What Is Islamic Finance? Banking Without Interest

Three restrictions shape everything and each is interpreted with a range of strictness:

• •Riba, a guaranteed return on money lent regardless of the outcome of what it funds, which is prohibited on the reasoning that money should not generate money by itself and that risk should accompany return
• •Gharar, excessive uncertainty or ambiguity in a contract, which rules out arrangements where what is being exchanged is not clearly specified and is why conventional insurance and many derivatives are questioned
• •Maysir, gambling, meaning gain that depends purely on chance
• •Investment in prohibited sectors, including alcohol, pork, gambling, conventional financial services, weapons in some interpretations and adult entertainment
• •A requirement in most structures that transactions be linked to real assets or genuine economic activity rather than to money alone
• •Zakat, an obligatory annual contribution on accumulated wealth above a threshold, which functions as a wealth rather than an income levy and is a separate obligation from the contract rules

The instruments recreate familiar functions through ownership and partnership. Murabaha is cost-plus sale: instead of lending money to buy a car, the bank buys the car and sells it to the customer at a disclosed mark-up payable in instalments, so the bank's profit comes from a trade in an asset it owned, however briefly. Ijara is leasing, with the bank owning an asset and charging rent, frequently with the customer acquiring ownership over time. Musharaka is a partnership in which both parties contribute capital and share profits by agreement and losses by proportion of capital, which is the arrangement most consistent with the underlying principle and the least used. Mudaraba pairs one party's capital with another's expertise. Sukuk, frequently called Islamic bonds, give holders an ownership interest in an asset and a share of the income it produces rather than a debt claim. Takaful replaces insurance with a mutual arrangement in which participants contribute to a pool from which claims are paid, which addresses the uncertainty objection by making the arrangement cooperative rather than a sale of risk.

The sharpest critics of the industry are Islamic scholars and economists rather than outsiders, and their objection is that many products reproduce interest in substance while avoiding it in form. A murabaha mark-up is frequently benchmarked to a conventional interest rate, produces an equivalent payment schedule and carries equivalent risk allocation, which leads to the charge that it is a legal device rather than a different economic arrangement. Tawarruq, in which a customer buys a commodity on deferred terms and immediately sells it for cash to a third party, delivers a cash loan through two sales and is widely used and widely condemned. The deeper argument is that the prohibition on riba was meant to shift risk-sharing towards partnership, and that an industry dominated by debt-like instruments has satisfied the letter while abandoning the purpose. Defenders reply that a new industry must compete with established banking, that customers want products with predictable payments, and that partnership structures carry real problems of monitoring and moral hazard that explain why they remain a small share of activity.

Islamic finance grew from almost nothing in the 1970s to a global industry holding assets measured in trillions of dollars, concentrated in the Gulf, Malaysia, Iran, Pakistan and Bangladesh, with substantial activity in the United Kingdom, which has issued sovereign sukuk and positioned itself as a Western hub. Governance rests on sharia supervisory boards of scholars who approve products, and the shortage of qualified scholars, their service on many boards simultaneously and their payment by the institutions they supervise have drawn obvious conflict of interest criticisms. Standard-setting bodies have developed accounting and governance standards, though interpretation still varies between jurisdictions and particularly between Gulf and Malaysian scholars, which fragments the market. The comparison most often drawn now is with ethical and socially responsible investing, since both screen sectors and both face the same question about whether screening changes underlying activity or merely reallocates ownership, and there has been growing convergence between the two in marketing and in practice.

Islamic finance prohibits guaranteed returns on money lent, excessive contractual uncertainty and gambling, so it rebuilds banking functions through trade, leasing and partnership, with cost-plus sale, leasing, profit-sharing partnerships, asset-backed sukuk and mutual insurance as the main instruments. Its most serious critics are internal, arguing that benchmarked mark-ups reproduce interest in substance while satisfying the form. The industry holds trillions in assets and is governed by scholar boards paid by the institutions they supervise.