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Summary: This Muslim knowledge guide revisits a paper on Islamic banking, focusing on Islamic subsidiaries of conventional banks in Malaysia, Sharia compliance, profit maximization, murabaha, riba, manager incentives, banking structure, and whether Islamic banks are truly Islamic in practice.

This is another article I translated that critiques Islamic finance. The previous ones got a good response and made many readers think. If you read those, you will see that the contradictions and struggles of so-called Islamic finance were already discussed by scholars decades ago. Solutions exist, but we know very little about them. This has a lot to do with the stance of the people who control the narrative.



Original title: HOW ‘ISLAMIC’ IS ISLAMIC BANKING? A REVISIT

Authors: Eliza Nor, Anwar Allah Pitchi, and Muhammad Usman. It was originally published in the International Journal of Accounting, Finance and Business. All three are from the Universiti Sains Malaysia, and the paper was published in 2020.
Main text: Literature widely suggests that Islamic banks and conventional banks do not differ much in terms of regulation, operational expectations, operational dynamics, and organizational structure (Asutay, 2007; Siddiqi, 1999). Considering this argument, this paper tries to discuss these issues by focusing specifically on the Islamic subsidiaries of conventional banks in Malaysia. The establishment of Islamic subsidiaries by conventional parent banks has raised many unresolved questions.

Based on an extensive review of theoretical and empirical literature related to Islamic banking and Islamic economics, this study identifies three major challenges facing Islamic banks. These challenges may cause the implementation of Sharia to be limited to a minimum scope.

The first challenge is the different goals between the conventional parent bank and its Islamic subsidiary. The main goal of a conventional parent bank is profit maximization (maximizing shareholder wealth), while the main goal of an Islamic subsidiary (in theory) is to comply with Sharia regulations (profit maximization is only secondary). Managers who are supposed to execute and follow Sharia rulings still need to follow instructions from the senior management of the conventional parent bank.

The second challenge is the profit-maximization motive of Islamic banks. Since an Islamic subsidiary is a subset of a traditional parent bank, its goals must align with those of the parent company.

Finally, if managers lack a deep background in Sharia law, their background can become an obstacle during the Sharia compliance process.

Islamic finance and banking started nearly forty years ago. Even today, despite many ways for Sharia scholars and practitioners to discuss ongoing issues, many unresolved questions and controversies remain around the industry, along with new problems that emerge alongside the development of Islamic banking and finance. One main reason why issues remain unresolved is that there is no clear distinction between Islamic banks and traditional banks, as both systems coexist in the same economy. Although Islamic finance was founded back in the time of the Prophet Muhammad, it has developed much more slowly than traditional finance. Traditional banking and finance have been accepted and practiced by most countries in the world for centuries, so the development of Islamic finance is to some extent benchmarked against traditional banking. In countries like Malaysia where Islamic banks exist, coexistence with traditional banks is almost unavoidable because these banks were originally established as traditional banks. Islamic banking windows were opened to meet the growing public demand and interest in Islamic banking products.

The successful implementation of the Islamic banking system in the Middle East encouraged local consortiums to establish Islamic banking in Malaysia. Therefore, in 1983, Malaysia enacted the Islamic Banking Act and established the first full-fledged Islamic bank, Bank Islam Malaysia. In 1999, the second Islamic bank, Bank Muamalat, was established. To this day, these are the only full-fledged local Islamic banks in Malaysia. Other local Islamic banks operate as subsidiaries of traditional parent companies, including Affin Islamic Bank Berhad; Alliance Islamic Bank Berhad; AmBank Islamic Berhad; CIMB Islamic Bank Berhad; Maybank Islamic Berhad, Public Islamic Bank Berhad; and RHB Islamic Bank Berhad.

In 1993, the Central Bank of Malaysia (Bank Negara Malaysia) gave traditional banks the option to open Islamic windows. These windows offered customers banking products that follow Sharia law through their existing traditional branches. As a result, 21 Islamic banking windows were set up by their traditional bank parent companies. In 2002, the Central Bank of Malaysia allowed traditional banks to open Islamic subsidiaries to replace their existing Islamic windows. These subsidiaries are governed by the Islamic Banking Act of 1983 (Mohamed Ariff, 2017).

Over time, issues related to Islamic banking operations have grown because of conflicts between Sharia goals and commercial goals. The former is built around Islamic concepts, while the latter is built on a capitalist economy. The task of Sharia scholars is to ensure that Islamic banks follow the goals of Sharia law. On the other hand, managers are the people responsible for carrying out Sharia rulings. At the same time, managers also have a duty to meet the business goals set by the board of directors. Because of this, managers are stuck in the middle between reaching Sharia goals and business goals. This conflict can lead to Islamic banks failing to follow Sharia. Beyond the differences between business goals and Sharia goals, the backgrounds of managers and staff also play a big role in making sure Islamic banks follow Sharia.

Since Islamic banking and finance began, the issues and challenges facing the industry have been widely debated by scholars, professionals, and regulators around the world. Many documents discuss how Islamic banking products are similar to traditional banking products (for example, see Dusuki & Abozaid (2007); Kuran (2004); Siddiqi (2006); Yousef (2004)). On the other hand, issues regarding Islamic banking operations have received very little attention in the literature. Some argue that there is not much difference between Islamic banks and traditional banks when it comes to regulation, operational expectations, operational dynamics, and organizational structure (Asutay, 2007); Siddiqi, 1999). To fill this gap in the literature, this article focuses on the operations of Islamic subsidiaries of conventional banks based on a newly developed conceptual framework.

There are two reasons for choosing Islamic subsidiaries of conventional banks. First, setting up Islamic subsidiaries by conventional banks has become a popular practice not only in Malaysia but also worldwide. Since the birth of Islamic finance nearly forty years ago, Islamic banking has become a profitable business. Many conventional banks have tried to seize this opportunity by establishing their own Islamic subsidiaries. As mentioned above, most Islamic banks in Malaysia exist as subsidiaries of conventional banks. Second, issues and controversies surrounding Islamic subsidiaries are expected to be more severe compared to established Islamic banks, because the former are under the control of non-Islamic conventional banks. On the other hand, for established Islamic banks, issues or conflicts related to Sharia may be less obvious because these banks exist independently and their decision-making processes are not influenced by a conventional parent bank.

Islamic Economics and Capitalist Economics

Before discussing issues related to Islamic banking, it is important to emphasize the differences between capitalist economics and Islamic economics, because Islamic economics and finance are only a small part of the larger capitalist economy.

Therefore, the influence of the former on Islamic economic and financial activities is almost inevitable, as the entire world is governed by capitalist economics. The difference between the two is only clear in theory. In reality, daily activities in both Muslim and non-Muslim countries are influenced by the capitalist economy.

The capitalist economy is built on a neoclassical framework that focuses on individual self-maximization while ignoring the maximization of social welfare (Asutay, 2007, p. 168). This approach contradicts the teachings of Islamic economics, which emphasize a balance between self-interest and social welfare.

Muhammad Zahid (2015) argues that the Muslim world has become a supporter of interest (riba) and secularism, which is the separation of daily life, activities, and education from religion. Muslims have also consistently supported the fiat currency and fractional reserve systems introduced by the Western world, which resulted from the fall of the Ottoman Caliphate in Turkey in 1923, the rise of the Western world, and the spread of secular ideologies.

The differences between capitalist economics and Islamic economics are obvious; the former emphasizes individualism, while the latter focuses on the welfare of both the individual and the entire society. Islamic economics also considers life in the afterlife, whereas capitalist economics only focuses on worldly life.

Similarities between Islamic banks and traditional banks: Islamic banks have two main goals: profitability and social objectives. However, profitability should not be the only goal, because Islamic banks must meet the social objectives set by the goals of Islamic law (Maqasid al Shariah), which is the fair distribution and circulation of wealth. Wealth circulation means that funds in society should flow from the rich (surplus sector) to the poor (deficit sector). Warde (2000, pp. 174-175) summarizes the functions and roles of Islamic banks in society as follows (based on the Islamic Banking Handbook, Vol. 6, p. 293):

(1) Broad social and economic benefits: Investment policies must focus on these sectors: agriculture, housing, and health services.

(2) Create job opportunities, focusing on promising economic sectors like agriculture, manufacturing, and technology-intensive activities.

(3) Promote and encourage entrepreneurship: Banks must prioritize small businesses through profit and loss sharing (PLS) mechanisms like mudarabah and musharakah.

(4) Promote social justice, equality, and poverty alleviation.

(5) Regional distribution of investments: (a) Direct funds to areas that lack investment. (b) Invest savings primarily in areas where savings were mobilized, so that people benefit from their own savings.

