Islamic banking was not started to cater to a financial need but to a
religious need. In theory, Islamic banking is supposed to work like
Depositors place their savings with the bank whom then provide the
funds to businessmen in exchange for a share of the profit (or loss).
This profit (or loss) is then passed on to the depositor. Interest may
be forbidden but profit is not. So what is the difference between
profit and interest?
The key difference is that interest is fixed and certain whereas
profit is not. Thus the more successful the project, the more the bank
will earn and pass this down to the depositors. This is called the
Profit/Loss Scheme (PLS) and is considered just according to Islamic
scholars. Not sharing the profit with the bank and depositor is
However, this plan has some serious flaws. Remember, the higher the
expected return, the higher the risk. The chief flaw is that the bank
and its depositors have to share in the risk of project failure, which
in the worst case may see the loss of the entire principle. The
depositor may be a pensioner who does not want to take risk. He or she
just wants principle to be assured and is contented with a little
return (i.e. interest) for his bank deposit.
If he is willing to risk his capital in hopes for higher return, there
are already instruments for him to invest in. He can buy stocks
directly or through trust funds. If he thinks George Bush is going on
a warpath against the Axis of Evil, he can buy defense contractors
like McDonald Douglas. If he thinks people are becoming more horny and
sinful, he can buy stocks in a condom manufacturer.
There is no need to specially start Islamic banking for these people
when they are already well served. The Islamic Bank, however, does not
cater to the group of people who just wants the preservation of
capital and are content with a low interest rate.
If all the world’s banks are Islamic, this group of people will have
to hide their money under their mattresses in order to ensure their
capital is preserved. But they have to spend lots of money on rat
poisons and traps to make sure their dollar bills do not get eaten.
Somehow or other, Islam tends to bring people back to the 7th century.
I wonder why.
Another problem is that under the PLS, there is an incentive for the
businessman who took the bank’s money to report a loss. That way,
they don’t have any profit to share with the bank.
Can you see the irony? Under the kaffir financial system, greedy and
unprincipled managers are reporting profits when they are making
losses so that they can cash in on their share options.
Under the amazing Islamic world financial system, unprincipled
businessmen will try to report losses when they are making profits.
This can be done by creative accounting. Let me give you a simple
Suppose that a date plantation owner needs financing to buy camel dung
fertilizer. The bank advances him the money in exchange for a share of
the profit. He uses it to buy dung from his dung merchant
brother-in-law at an inflated price. This jacks up the costs. He
cannot make a profit from his dates because he bought grade F dung
instead of grade A. He does not owe any money to the bank, since his
plantation is making a loss but he splits the money with his crooked
To prevent fraud, the Islamic banks must have a detailed knowledge of
the businesses they invest in and have a say in the management. In
this case, the bank must be able to tell the difference between grade
A dung and grade F. In practice, it is impossible for a bank to
acquire such detailed expertise in such a wide range of businesses
that banks deal in. Even if they could, they don’t have the manpower
to supervise management decisions. In the conventional banking system,
banks usually don’t get involved in management.
Other possible accounting tricks to reduce accounting profits include
1)Early recognition of expenses.
2)Late recognition of revenues.
3)Change from FIFO accounting to LIFO accounting
4)Shortened amortization/depreciation periods
5)Reporting bogus revenues. Etc
In practice, Islamic banks are aware of this problem. A report by the
Institute of Islamic Banking and Insurance stated:
“While designing an alternate to interest-based system, it was
realized that large scale resorting to PLS system of Islamic banking
could pose serious risks and hazards to Islamic banks due to
wide-spread tendency to adopt unethical accounting practices to
conceal true profits, high rate of illiteracy and host of other
In practice most so called Islamic banking is not truly based on the
PLS. This means that depositors and the banks get fixed return for
their money. The common financial instruments are:
1)Muradaha (Cost-plus sale).
2) Deferred payment sales
3) Purchase with deferred delivery
5)Loans with a service charge
The most important is the Murabaha. This is how it works. The bank, at
the request of its client, buys some goods and resells the goods to a
client at a fixed profit (read interest) regardless of the success or
failure of the client’s business. The payment can be in one go or in
installments over many years. The only risk that the bank take is that
the client cannot honor its agreement to pay up – same as in
Whether his client makes a lot or money or lost money, he is entitled
to ask for his fixed “profit”. So in spirit, there is no
difference with conventional financing. It is the same for the other
instruments. The whole Islamic banking is an exercise in
self-delusion. An Islamic scholar, Justice Taqi Usmani said:
“Islamic banks are using the instrument of Murabaha within the
framework of the conventional benchmarks like Libor etc. where the net
result does not differ from interest-based transactions.”
“When the common people realize that the net result in the
transaction of the Islamic banks is the same as was in the
transactions of conventional banks, they become skeptical towards the
function of Islamic banks. It therefore, becomes very difficult to
argue for the case of Islamic banking before the common people,
especially before the non-Muslims who feel that it is nothing but a
matter of twisting documents only.”
Commendably frank, the Institute of Islamic Banking and Insurance
“It is therefore, seriously apprehended that if the present sad
state of affairs is allowed to continue, even many innocent Muslims
may develop doubts about the feasibility, practicability and
usefulness of the ‘Islamic system of banking’ notwithstanding that
the fault lies with us and not with the system.”
Personally, I think it is better for Muslims to say that the fault
lies with the system and not with themselves. They should stop kidding
themselves and proclaim that lending money for interest is part of the
modern world and cannot be banned. But to say that would be to admit
that the system is flawed and then the whole edifice of Islam will
come crashing down. It is too painful to do that and you might get
accused of blasphemy. So Muslims will continue to bang their heads
against the brick wall trying to make Islamic banking work. That’s