27 January, 2017

Quora Answer: If Interest is Haram in Islam, How do Islamic Banks Make Money to Operate?

The following question was asked on Quora and answered on the 28th November, 2015.


Answer: Firstly, it is not interest that is haram, but riba’.  Depending on the opinion of the scholar and the understanding of banking, interest may or may not be riba’.  For something to be considered riba’, usury, there has to be an element of zhulm, oppression.  And one of the forms of zhulm is creating wealth from nothing though systematic advantage.

If you deposit money in the bank, and the bank uses it and grows its value, and grants you a return in the form of interest, it may not necessarily be haram.  Some would argue that the fact that the bank guarantees a fixed return on something that is not fixed is itself haram.  But we must consider that the bank has already factored in its projections and return on investment.  Whatever the bank pays out in interest is miniscule compared to its returns.  It can be argued then, that this interest is no necessarily riba’, but this is an issue of ikhtilaf.

Here is an example of real riba’ that people do not realise.  If, for example, I were to ask you to lend me $100, and you only had $70, you cannot possibly lend me $100.  That money simply does not exist and you cannot lend beyond what you possess.  The bank has no such limitation.  Depending on the Basel II or III regulatory framework, a bank need only have 11 to 17% of the money it lends out.  That means, to ‘lend’ you $100, the bank need only have $17.  The money is just numbers on a programme.  It does not physically exist.  That is riba’ on a massive scale.

Coming to Islamic banks, or shari’ah compliant banks, the brutal truth is that they are not truly Islamic.  Which ‘Islamic’ bank can afford, in the current economic climate and regulatory framework, to back 100% of its loans?  The entire idea of Basel III is to eventually move towards that, but we are far away from that.  So the actual question should be: are ‘Islamic’ banks actually Islamic?  And the answer is no.

On the second part of the question, banks do not make the bulk of their money from charging interest.  Whatever they earn from their loan portfolio is negligible compared to other sources of income.  The primary source of income for most banks is their core deposits and their wholesale deposits.  Banks may negligible interest for this ‘capital’ which they then lend out, use in transactions and manipulate LIBOR and other interest rates to generate income.  The breadth of activity the banks can do with deposits to generate income alone would stagger the average person who is not involved in the financial sector.

Banks also earn through their investment arm.  There are entire books on different strategies, hedges and fact that the international regulatory framework is entirely inadequate in policing what goes on.  This also includes services that banks never advertise but they all engage in to an extent, either wilfully or by pretending they do not know: fund transfers for tax avoidance and money laundering.

And finally, banks raise capital through share placements.  Shareholder equity is an extremely important part of the equation.  Share issuance is relatively cheap and all the costs can be kept internally if required.  Also, banks can issue bonds, corporate papers if they do not want to dilute existing holdings.

So, do ‘Islamic’ banks do this?  Absolutely.  ‘Islamic’ banks are no different from normal banks.  They engage in the same activities but put a veneer of being shari’ah compliant by calling these same things by different names and using fancy jurisprudential terms such as mudarabah and mashirkah.  ‘Islamic’ banking and finance is an exercise in corporate imaging and branding.  It is not real.


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