Based on the functions and roles of Islamic banks mentioned above, it is clear that Islamic banks should provide financing to entrepreneurs starting new businesses in sectors that use new technologies, such as information technology, biotechnology, and nanotechnology. However, these entrepreneurs may lack experience and a track record because their businesses are small and new. They may need a lot of capital to expand, so they might seek funding from Islamic banks. However, due to the nature of these businesses, these entrepreneurs may lack the collateral to offer banks. Entrepreneurs with new businesses, lacking a track record and collateral, are likely to be excluded from getting financing because their businesses are risky and have a high chance of failure. Therefore, their applications might be rejected. This leads to the problem of financial discrimination by Islamic banks. According to Asutay (2007, p. 177), financial discrimination in personal banking has become a major issue. When comparing debt financing in both types of banking, entrepreneurs rejected by traditional banks may receive the same treatment from Islamic banks.

In theory, Islamic banks should provide equity-based financing, such as profit-sharing partnership (mudarabah) and joint venture (musharakah) (M&M). Both mudarabah and musharakah are based on profit and loss sharing (PLS), where both the financier and the entrepreneur share profits and losses according to a pre-agreed ratio. These types of financing are suitable for entrepreneurs with new businesses. However, in practice, Islamic banks have been avoiding M&M financing. Evidence provided by Aggarwal and Yousef (2000), Iqbal and Molyneux (2005), Hasan (2007), and Nagaoke (2007) shows that Islamic banks rarely provide long-term financing to entrepreneurs seeking funds. Asutay (2007) argues that equity financing contributes more to economic growth than debt financing because the former is long-term. The fact that Islamic banks avoid equity financing suggests they are not particularly interested in economic development and social welfare. Islamic banks are more interested in providing financing with fixed returns, such as cost-plus financing (murabaha), deferred payment sale (bay bithaman ajil), and leasing (ijarah), rather than offering PLS-type products.

On the other hand, Islamic banks often operate in ways that mimic traditional banks, where (1) both avoid providing financing to entrepreneurs with risky businesses, and (2) both rely heavily on debt financing to ensure fixed returns (Warde, 2000, p. 22). Therefore, the goal of reaching deep into rural areas to serve them has not been achieved. Most evidence highlights that Islamic banks prefer to invest in short-term commercial deals rather than the manufacturing or agricultural sectors (Warde, 2000, p. 175). As Asutay (2007) and Warde (2000) point out, the main sectors Islamic banks should focus on are agriculture, manufacturing, and technology-intensive industries. Traditional banks are built on a fractional reserve system, which expands the money supply by multiplying loans. In this system, commercial banks use excess reserves from money deposited by savers to make a profit by charging interest to borrowers (for example, see Mishkin, 2016). This system goes against Islamic teachings because the profit comes from riba, and the bank uses other people's money—the money of the savers—to earn that profit.

Islamic banks, just like traditional banks, create money through debt financing (Zaman, 2020). The effects caused by credit expansion in traditional banks and Islamic banks are almost the same. This credit expansion can be linked to artificial scarcity (due to greed and self-interest), trade distortions (due to wealth accumulation, inflation, and the financialization of capital), and inherent boom-and-bust cycles (business cycles); ecological destruction (deforestation) and wealth polarization (wealth concentrated in the hands of a few); income inequality. Because of the nature of the money supply, as global debt increases, the business interests served by that debt allow the rich to become even wealthier. Over the past decade, more and more wealth has been concentrated in the hands of fewer and fewer people (Jha, 2013, pp. 356-359). Sabirzyanov and Hashim (2015) argue that Islamic banking and finance create bubble economies through debt financing under a fractional reserve system. Like traditional banks, Islamic banks support the expansion of the money supply, which leads to economic inflation. Even though price levels rise, the GDP growth rate does not change because the actual production in the economy likely stays the same.

Empirical evidence supports the argument that there is no major difference between Islamic banks and traditional banks. Chong and Liu (2009) empirically studied the differences between Islamic and traditional banks and found that Islamic banks do not differ much from traditional banking operations. In terms of assets in the Islamic banking industry, only a small portion of financing is based on profit and loss sharing (PLS) principles. In Malaysia, the vast majority of Islamic bank financing is still based on non-PLS models allowed by Sharia, but these ignore the spirit of prohibiting usury. Their research shows that in practice, Islamic deposits are not interest-free. One possible explanation for why Islamic deposits are not interest-free is that depositors' funds are mainly invested in non-PLS financing in practice. Due to increased competition from the traditional banking industry, the return rates on Islamic deposit accounts are linked to the return rates of traditional bank deposits. They concluded that the Islamic banking practiced in Malaysia today is similar to traditional banking, so the benefits of Islamic banking only exist in theory.

In Pakistan, research has also been conducted on the similarities between Islamic banks and traditional banks. Hanif (2016) chose five contracts or products to analyze: deposits, cost-plus financing (Murabaha), leasing (Ijarah), diminishing partnership (Reducing Musharaka), and Islamic bonds (Sukuk). The results show that even though these financial contracts look at legal forms, their economic substance matches traditional banking more closely. The study found that despite philosophical differences, the financial results of the Islamic finance system match traditional banking. This happens mainly because pricing is linked to the interbank offered rate (Islamic Bank OR), which ignores market mechanisms or the actual price of goods and services provided. Some also argue that putting Sharia-based financial contracts into practice is more demanding than what the contracts themselves require. Islamic banks prefer Sharia-compliant financial contracts because they are similar to traditional financial products (Hanif, 2018). A recent study on how customers perceive Islamic banks in Malaysia found that most people surveyed do not think Islamic banking is fully compliant with Sharia. This shows how important it is to implement a profit-and-loss sharing (PLS) system in the current financial setup. The results also show there is not much difference between Islamic banks and traditional banks, as both focus on efficiency and keeping their current services running (Rahmi, Azma, Obad, Zaim, and Rahman, 2020).

Evidence shows that Islamic banks currently fail to meet all the requirements set by the El Hawary four-part classification (El Hawary, Grais, and Iqbal, 2004: 5): (1) risk sharing (financial deals must reflect a balanced risk and reward distribution for everyone involved); (2) materiality (financial deals must be linked, directly or indirectly, to real economic transactions); (3) no exploitation (financial deals should not lead to any party involved being exploited); (4) no funding for sinful activities (such as producing alcoholic drinks). Therefore, the argument that Islamic banks offer a different alternative to traditional financing is not supported, because there is no real difference between Islamic banks and traditional banks (Khan, 2010). If Islamic banks do not operate much differently from traditional banks in reality, they will fail to reach their original goals of promoting social justice and equality or reducing poverty if they do not direct funds to the people who need them.

In terms of financing, Islamic banks limit their social role to zakat and other charitable activities like religious endowments (waqaf) and voluntary charity (sadaqah), which overlooks economic development and social justice. Even though the Islamic banking industry has been growing worldwide, the lives of Muslim people have not improved much. From the early days, it was clear that Islamic banks should not be driven by profit maximization, but should instead provide socio-economic benefits to their communities (Warde, 2000, p. 153). In practice, Islamic banks tend to make profit maximization their main goal, which is the same as the goal of traditional banks. In theory, the purpose and foundation for establishing Islamic financial institutions are completely different from those of traditional financial institutions. Islamic banks should follow the goals of Islamic law (maqasid al-shariah) regarding the protection of wealth. According to Islamic law rulings, five dimensions of public welfare (maslahah) must be protected in Muslim society: faith, life, intellect, prosperity, and property (Khairul Mukminin, 2018).

Laldin and Furqani (2012:4) define the goals of Islamic law (maqasid al-shariah) as follows: '...as a way of life, Islam forms standards, guidelines, values, and directions based on divine revelation (wahi) to be applied in daily life to solve human problems and guide the direction of human life.' The principles of goals (maqasid) and public welfare (maslahah) cannot and must not contradict the Quran and the Hadith, as both are the core of all other principles and rules. However, in the current situation, the interpretation of public welfare (maslahah) comes only from practical methods and reasoning, rather than from the Quran and the Hadith. Therefore, some international financial institutions manipulate the interpretation of public welfare (maslahah) and goals (maqasid) to justify their actions and norms (Sabirzyanov and Hashim, 2015). When it comes to mal (wealth), the main goal of Sharia is the legal protection of funds. How funds should be invested is only a secondary goal. However, Islamic banks put profit maximization first. Despite various profitable investments, Islamic banks should prioritize protecting the wealth of depositors instead of investing just to get higher profits. Islamic banks are advised not to engage in normal profit-seeking or maximize their funding sources as financial gains. Some also argue that Islamic banks pay less attention to the overall well-being of society (Khairul Mukminin, 2019). A critical study on the performance of international financial institutions shows a gap between the reality of these institutions and the goals of Islamic economics. Instead of bringing benefits to society, the Islamic banking and finance industry has achieved high profit margins (Sabirzyanov and Hashim, 2015).

From the perspective of Sharia, regarding interests, the rights of Allah must be given supreme status, and human rights will come after all other commitments are fulfilled. In the long run, Islamic banks can protect the value of wealth and other higher values by upholding Sharia, so they should put protection first, followed by establishment and cultivation (Khairul Mukminin, 2018).

