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Misconception Number One: Islamic Banks Have to Rent Interest Free

islamic finance ©Ammar Abd Rabbo [1]

Islamic finance [2]. It’s been a few months now that not a day goes by without a press artcile being written about Islamic finance. Forums on the Internet and blogs have plenty of comments about it too.

But they all have one thing in common: big impact, stereotypes, even misinformation, and above all, misconceptions. That’s why we turned to ACERFI [3] (Audit, Compliance, Ethics and Research on Islamic Banking) and AIDIMM [4] (Association for Innovation and Economic and Housing Development) for a series of articles which aim at clearing these misconceptions and allowing everybody to understand the precise background of Islamic finance.

For the first article, Mouhammad Patel, a member of ACERFI, and Boubkeur Ajdir, a member of AIDIMM have decided to clear the misconception that Islamic banks have to lend money to their clients for free.

Although they are aimed at a large audiance, future articles may contain specific vocabulary. However, it is not necessary to precisely understand their meaning in order to get the general idea. You can browse AIDIMM’s online glossary for more information: Islamic Finance Glossary [5].


Misconception Number One: Islamic Banks Have to Lend Interest Free

That’s untrue. An Islamic bank is not a non-profit organization nor a charity. It is a trading company whose activity is based upon making profits by offering a wide range of services of financial products to meet their clients’ demand for funding and/or investment requirements, using transactions that are allowed by Islamic law.
So an Islamic bank isn’t just a financial intermediary. It plays the following roles, with the benefits and risks attached to them:
– Trader in murabaha or salam operations
– Lessor in ijara or musharaka mutanaqissa operations
– Entrepreneur or manufacturer in mudharaba or istisnâ’ operations
– Provider of services subject to payment in ju’aalah, wakaalah contracts
– Investor through wakaalah, mudharaba, musharaka operations
– Entrepreneur through qardh contracts, among others…

So the purpose of an Islamic bank isn’t to provide its clients with interest-free loans. However, it might do that in certain cases and for a limited amount, in forms of qardh hassan. But this doesn’t pertain to its primary activity. Just like any other trading company, its operations are done in a way that it can face expenses and make profit. It has to keep accounting statements. It also has to conform to very strict specific regulatory requirements, complying with capital adequacy ratios for example.

Its capital comes from its own funds first and foremost. It is able to offer service, halal investment and financing products mainly thanks to its clients’ money, on deposit accounts (blocked or not). Its incomes come from financial investments made on financial markets (for instance the commodities market or the housing market using buy/sell operations). The bank is kind of going to act as an agent for its clients, by making their deposit grow without guaranteeing an income in advance. However, specialists have come up with a number of halal mecanisms that cover the bank and the clients’ losses.

In the Western world, an Islamic bank cannot borrow money from other banks on the interbank market because of interest rates. Which makes it even more difficult. In case of liquidity problems, it cannot borrow money from the Central Bank either, because of interest rates.

So all these elements put together help us understand that an Islamic bank is not a social institution that can lend interest-free money to all Muslims. It is a private company first and foremost – not a state one – that trades in accordance with Islamic law.

[Translated from French ‘Idée reçue n°1 : la banque islamique doit prêter à taux zéro [6]’ by Mouna M. [7]]