Islamic Banking – Is No Interest Really No Interest?

Regular readers know that while I am not religious, I am interested in religion. As a result, I have read the Koran a few times over the years. As an economist, one obvious question that comes up is – how can you run a banking system if charging or paying interest is prohibited? I’ve always thought the answer is smoke and mirrors. After reading this, my answer is still smoke and mirrors.

The chief loophole was murabaha. Let’s say that you, a small businessman, wish to go into business selling cars. A conventional bank would examine your credit history and, if all was acceptable, grant you a cash loan. You would incur an obligation to return the funds on a specific maturity date, paying interest each month along the way. When you signed the note and made the promise, you would use the proceeds to buy the cars—and meet your other expenses—yourself. But in a murabaha transaction, instead of just cutting you the check, the bank itself would buy the cars. You promise to buy them from the bank at a higher price on a future date—like a futures contract in the commodities market. The markup is justified by the fact that, for a period, the bank owns the property, thus assuming liability. At no point in the transaction is money treated as a commodity, as it is in a normal loan.

But here’s the catch: most Muslim scholars agree that there is no minimum time interval for the bank to own the property before selling it to you at the markup. According to Timur Kuran, the typical interval is “under a millisecond.” The bank transfers ownership of the asset to its client right away. The client still pays a fixed markup at a later date, a payment that is usually secured by some sort of collateral or by other forms of contractual coercion. Thus, in practice, murabaha is a normal loan.

Since murabaha must be asset-based, however, it can’t help a small businessman who needs a working-capital loan, for example, to provide cash on hand to meet payroll or other expenses. To get such capital from an Islamic financial institution, an entrepreneur would have to sell the bank an equity interest in his business. This is far riskier for the bank and thus much harder to obtain.