Sharia compliance

In the case of Islamic financial transactions, all deals must follow and comply with Islamic law and business transaction rules. Sources of Islamic law include the Quran and Sunnah, along with secondary sources like ijma' and qiyas (Engku Rabiah Adawiah, 2013). The concept of Shariah compliance is often misunderstood as just meeting the minimum legal requirements set by Islamic jurisprudence. Instead, Shariah compliance means growing Islamic finance within the spirit and value system of Islam, and achieving the ideals and goals of Shariah in the financial sector (Laldin and Furqani, 2013a). Maqasid al Shariah is seen as a grand framework that provides guidelines and direction to ensure maslahah (benefit) is achieved and mafsadah (harm) is prevented in all financial contracts (Laldin and Furqani, 2012).

For branch managers, achieving both profit maximization and Shariah compliance is not easy, because in Malaysia, both Islamic and conventional products are offered at the same branch. When this happens, it is clear that there is a mix of lawful and unlawful practices. Although some banks separate the branches that offer Islamic products from those offering conventional ones, it is still questionable whether their daily operations follow Islamic rules. This is not a major issue because the products they offer are Shariah-compliant; it is a micro-level issue. Islamic banks have focused on Shariah-compliant products since they started, rather than products based on Shariah, so the problem is whether daily practices follow Shariah. In other words, do the daily operations of Islamic subsidiaries follow Shariah? In reality, achieving Shariah compliance at a macro level is much harder than at a micro level.

The idea of wealth circulation is a macro goal of Shariah, while the ideas of fair and transparent financial practices relate to the micro goals of Shariah regarding transaction tools and mechanisms. As mentioned before, the role of Islamic banks is to move wealth from the rich (surplus sector) to the poor or those in society who need funds (deficit sector), so that effective wealth circulation can be achieved in society. However, if Islamic banks do not practice what they should and instead act like conventional banks, this goal is hard to reach. If Islamic banks are not much different from conventional banks, the main goal of setting up Islamic banks will remain just a theory.

Islamic Banking: Theory and Reality

In theory, Islamic banking is a subset of the Islamic economic system, aimed at achieving a just, fair, and balanced society, which is written in Sharia (for example, see Ahmed, 1972; Chapra, 1985, 2000; and Siddiqi, 1981). The ban on interest, gambling, and excessive risk is meant to create a fair playing field to protect social interests and promote social harmony (Dusuki and Bouheraoua, 2011).

However, in reality, Islamic banks are a subset of conventional parent banks, and those parent banks are a subset of the capitalist economic system. This conceptual framework was developed based on the arguments presented in the previous sections. This is common in Malaysia and Pakistan, where Islamic banks are often subsidiaries of conventional parent banks. Both the conventional parent bank and the Islamic subsidiary are part (subsets) of the capitalist economy. The CEO, chairman, and board of directors of the conventional parent bank are the parties who may influence the decisions of the CEO, chairman, and board of directors of the Islamic subsidiary. Sharia board members provide advice on Sharia issues and may communicate directly with the boards of Islamic subsidiaries. On the other hand, the Sharia committee may not have direct contact with the general managers and branch managers of Islamic subsidiaries. Because they act as advisors to the boards of Islamic subsidiaries, Sharia board members may not have authority in the decision-making process. Managers may have more power than the Sharia committee during the decision-making process (for example, see Ullah et al. (2016)).

Challenges in implementing Sharia in Islamic banks. The main motivation for choosing Islamic banks is to avoid interest and follow Sharia (Bley and Kuehn, 2004; Haque et al., 2009; Hanif et al., 2012). However, following Sharia has been one of the biggest obstacles for Islamic banks. This section discusses the challenges of implementing Sharia. The main challenges include a lack of understanding among staff and managers of Islamic banks regarding the primary goals of establishing these banks. Customers are willing to pay high prices for products and services that follow Sharia, which helps the high profitability of Islamic banking (Lee and Ullah, 2008, 2011). However, achieving Sharia goals has become one of the biggest challenges for Islamic banks. Ullah (2014) found that Islamic banks in Bangladesh do not follow Sharia well, especially in investment activities, where there are serious Sharia violations. This happens because of a lack of knowledge and seriousness about following Sharia, a lack of proper care in Sharia audits, and a lack of skill and experience among members of Sharia supervisory boards.

Islamic banks face tough competition from traditional banks when creating new products. A simple solution is to rely on a loose interpretation of Sharia, which helps Islamic banks compete faster in profitable markets. The difficult way is to improve management and introduce different products based on profit and loss sharing (PLS) (Warde, 2000, p. 153). The literature shows that many Islamic banks choose the first solution. Because of this, Sharia compliance, which is the pillar of Islamic banking, has to take a backseat.

The main challenges Islamic banks face in following Sharia include: (1) the different goals of Islamic subsidiaries and their traditional parent banks; (2) the goal of Islamic banks to maximize profit; (3) the role of branch managers.

Different goals between Islamic subsidiaries and their parent companies

As Adam Smith proposed in his book The Wealth of Nations, business goals are based on a capitalist economy. Under a capitalist system, individuals are not limited by profit and are allowed to pursue their own interests. Built on Adam Smith's capitalist economy, a company's main goal is to maximize profit and increase market share. In other words, the main goal of a company is to maximize the wealth of the shareholders who contribute to the company and expect to make a profit from their investment. Shareholders appoint managers, who act as agents, to ensure the company's daily operations align with its goals.

The goals of traditional banks align with the economic theory proposed by Friedman (1970). As Friedman (1970) pointed out, company executives or managers are hired by the business owners and have a direct responsibility to those owners, who are their employers. They have a responsibility to run the business to maximize the company's profit while following the basic rules of society, whether required by law or ethics. According to Friedman's (1970) theory, the main goal of a traditional bank's parent company is to maximize shareholder wealth.

On the other hand, the main goal of establishing an Islamic bank is to follow the rules of Sharia, provide benefits to society as a whole (Warde, 2000), and protect the public interest (achieving maslahah). In other words, Islamic banks are built on a religious foundation, and making a profit is only a secondary goal for them. The business side of an Islamic bank works hand-in-hand with religion and the core content of Sharia (Engku Rabiah Adawiah, 2013). Therefore, there are different goals between a traditional parent bank and its Islamic subsidiary.

In an Islamic bank, the goals of the managers and the Sharia board are expected to be the same. In other words, the main goal for both sides is to meet the requirements set out in the Sharia amendment. However, evidence from experience shows this is not the case. For example, in a 2016 study by Ullah and others, these areas were used to check if managers and the Sharia board had the same goals: social welfare, ethical investment, fairness and justice, charity, solidarity, profiteering, secured investment, and traditional mutual benefit. Based on interviews, they found that managers only placed a moderate amount of importance on social welfare, fairness and justice, charity, and solidarity. On the other hand, the Sharia board places high importance on these areas because their main goal is to earn the pleasure of Allah. Regarding profits, managers believe maximizing profit is the main reason for starting an Islamic bank, and they are willing to sacrifice fairness and justice to get high returns. For secured investment, managers prefer financial tools that are convenient, safe, and offer a fixed return. Managers do not like profit-sharing tools like mudarabah and musharakah because these tools are risky and make investment returns uncertain. To compete with traditional banks, managers at Islamic banks choose to offer products similar to those of traditional banks to meet customer needs. Sharia scholars say that managers even ask them to find ways to make all traditional products comply with Sharia. Since managers have more power in decision-making than Sharia scholars, the managers use several pressure tactics to get the scholars to accept the lowest level of Sharia compliance in matters related to Sharia.

For subsidiaries of traditional parent banks, the boards of the Islamic subsidiaries are not independent because they must follow instructions set by the board of the traditional parent bank (see Figure 1). Then, these instructions are passed to the branch managers of the Islamic subsidiary. At the same time, branch managers must follow Sharia rulings passed by Sharia authorities and upheld by the Islamic subsidiary's Sharia board. As mentioned, the parent bank and the Islamic subsidiary have different goals because the former is based on a capitalist economy, which is non-Islamic, while the latter is based on Sharia. To make sure the goals of the parent bank and the Islamic subsidiary align, the Islamic subsidiary only achieves the minimum level of Sharia compliance.

If the parent bank is a conventional bank and the subsidiary is an Islamic bank, how can competition between the two types of banks be achieved when the Islamic bank is just a subsidiary of a conventional parent company? Of course, these subsidiaries do not compete with their parent banks. Instead of competing with or being different from conventional banks, Islamic banks end up imitating the products and practices of conventional banks. This goes against what Dusuki and Abdullah (2014) argued, which is that Islamic banks should compete with conventional banks. Therefore, Islamic banks must realign their goals with the goals of Sharia.

The main challenge for conventional banks transitioning to Islamic banks is the goal of profit maximization while complying with Sharia principles (Shafii, Shahimi, and Said, 2016). Some argue that the operations of Islamic banks are similar to those of conventional banks, except that the former must follow Sharia rulings (Haniff, 2011; 2014). In the current context, Islamic finance tries to gain profitability and efficiency from traditional finance by changing its external structure. Making these changes without altering any substance is not enough, because the goals of the capitalist system are still maintained. For example, current Islamic finance products are modified from traditional counterparts to meet Islamic law requirements (Laldin & Furqani, 2013b, pp. 32-33).

