This issue results quite interesting because we can realize how culture can influence a huge financial activity in the world that we would believe it is totally standardized in all the countries. But when we discover that in Islamic economies is prohibited the using of interest rates to obtain returns on capital (which for us, westerns, is just natural) it is worth understanding this situation. So, how can a bank operating in Islamic countries obtain its main source of income which is changing intermediation margins?
In Islam, interest is prohibited because the interest in a loan is considered rise of capital without any effort and a false creation of value, so the real increase of income should result from investment, labor and other activities. Some arguments supporting this prohibition in Islam is that interest rates have no moral foundation, that abstinence from consumption is not a justification of returns and that there is no risk to justify the increase of payment for capital lending if the loan is guaranteed.
The really foundation of this concept is the relation between creditor and debtor which is redefined in Islam with the provider of funds becoming a partner in the objective of the loan which generally would be a project, thus assuming the risk activity with the party receiving the loan which generally would be an entrepreneur and shares profit at a pre-agreed portion, not a fixed return as the banking system we know. In this case the creation of incremental wealth justifies the sharing of profit between the lender and borrower of money; this is the profit and loss sharing (PLS) principle. This principle is based on the Koran, which allow trade but not interests nor usury mainly because Islam looks for an equitable distribution of profits between investors and entrepreneurs so it sees unjust to guarantee a return on capital or loan in a situation in which the lender does not make any effort. Here is where the profit and loss sharing (PLS) principle appears as a ruling system not just in banks but in all Islamic economic institutions.
In business operations of Islamic banks there are commissions or fixed-charges depending on services and business operations so they raise funds by applying an interest-free current account by a profit sharing basis.
As Bellalah and Ellouz (2004) explain:
The special principle of Islamic banks is that investors share in bank’s profits and losses rather than obtain a fixed interest as in the western system. The holders participate in the outcomes of banks at a profit or loss sharing ratio which depends on the short or long term basis. (p.536)
In the case of long term deposits they have a higher profit and lose sharing ratio due to their greater risk and to obtain a profit share, depositors must keep their funds until the end of the contracted period. Finally funds can be used in profitable issues like real investments in trade or on loans on a profit sharing basis and in non-profitable issues like holdings of cash reserves and the provision of interest-free loans to customers and entrepreneurs.
This is a report that explains briefly what are the main concepts in islamic banking system, and at the same time it gives an insight of the financial development in the region.
References:
Mondher Bellalah, & Siwar Ellouz. (2004). Islamic Finance, Interest Rates and Islamic Banking : A Survey of the Literature. Finance India: SPECIAL ISSUE, 18, 533-546. Retrieved April 29, 2010, from ABI/INFORM Global. (Document ID: 676725991).
WealthCity. (2009). Islamic Banking & Finance / Shariah Investments – WealthCity [Video file]. Retrieved from:
http://www.youtube.com/watch?v=XeQkY7DoY9U
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