According to Al-Atyat (2007) and Al-Atyat and Hakeem (2010), as cited by Ahmed and Hussainey (2015), the main reason for switching from traditional banking to Islamic banking is to use the profitability of Islamic banks. Many studies prove that Islamic banks are more profitable than traditional banks (for example, see the research by Khediri, Charfeddine, and Youssef (2015), and Ramlan and Adnan (2016)). This also relates to the motivation of managers entering the Islamic banking industry to use the industry's profitability, rather than achieving Sharia goals from the overall business model (Ullah et al., 2016). A study on Islamic banking practices shows that wealth maximization, Sharia rulings (fatwa), the competitive environment, and minimal risk management approaches in the Islamic banking industry push Islamic banks to adopt debt-based financing. Islamic banks defend their practices by adopting Sharia rulings from Sharia scholars to make them comply with Sharia, but they are not based on Sharia. The study concludes that the policies and practices of Islamic banks have deviated from Islamic banking theory and Islamic principles. The focus of Islamic banks has always been on profit maximization rather than social welfare (Ahmed, Akhtar, Ahmed, and Aziz, 2017).

Al-Omar and Iqbal (1999) raised questions about the authenticity of large multinational banks operating in the Islamic banking industry. Their participation in the Islamic banking industry is purely a business activity to use the profitability of Islamic banking operations. Another worrying issue is whether traditional banks strictly follow Sharia regulations and comply with the rules of the Islamic banking industry. Some people think the main factors affecting the shift from traditional banks to Islamic banks are risk and profitability (Al-Alani and Yaacob, 2012).

As previous studies cited by Shafii, Shahimi, and Saaid (2016) show, an environment where Islamic banks operate alongside traditional banks does not fully support Islamic banks in following Sharia principles, because these banks are based on traditional economic systems (for example, see the study by Al-Oqool (2011); Al-Atyat (2007); Al-Martan (2005); Al-Omar & Iqbal (1999); and al-Rabiaa (1989)).

Research in the literature highlights many challenges and obstacles to successfully converting traditional banks to an Islamic banking model. Most studies (for example, Alani & Yaacob, 2012; Al-Oqool, 2011; Al-Atyat, 2007; Al-Martan, 1999) prove that human resources, regulations and legislation, Sharia compliance, and Islamic banking products are the main obstacles affecting the shift of central banking institutions to Islamic banking.

The role of managers

According to Azid, Asutay, and Burki (2007), company managers have two main duties. These are (1) maximizing profit for shareholders and (2) protecting the interests of stakeholders. Stakeholders include not only employees, customers, and suppliers, but also society and the environment. The second role aligns with the goals of Sharia (maqasid), where activities should benefit the entire Ummah, covering human life and well-being. Since Islamic banks often operate as subsidiaries of larger conventional entities, managers are caught between following instructions from top management or the board, and following Sharia rulings passed by the Sharia board, which is a primary requirement for an Islamic entity. In an Islamic subsidiary of a conventional bank, the branch manager is responsible for carrying out instructions set by the board. At the same time, he or she must also follow Sharia rulings passed by the Sharia board. The parent conventional bank aims for profit maximization, which fits a capitalist economic system, while the Islamic subsidiary aims to achieve Sharia goals. This puts the manager in the middle of these two objectives. Because the Islamic bank is just a subsidiary of a conventional parent bank, the goals of both entities must align. Therefore, the goal must be profit maximization.

Another major issue is the background of the managers themselves. Literature widely suggests that managers in Islamic banks lack Sharia knowledge and exposure because they often come from conventional backgrounds. If people who should follow Sharia rules do not clearly understand Sharia principles, then carrying out Sharia rulings will be difficult.

Conclusion and suggestions

The Islamic banking and finance industry started nearly forty years ago. However, many issues remain unsolved today, and new problems keep appearing alongside the growth of Islamic finance. One main reason why issues remain unresolved is that there is no clear distinction between Islamic banks and traditional banks, as both systems coexist in the same economy. Even though Malaysia is known as a center for Islamic banking and finance, there are only two full-fledged Islamic banks; Bank Islam and Bank Muammalat. All other Islamic banks are just Islamic subsidiaries of large conventional banks.

Setting up Islamic subsidiaries for conventional parent banks has caused many unsolved problems. This is likely because the conventional parent banks and their Islamic subsidiaries have different goals. The main goal of a conventional parent bank is to maximize profit for shareholders, while the main goal of an Islamic subsidiary is to follow Sharia rules, with profit being only a secondary goal. Managers who should carry out and follow Sharia rulings still have to follow orders from the top management at the conventional parent bank. The Islamic subsidiary and the traditional parent bank operate out of the same branch. Staff members who work for the traditional parent company also have to handle duties for the Islamic subsidiary. In this situation, conflicts of interest are almost impossible to avoid.

Since most Islamic banks in Malaysia are subsidiaries of traditional banks, and staff often face conflicts of interest between traditional and Islamic banking tasks, the best solution may be to train staff and managers to deeply understand Islamic banking and Islamic teachings. This knowledge helps staff realize why it is important to keep Islamic and traditional banking tasks separate, as there should be a clear distinction between the two.

In short, following Sharia at a minimum level is not enough to truly fulfill Sharia. To reach the goals of Islamic banking, the Islamic spirit of sincerity and honesty should be rooted in the hearts of the managers and staff. If managers and staff have a strong Islamic spirit and always aim for maximum Sharia compliance, then the goals of Islamic banking—such as social justice, poverty relief, and preventing exploitation—can finally be achieved. view all

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Summary: This Muslim knowledge guide translates and explains Mahmoud A. El-Gamal's discussion of an Al-Azhar fatwa on bank interest, fixed investment profits, riba, mudaraba, jurist disagreement, historical context, and whether bank returns can be treated as lawful investment income.

I posted a screenshot of a book written by Imam Chen Yufeng on my social media. At the end of the book, Imam Chen shares a personal experience regarding interest. He mentions that issue 168 of the Al-Azhar Journal once ruled bank interest as lawful. A friend later found the original source of this fatwa, along with a commentary article explaining the background of the ruling, titled

“The recent Azhar fatwā:Its logic, and historical background”

I will not post the link here, so please search for it yourself. The original text is in English and includes the Arabic version. I have translated the article below for your reference, as it complements the post I shared earlier.

You cannot buy Imam Chen's book, and there is no digital version, so please stop asking me how to purchase it.







“The recent Azhar fatwā:Its logic, and historical background”

Author: Mahmoud A. El-Gamal

Rice University, USA
Author's Preface:

I am not a jurist, but an academic researcher. Therefore, I am not qualified to endorse or reject this fatwa. The purpose of this article is only to explain and summarize the ruling. To explain what this fatwa says? It says nothing. How scholars view it and the logic behind it.

What does this religious ruling (fatwa) say?

It is perfectly fine to deposit your money in a bank and appoint the bank as your agent for investments in exchange for an agreed-upon profit. Neither the Quran nor the Hadith forbids this kind of deal where profit or payment is set in advance, as long as both sides agree to it.

There is no doubt that both sides agreeing to a set profit beforehand is allowed under Islamic law. It also makes logical sense so that each party knows exactly what their share will be.

As everyone knows, a bank only sets these profits or returns for clients after carefully studying global and local markets, economic conditions, the specifics of each deal, the type of investment, and the average expected profit.

This set profit rate can go up or down over time. For example, an investment project might start with a 4% return, grow to over 15%, and then recently drop back to near 10%.

The people who set these rates and manage their changes must follow government rules. Setting a fixed number in advance—especially in these times when honesty is rare—benefits both the investors and the bank.

Investors benefit from stable profit rates, which helps them plan their lives. Bank managers benefit from performance incentives, which push them to work harder to maximize profits and keep the bank profitable even after paying the investors their set returns. What if the bank loses money during that time? How can it set a profit rate in advance? The answer is that a bank might lose money on one investment but make a profit on many others, which covers the loss.

In short: it is allowed for someone to invest money through an institution into a bank or other financial firm with a pre-set profit. There is nothing suspicious about it. This type of transaction is judged by its benefits and is not considered associating partners with Allah (shirk). Therefore, investing money in a bank with a pre-agreed profit or return is allowed and causes no harm. Allah knows best.

What does this religious ruling (fatwa) not say?

Please note that this fatwa does not explicitly state that all bank interest is halal.

Dr. Tantawi has clearly stated elsewhere that interest on bank deposits is riba, and interest on bank loans is also riba. (See Mucamalat al-Bunuk..., 2001, pp. 139-142)

There are three points of contention here.

First, are funds held for business operations considered deposits?

Second, are funds borrowed for business operations considered loans?

Third, is it forbidden to pre-determine the profit for one party in an investment activity?

There is little disagreement regarding deposits.

There is substantial disagreement regarding loans:

Abdullah Al-Najjar explains Dr. Tantawi's position as follows:

Funds given to a bank cannot be seen as a form of loan because the bank has no need, and only those in need apply for loans. Anas ibn Malik reported that the Prophet said: 'On the night of the Ascension, I saw written on the gate of Paradise: Charity is rewarded tenfold, and a loan is rewarded eighteenfold.' I said: 'O Jibril!' Why is borrowing more expensive than giving charity? The angel Jibril said: 'Because a beggar asks when they still have something, but a borrower only asks when they are in urgent need.' — Sunan Ibn Majah

Therefore, if a transaction is not a loan, bank customers must be seen as investors who intend to seek profit from the bank (the bank announces the return rate they pay, and customers choose the bank they prefer).

Jurists believe that once deposit funds are used, they are promised, and because holding a guarantee (like a loan) is more reliable than holding a trust (like a deposit), the deposit contract becomes a loan, and any increase is forbidden interest (riba).

the 'preset profit' in profit-sharing (mudaraba) is the core of what this Islamic law forbids.

Al-Qaradawi and many others believe that the hadith regarding sharecropping (muzara'ah) provides the basis for the prohibition. The Sharia committee mentioned the claim of 'consensus' put forward by Ibn Qudamah in Al-Mughni and confirmed that this 'consensus' is as binding as the classical texts.

The 14th session of the Fiqh Academy, January 2003, Decision #133 (7/14), pages 20-24.

Religious law and secular law describe the relationship between a depositor and a bank as a loan relationship, not an agency relationship. In contrast, an investment agency is where an agent invests funds on behalf of a principal in exchange for a fixed wage or a share of the profits. In this regard, religious scholars have a consensus that the principal owns the investment funds and therefore has the right to receive investment gains and is responsible for losses, while the agent has the right to receive a fixed wage under the conditions set by the agency. Therefore, a traditional bank is not an investment agent for the depositor. The bank receives funds from the depositor and uses them, thereby guaranteeing said funds and making them a loan. In this regard, the loan must be repaid at face value without any increase.

For centuries, jurists from all schools have agreed that you cannot pre-set investment profits in any partnership, whether as a fixed amount or a percentage of the capital. This ruling is based on the idea that pre-setting profits guarantees the principal, which goes against the nature of a partnership where you must share both profits and losses. This consensus is well-established and has no reported disagreements. In this regard, Ibn Qudamah wrote in Al-Mughni (Volume 3, page 34): All scholars agree that if one or both parties set a known amount of profit, the partnership (qirad or mudaraba) becomes invalid. The consensus of religious scholars is itself a legal proof.

Pre-specifying profits

Dr. Tantawi and his supporters rejected the loan issue and held a long discussion on the problem of pre-set profits. Dr. Tantawi cited Abdul-Wahhab Khallaf and Dr. Ali Al-Khafif to support his view that it is inappropriate to limit investment institutions to traditional mudaraba, which has profit sharing but no specific profit amount.

The main argument for fixed profits

Tantawi (2001, page 131) quoted Khallaf (pages 94-104), Al-Khafif (pages 165-204), and others (pages 204-211) word for word, saying: In this era of corruption, dishonesty, and greed, not fixing profits as a percentage of capital would leave the principal at the mercy of the agents managing the investment funds, whether they are banks or other institutions.

Therefore, he and earlier scholars turned to the well-known issue of moral hazard, which is unrelated to profit distribution.

Second, once the loan or deposit argument is rejected, the remaining issue is how to handle the consensus theory in Al-Mughni and the hadith it is based on.

Is the claim of consensus accepted? Is it binding?

Does this decision have a basis in the Quran and Sunnah, or can it be overturned?

If a partnership is considered flawed because the profit margin is predetermined, does this make it forbidden interest (riba), or is it a permitted lease (ijara), such as whether a mutually agreed upon (though uncertain) wage payment is legal?

Hadith on tenant farming.

Hanzalah ibn Qays narrated: I asked Rafi ibn Khadij about renting land for gold and silver. Rafi replied: 'There is no harm in this. In the time of the Prophet, people rented land for the crops and straw that grew along the waterways. Sometimes there was a harvest, and sometimes there was none. People rented land this way, so the Prophet forbade it. As for rent that is fixed and guaranteed, there is no harm.'

— Sunan Ibn Majah

This hadith shows that it is forbidden to pre-arrange any geography, time, or quantity for land rented to tenant farmers. Jurists concluded that because of uncertainty, predetermined compensation for either party is not allowed. This ruling on tenant farming applies to other partnerships, including profit-sharing partnerships (mudaraba). Therefore, Ibn Qudamah believed that jurists reached a consensus that it is not allowed to pre-specify profits in a mudaraba.

Dr. Abdullah Al-Najjar wrote a detailed discussion on this hadith and the conclusions drawn from it. He argued that the prohibition does not stem from the condition of pre-specifying profit itself, but from the uncertainty (gharar) that could lead to disputes (citing the narrative and analysis in Al-Shawkani's Nayl Al-Awtar). On the other hand, he argued that this type of partnership is essentially an employment contract with an unknown reward, and is therefore full of uncertainty. However, a consensus ruling actually permits this contract (including profit sharing) despite the uncertainty (as Ibn Qudamah stated). Therefore, this type of partnership belongs to a category of contracts where uncertainty (including that caused by pre-specifying profit) is ignored, as long as it does not lead to legal disputes.

Dr. Al-Najjar presented many other arguments based on the analysis of Al-Shawkani and Ibn Qudamah. He said: This might be Rafi's own non-binding conclusion; it might be limited to specific types of tenant farming; Zayd ibn Thabit disagreed with this hadith, claiming it related to a specific incident where one person killed another (recorded by Abu Dawud); the hadith narrated by Ibn Umar suggests that renting land is permitted (recorded by Bukhari), which challenges the hadith; other companions of the Prophet, including Ibn Abbas and others, disagreed with Rafi's view. Ibn Qudamah said that some of Rafi's narrations differ from the consensus of the companions and must therefore be discarded.

At the Al-Azhar conference, Dr. Muhammad Rif'at Uthman presented a counter-argument. According to Al-Nawawi, the hadith does not forbid renting land for a fixed rent (which was the focus of previous arguments), but it does forbid pre-specifying profits.

Most jurists believe that a profit-sharing partnership (mudāraba) that is known to be flawed or invalid from the start is not allowed. Dr. Tantāwī focuses on the consensus view that when a mudāraba is considered flawed, such as when an investor's profit is specified in advance, the contract becomes an employment contract ('ijara). Under this, the entrepreneur or worker is entitled to a market wage, as noted by ibn al-Humām in Fath Al-Qadīr and Al-Shaficī in 'um. He summarizes this (2001, p. 133):

Therefore, we say that a bank investing for a pre-specified profit becomes an employee of the investor. The investor accepts the amount the bank gives them as their profit, and any excess profit, whatever it may be, is treated as the bank's wage. Thus, this type of transaction is free of interest (Ribā). In short, we cannot find any canonical text or convincing analogy that forbids specifying profit in advance as long as both parties agree.

Quotes from early jurists

Dr. Tantāwī (2001, p. 95) quotes Dr. Khallāf, who in turn quotes Muhammad Abduh's 1906 article in Manār (#9, p. 332): When a person gives their money to another for investment and receives a known profit, this does not constitute clearly forbidden Ribā, regardless of the pre-specified profit rate. This is because legal rules that disagree on forbidding pre-specified profit do not constitute the clear type of Ribā that ruins families. This type of transaction is beneficial to both the investor and the entrepreneur. In contrast, Ribā for the borrower is only due to need and is not their fault, while for the lender, Ribā leads to greed and a hardened heart. These two types of transactions cannot have the same legal status (hukm).

Dr. Khallāf, in Liwā' 'Islām (1951, #4 (11)), continues (quoted in the same, pp. 95-6): There is no evidence that profit cannot be specified in advance. Just as profit can be shared between two parties, the profit for one party can also be specified in advance. Such a condition might not align with the views of jurists, but it does not contradict any canonical text in the Quran or Sunnah.

Core argument

Dr. Khallaf summarizes the basis for the current Al-Azhar ruling as follows: The only objection to this type of transaction is the validity of mudāraba, which requires that profit must be set as a percentage share rather than a specific capital amount or percentage. My response to this objection is as follows: First, there is no evidence for this condition in the Quran or the Sunnah. We live in a very dishonest time now, and if we do not set a fixed profit for the investor, his partner will swallow up his wealth.

Second, if a mudāraba is considered flawed because it violates one of its conditions, the entrepreneur becomes an employee, and what he takes is considered a wage. There is no difference in calling it mudāraba or 'ijāra: it is a valid transaction that benefits the investor who cannot invest funds directly and benefits the entrepreneur who receives the funds. Therefore, this is a transaction that benefits both parties without harming either side or anyone else, and banning such a beneficial transaction will harm the Ummah.

Key points

Recent academic journals from Al-Azhar do allow certain types of bank interest to be used as investment profit.

This fatwa is at least a century old.

Most jurists oppose this fatwa.

A minority have questioned the authenticity, authority, and applicability of the hadith regarding sharecroppers.

A minority have questioned the logic of prohibiting the pre-specification of profit.

Can we still claim that a consensus exists?

If this issue is controversial, should we proceed with caution? Should we follow the view of the majority? view all

Reposted from the web

Summary: This Muslim knowledge guide presents a critical look at Islamic finance, including Sharia compliance, profit-and-loss sharing, murabaha, interest benchmarks, social justice concerns, scholar critiques, banking practice, and the gap between ideal Islamic finance and real-world banking.

This article is a collection and compilation of critiques on Islamic finance. The content mainly comes from the English Wikipedia entry 'Challenges in Islamic finance' and various scholars' blogs. The skepticism from these foreign scholars shows that so-called 'Islamic finance' is not as competitive as we imagine. It has many problems and perhaps should not even be promoted under the name 'Islamic'.



The challenge facing Islamic finance is the difficulty of providing modern financial services without violating Sharia law. The development of the Islamic banking and finance industry centers on avoiding interest, which is seen as an unjust and exploitative gain in trade or business.

Most Islamic banking customers come from the Gulf and developed countries in the Muslim world. Challenges include the fact that interest rate benchmarks have been used to set Islamic 'profit' rates, so the 'net returns are not substantially different from interest-based transactions'. In essence, Islamic banking is 'nothing more than a matter of changing contracts...'.

Religiously, Islamic finance prefers a profit and loss sharing (PLS) model. However, this causes problems, including the need to wait for investment projects to generate earnings before profits can be distributed, which increases risk and complexity for financial service providers.

The Islamic finance industry has been praised for developing a 'theory' into an industry worth about 2 trillion US dollars. It has attracted banking users who could not use traditional banking services for religious reasons, drawn non-Muslim bankers into the field, and (according to other supporters) introduced a more stable and lower-risk form of financing.

However, the industry is also criticized for ignoring its 'basic philosophy' and moving in the wrong direction for decades, leading both outsiders and ordinary Muslims to question it. First, it abandoned the original financing method advocated by its promoters—risk-sharing financing—in favor of fixed-markup purchase financing (especially murabaha). It then distorted the rules of fixed-markup murabaha to effectively provide traditional cash interest loans like conventional interest rates, but disguised them with 'word games' while bearing 'higher costs and greater risks'.

Other issues and complaints raised include that the industry has made no effort to help small vendors and the poor. How to deal with the problem of inflation; Delayed payments; A lack of currency and interest rate hedging; Or a lack of short-term cash deposit accounts that follow Sharia law; Most Islamic banking businesses are owned by non-Muslims;

In a series of interviews with Pakistani banking professionals (traditional and Islamic bankers, Sharia banking advisors, business people using finance, and management consultants) in 2008 and 2010, economist Faisal Khan noted that many Islamic bankers expressed 'skepticism' about the differences, or lack thereof, between traditional and Islamic banking products. He also noted a lack of external Sharia compliance audit requirements for Islamic banks in Pakistan, and that Sharia boards lacked awareness of their banks failing to follow Sharia-compliant practices or were unable to stop them. However, this did not stop devout people from using the banks (one person explained that if his Islamic bank was not truly following Sharia, 'the punishment is on their heads, not mine!'); I have done what I can do.

An estimate of customer preferences in the Pakistani banking industry (provided by a Pakistani banker) is that about 10% of customers are 'strictly traditional banking customers,' 20% are strictly Sharia-compliant banking customers, and 70% prefer Sharia-compliant banking but will use traditional banking if the 'price difference is significant.' A survey of Islamic and traditional banking customers found that Islamic banking customers were more observant (attending Hajj, performing namaz, keeping a beard, etc.), but they also had higher savings account balances than traditional banking customers, were older, better educated, traveled abroad more, and tended to open a second account at a traditional bank. Another study using 'official data' reported to the State Bank of Pakistan found that for lenders who received both Islamic (murabaha) financing and traditional loans, the default rate for traditional loans was more than twice that of the others. If the vote share of religious political parties increases, borrowers are 'less likely to default during Ramadan and in large cities, which suggests that religion—whether through personal piety or network effects—may play a role in determining loan defaults.'

As of 2016, the key challenges facing the Islamic finance industry, including Islamic bonds (sukuk), according to the 2015/16 State of the Global Islamic Economy Report and International Monetary Fund data, include:

Public awareness and understanding of Islamic financial products and services are low, which keeps people from using them.

There is a need to improve regulatory clarity and coordination, strengthen cooperation between Islamic and traditional financial standard-setters, and further improve regulatory tools. This is to address the complex financial products and company structures in some countries where regulatory frameworks fail to handle risks specific to the industry.

There is a scarcity of monetary policy tools that follow halal rules and a lack of understanding of monetary transmission mechanisms.

Underdeveloped safety nets and resolution frameworks. A lack of a complete Islamic deposit insurance system, where insurance premiums cannot be invested in halal assets, or a lack of a halal lender of last resort.

Regulators do not always have the ability or the will to ensure compliance with Islamic law.

Imitating traditional finance.

Some supporters of Islamic banking, such as Taqi Usmani, D. M. Qureshi, Saleh Abdullah Kamel, and Harris Irfan, and skeptics like Muhammad Akram Khan, Mohammad Omar Farooq, Feisal Khan, Mahmoud El-Gamal, and Timur Kuran, have studied the differences between Islamic and traditional banks and expressed regret over their similarities.

Taqi Usmani argues that Islamic banking has completely ignored its basic philosophy. First, it ignores the risk-sharing model (musharaka) between the financier and the user of funds, preferring fixed markup models like cost-plus financing (murabahah) and leasing (ijarah), which theoretically should only be used when risk-sharing is impractical. Second, it ignores the rules of cost-plus financing (murabahah) and leasing (ijarah) themselves. For example, it uses murabahah financing to borrow cash without even buying any goods in the process, or uses leasing (ijarah) where the lessor does not take responsibility for ownership or provide the lessee with any rights of use.

Interest rate benchmarks are used to set Islamic profit rates, so the net result is not substantially different from interest-based transactions. Ignoring these basic principles weakens the influence of Islamic banking among non-Muslims and especially the general public. Usmani believes the public now has the impression that Islamic banking is just a matter of swapping documents.

In March 2009, Usmani declared that 85% of Islamic bonds (sukuk) were non-Islamic. At the time, Usmani was the chairman of the Sharia board for the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), which sets standards for the global Islamic banking industry. Others, such as Hassan Heikal, have also criticized the authenticity of Islamic bonds.

Another pioneer of the Islamic banking industry, DM Qureshi, told a questioner at a 2005 Islamic banking conference, 'With all due respect, today's Islamic banking is a labeling industry.' Everything traditional is just given a new label, and then you call it Islamic.

Mohammad Najatuallah Siddiqui also criticized the trend of copying traditional interest-based financial tools and making minor changes to terms and phrases, such as using sukuk for bonds or tawarruq for loans. He said this trend gives Islamic finance a bad reputation. One Islamic bank, Lariba, even issued a fatwa from its Sharia board, which included famous Sheikh Yusuf al-Qaradawi, stating: 'We have reached a consensus that there is no objection to using the word interest to replace profit or rate of return.' Siddiqui stated that practitioners of Islamic finance are eager to prove in theory that their finance is different from traditional finance, but in reality:

They are busy finding ways to make them similar. Starting around the 1980s, Sharia advisors mainly focused on designing alternatives to financial products that were already familiar to the market while trying to keep them compliant with Sharia.

A Muslim banker at Deutsche Bank, Harris Irfan, wrote about how he felt when selling Islamic banking products that did not truly comply with Sharia. He complained that he felt like a fraud, suffering from incoherent pietism and cognitive dissonance while trying to fit a square peg into a round hole.

Muhammad Akram Khan, a senior expert in Islamic economics, criticized Islamic banks for claiming to build their business on something other than interest while designing a series of tricks and ruses to hide interest.

Mahmoud Amin El-Gamal and Mohammad Fadel complained that Islamic banks charge fees that are too high. Fadel described the foundation of the industry as charging fees to create financial products that seem to meet the formal requirements of Islamic law while keeping all the economic features of traditional products.

El-Gamal described modern Islamic finance as Sharia arbitrage, which means taking advantage of price differences between Islamic and traditional markets because devout Muslims are willing to pay extra for financing they believe follows Sharia. In this system, a bank's Sharia board earns fees by finding a suitable classical Arabic name for an Islamic-style product and using that name to justify the Islamic brand and make it seem more credible.

According to Sayyid Tahir:

There is no evidence that the arrangements of Islamic banks are based on any kind of Sharia foundation. For example, the formulas for legal liquidity requirements, capital adequacy, and risk management standards in Islamic banks are the same as those in interest-based banks.

According to AW Duskuki and Abdelazeem Abozaid, the only difference investigators might find between Islamic finance and traditional finance is

in technical details and legal form, but the substance is the same. In fact, Islamic bankers use the same financial calculations as other bankers to figure out the present and future value of investments. Therefore, in the end, skeptical Muslims and other critical outsiders will find that Islamic banks actually charge interest, just under a different name like commission or profit.

Saleh Abdullah Kamel, the 1997 winner of the IDB Islamic Banking Prize, has a different view. He pointed out that the industry only has most of the features of traditional banking.

The investment models favored by Islamic banks have turned into a mix of loans and investments. This hybrid model has most of the features of interest-based loans and the flaws of the Western capitalist system. It does not highlight the features of Islamic investment based on risk-sharing and actual investment. It does not recognize the guarantee of capital and its returns.

Another criticism of mimicking traditional banking (raised by Mahmoud El-Gamal) is that imitating the 'past returns and past trends' of traditional finance, such as seeking to be the first bank to offer an 'Islamic hedge fund,' can bring huge initial profit margins. This is because the imitator is a 'first mover' in the Islamic finance industry and has 'access to monopoly markets and free indirect publicity.' This tempts other banks to try to follow suit, but long-term returns are often limited.

Skeptics of the industry have offered several explanations for why they believe the industry has failed to provide a real alternative to traditional banking. According to MO Farooq, Sharia boards face pressure, and it is indeed difficult to review the institutions that pay their salaries, which is a modern version of the medieval 'court ulama'.

Feisal Khan argues that Islamic banking is caught in a 'vicious cycle' where traditional piety conflicts with feasibility. Inspired by the Islamic revival movement, a large number of pious Muslims seek to finance, invest, and save in ways that do not use interest and 'standard debt contracts'. Efforts to provide interest-free alternatives that truly comply with Sharia—'participatory' or 'profit and loss sharing' financing—have failed because, in most cases, information asymmetry between the financier and the recipient makes this financing model unprofitable. Large banks are unwilling to let this obstacle stop them from profiting from the vast market of pious Muslims, so they look for 'scholars willing to certify traditional instruments as Sharia-compliant' and give more business to the most helpful scholars. The result is a 'fairly wide' range of financial products and services that 'closely' mimic traditional products and services but come with Sharia certification, which adds extra transaction costs.

Another explanation given by Farooq, citing Muhammad Nejatullah Siddiqi, is the shortage of Sharia experts. Generally speaking, these experts have not received enough training in the intent or purpose of Islamic law, so they cannot evaluate the pros and cons of certain financial products. They also lack training in economics and cannot analyze the consequences of using complex financial transactions like tawarruq, which allows lenders to provide cash to borrowers in a way that complies with Islamic law but is more complex and costly than traditional loans.

Timur Kuran argues that the importance of the Islamic economic foundation in Islamic banking is that it is primarily a tool to reaffirm the primacy of Islam, and only secondarily a tool for radical economic change.

The promises and challenges of profit and risk sharing.

According to a 2006 paper by Suliman Hamdan Albalawi, at least in Saudi Arabia and Egypt, Islamic banks no longer use profit and loss sharing (PLS) techniques as a core principle, and Malaysia has also seen a decline.

A study on the most commonly used Islamic finance models found that PLS financing in major Islamic banks dropped from 17.34% in 1994-1996 to just 6.34% of total financing in 2000-2006. In the sample, debt-based contracts or debt-like instruments were more popular. During the 2004-2006 period, 54.42% of financing was based on murabaha, 16.31% on ijara, and 5.60% on salam and istisna. Another survey of the largest Islamic banks released in 2010 found that the use of PLS ranged between 0.5% and 21.6%.

Authors Humayon A. Dar and J. R. Presley explain why PLS tools, where the financier provides capital and partnership financing, have dropped to a negligible percentage, including:

Bank clients have a strong incentive to report less profit than they actually earn, because the higher the declared profit, the more money the client must pay to the financing bank. This puts banks at a disadvantage when using PLS compared to using fixed-income models.

Property rights are not clearly defined in most Muslim countries, which makes it hard to share profits and losses.

Islamic banks compete with traditional banks that have deep roots and hundreds of years of experience. Islamic banks are still unsure about their own policies and practices, so they avoid taking on risks they cannot predict.

Profit and Loss Sharing (PLS) is often not suitable or possible for things like short-term resource needs, working capital, or non-profit projects in education and health.

In some countries, interest is treated as a business expense and is tax-free, but profit is taxed as income. Because of this, business clients who get funding through PLS pay higher taxes than those who take out loans and pay interest.

At least as of 2001, there was no secondary market for Islamic financial products based on PLS.

As a form of PLS, profit-sharing partnership (mudaraba) gives bank shareholders limited control and leads to an unbalanced governance structure. Shareholders want a consistent and complementary control system, but profit-sharing partnership (mudaraba) financing lacks this.

The industry has not been able to get customers to accept the periodic losses (the L in PLS) that come with investments. The profit-sharing partnership (mudarabah) feature, where bank clients and investors share in the bank's losses, is thought to make Islamic financial institutions more stable than traditional banks. In its 2015 paper, Islamic Finance: Opportunities, Challenges, and Policy Options, the International Monetary Fund listed ensuring that profit-sharing investment accounts (PSIA), also known as profit-sharing partnership (mudarabah) accounts, are handled in a way that keeps the financial system stable as a major regulatory challenge. Supporters like Taqi Usmani argue that normal trade activities naturally lead to occasional losses. They believe that expecting stable returns without any risk of loss is an unnatural product of capitalist banking, caused by separating finance from normal trade. Over decades of development, Islamic banking has faced bad debts and even major financial difficulties, such as the significant corruption scandal at the Dubai Islamic Bank in 1998.

However, at least up until 2004, no Islamic bank had passed bad debts on to its depositors. No Islamic bank reduced the value of depositor accounts when writing down the value of bad assets for fear of losing those depositors.

Beyond the disadvantages for lenders, critic Feisal Khan argues that the widespread use of profit and loss sharing (PLS) could cause serious damage to the economy. He points out that if banks held direct equity in every business as required by profit-sharing contracts (mudarabah) and partnership contracts (musharakah), credit would shrink. Central banks would then be unable to use standard credit expansion methods, such as buying bonds or commercial paper, to prevent the liquidity crises that occur in modern economies. While purists like Usmani are correct that cost-plus financing (murabahah) and other fixed-income tools—which have already pushed out PLS—are essentially just another name for traditional banking, banning them in favor of more authentic profit and loss sharing might leave central banks unable to prevent economic contraction and extreme unemployment.

Besides ignoring profit and loss sharing in favor of cost-plus financing (murabahah), the industry is accused of failing to follow Islamic law rules for murabahah. It often fails to buy or sell the actual goods or inventory that are a key condition for compliance. Banks do this when they want to lend cash rather than fund a purchase, even though it adds extra costs without serving any other purpose. In 2008, Arabianbusiness.com complained that sometimes there were no goods at all, only cash flowing between banks, brokers, and borrowers. Often, the goods have nothing to do with the borrower's business, and there are not even enough existing goods in the world to account for all the transactions taking place. Two other researchers reported that billions of dollars in synthetic murabahah transactions have taken place in London over the years, with many people doubting whether the banks actually owned the deposits or even the underlying assets.

Early supporters of Islamic banking called for setting up different accounts for different types of deposits so that earnings could be distributed to each type. Critic Muhammad Akram Khan argues that, in reality, Islamic financial institutions pool all types of deposits together.

Critics complain that banks following Sharia rules often just take the word of the bank or the borrower that they are following compliance rules, without doing real audits to check if it is true. An observer (L. Al Nasser) complained that when dealing with peers in the industry, Sharia authorities show too much trust in their subjects. He said Sharia audits are needed to reach transparency and make sure institutions keep their promises to customers. Also, when doing outside Sharia audits, many auditors often complain about the high number of violations they see but cannot discuss because the records they check have been tampered with.

Illegal gains

Even though Islamic banks forbid charging interest, their profit margins are usually based on interest rates. Islamic banker Harris Irfan says there is no doubt that benchmarks like LIBOR are still necessary for Islamic banks, and most scholars accept this no matter how imperfect the solution seems. However, Muhammad Akram Khan wrote that following the traditional bank benchmark LIBOR goes against the original purpose of designing and offering Islamic financial products.

Skeptics also complain that the returns on Islamic bank accounts are very close to those of traditional banks, even though their different mechanisms should theoretically lead to different numbers. A 2014 study using the latest econometrics techniques looked at the long-term relationship between time deposit rates at traditional banks and participation banks (Islamic banks) in Turkey. It found that the time deposit rates of three out of four participation banks were significantly cointegrated with those of traditional banks, and the causal relationship between Islamic bank yields and traditional banks was permanent. Skeptics believe this closeness shows that Islamic banks manipulate their yields. These banks are often smaller and have weaker foundations, and they feel the need to reassure customers about their financial competitiveness and stability.

Liquidity issues

The Islamic banking and finance industry lacks a way to earn returns on money that is parked short-term while waiting for investment, which puts these banks at a disadvantage compared to traditional banks.

Banks and financial institutions must balance liquidity—the ability to quickly turn assets into cash or cash equivalents in an emergency without a big loss when depositors need it—with competitive rates of return on funds. Traditional banks use the interbank lending market to borrow money for liquidity needs and invest for any period, including very short terms, to boost their earnings. Calculating the return for any period is simple: just multiply the loan term by the interest rate.

However, the profit and loss sharing (PLS) model preferred in Islamic finance means profits can only be shared after the invested project is finished. Since you cannot determine profit or loss in the short term, money deposited for a short time does not earn any return. Islamic financial institutions cannot use traditional interbank lending markets for short-term borrowing.

Because there are few or not enough Islamic money market investment tools, as of 2002, the liquidity—or money without returns—held by Islamic banks was on average 40% higher than that of traditional banks. The Islamic Financial Services Board found that the daily volume of interbank transactions between Islamic financial institutions, between Islamic and traditional banks, and between Islamic financial institutions and central banks is very low compared to traditional money markets. While Muslim countries like Bahrain, Iran, Malaysia, and Sudan have started developing Islamic money markets and issuing securitized documents based on profit-sharing partnership (musharakah), profit-sharing investment (mudarabah), and leasing (ijarah), as of at least 2013, the lack of a proper and effective secondary market means these securities are much smaller in number than those in traditional capital markets.

Regarding non-PLS, or debt-based contracts, one study found that the business model of Islamic banks is changing over time and moving toward taking on more liquidity risk.

To solve the problem of money held for liquidity or lack of investment opportunities not earning a return, many Islamic financial institutions, such as the Islamic Development Bank and Faisal Islamic Bank of Egypt, openly earn interest from their excess funds, which are usually invested in safer debt-like or overseas debt instruments. Sharia experts do not forbid this practice, but instead provide the necessary religious rulings (fatwa) to comply with Sharia based on the rule of necessity (darurah). Researchers Frank Vogel and Frank Hayes write:

Islamic finance and banking scholars cite necessity to allow exceptions and relax rules. They issued fatwas allowing Islamic banks to deposit funds into interest-bearing accounts, especially abroad, because these banks have no other investments during periods of necessity. However, they usually attach conditions to such fatwas, such as requiring that illegal earnings be used for religious charitable purposes like charity, training, or research.

Lack of social responsibility

According to Islamic teachings, Islamic banks should adopt new financing policies and explore new investment channels to encourage development and improve the living standards of small-scale traders, but Taqi Usmani complains that few Islamic banks and financial institutions focus on this. Islamic scholar Mohammad Hashim Kamali regrets that Islamic banks focus on short-term financing, which mainly focuses on financing already produced goods rather than creating or increasing production capital or focusing on facilities like factories and infrastructure.

Muhammad Akram Khan also complains that in the process of merging with traditional banking, Islamic bank product development mimics traditional banking instead of building a different type of banking consistent with fair and equal income distribution and ethical investment models.

Another scholar, Mahmoud El-Gamal, also regrets that Islamic banks value form over substance and suggests rebranding Islamic finance to emphasize issues like community banking, microfinance, and socially responsible investment.

Criticisms from other unorthodox economists are even more intense.

Muhammad O. Farooq questions the basic premise of Islamic banking, arguing that it focuses on abolishing all interest at the expense of the big picture of pursuing overall economic justice, and cites the Quran's warning against the concentration of wealth:

Whatever Allah has restored to His Messenger from the people of the towns is for Allah and for the Messenger, and for the near relatives and the orphans and the needy and the wayfarer, so that it will not be a perpetual distribution among the rich from among you...

He questioned if greed and profit are bigger causes of exploitation than loan interest. He believes that in a competitive and regulated market, loan interest might not actually count as interest.

The Islamic banking and finance movement has adapted to political tyranny. It is supported by a small, wealthy class of rentiers in the Muslim world and is increasingly manipulated by global financial giants. Because of this, it is easily limited to just talking about opposing exploitation, and it might even unintentionally become a tool for exploitation itself. The real world is full of exploitation, such as child exploitation, sexual exploitation, and labor exploitation. Interest might only be a small part of global exploitation. However, supporters of Islamic economics and finance remain obsessed with interest.

He used the profit motive of the East India Company as an example. Before 1858, the company colonized and ruled India at the expense of the Muslim Mughal Empire, and its shares were equity rather than debt instruments. He found it curious that although books promoting Islamic banking and finance often claim that loan interest exploits the poor and Muslims, there is almost no empirical or focused research on exploitation or injustice within Islamic economics. For example, Farooq complained that in two important bibliographies on orthodox Islamic economics, there was not a single citation about exploitation or injustice. These were 'Muslim Economic Thought: A Survey of Contemporary Literature,' which had 700 entries under 51 subcategories across 115 pages, and 'Islamic Economics: Annotated Sources in English and Urdu' by Muhammad Akram Khan.

Timur Kuran complained that Islamic banks in Egypt and other Muslim countries follow Western banking practices and do little to help economic development or job creation. However, they do not follow the practices of Western venture capitalists, who have funded the global high-tech industry. Since the operating principles of venture capital are the same as profit and loss sharing, even though venture capital does not avoid haram (forbidden) products, using venture capital could bring huge benefits to Egypt and other poor Muslim countries seeking economic development.

Lack of uniformity in Sharia.

Most Islamic banks have their own Sharia boards to rule on bank policies. Researchers Frank Vogel and Frank Hayes believe the four schools of Sunni Islamic law (Madhhab) do not agree on Islamic banking practices. They apply Islamic teachings to business and finance in different ways. There are disagreements on specific points of religious law both between the four schools and within them. Also, Sharia boards sometimes change their minds and overturn previous decisions.

Ibrahim Warde asks if boards just rubber-stamp the banks that pay their salaries. Munawar Iqbal and Philip Molyneux say that disagreements between boards about what counts as Sharia-compliant can cause trouble, because customers might doubt if a bank is truly following the rules. If Islamic banks are not seen as truly Islamic, they will quickly lose most of their market.

Late payments and defaults.

In traditional finance, late payments or loan defaults are discouraged by interest that keeps adding up. Muhammad Akran Khan says that controlling and managing late accounts has become a thorny problem in Islamic finance. Although many suggestions have been made to fix the problem of overdue loans in Islamic banks, Ibrahim Warde says:

Islamic banks face serious issues with late payments, not to mention outright defaults, because some people use every legal and religious trick to delay. In most Islamic countries, various forms of fines and late fees have been set up, but they have been banned or found impossible to enforce. Late fees, in particular, have been treated the same as interest. Therefore, debtors know they can pay Islamic banks last because there is no cost for doing so.

Warde also complained:

Many business people who borrowed large amounts of money for a long time took advantage of the shift to Islamic finance. They paid back only the principal and wiped out the accumulated interest. Given the double-digit inflation over the years, this was usually a tiny amount.

How to deal with inflation

Inflation is also a problem for financing. Islamic banks do not copy traditional banks; they actually provide loans without interest or any other fees. Whether and how to compensate lenders for money that loses value due to inflation is a problem that "troubles" Islamic scholars. If lenders lose money by giving loans, businesses will not be able to get financing. Suggestions include indexing loans to inflation, which many scholars oppose because they think it is a form of interest and encourages inflation. Other ideas include measuring loans by commodities like gold, or doing more research to find an answer.

The influence of non-Muslims

Almost all, if not all, customers of Islamic banking and finance are Muslims. But most financial institutions that provide Islamic banking services are Western and owned by non-Muslims. Supporters of Islamic banking believe that the interest Western banks have in Islamic banking is proof of strong and growing market demand, and therefore an "achievement of the Islamic movement."

However, critics complain that these banks lack a deep commitment to the faith of Islamic banking, which means:

The Muslims hired at these institutions have almost no input into actual management. This leads the Muslim public to sometimes have well-founded doubts about how seriously these institutions follow Sharia law. A traditional Malaysian bank offering Islamic investment funds was found to have invested most of these funds in the gambling industry. The managers running these funds are not Muslim.

The interest from traditional banks does not show that Islamic banking is growing stronger. Instead, it shows how similar Islamic and traditional banks are, so the latter can enter the Islamic banking sector without making any real changes to their business. El-Gamal doubts whether the interest of large non-Muslim banks in Islamic finance comes from the profitability of Islamic financial business.

When the market hits a downturn, these banks are more likely to exit the industry. Harris Irfan believes that non-Muslim banks like Deutsche Bank lack an ideological commitment to Islamic banking, which has led and will continue to lead them to exit the industry when the market hits a downturn. In early 2011, during the bursting of the real estate bubble, Deutsche Bank did not keep a single dedicated Islamic structurer or salesperson. Islamic finance has become a luxury that banks cannot afford. Perhaps partly because of this, in February 2011, the Central Bank of Qatar ordered traditional lenders to close their Islamic operations in the country by the end of the year. The central bank insisted that it was too much for traditional banks to follow alternative capital adequacy rules for Islamic finance, and it was hard to supervise and monitor the Islamic and traditional operations of commercial banks because depositors' funds would get mixed together.

Stability/Risk

Opinions differ on whether Islamic banking is more stable and carries less risk than traditional banking.

Supporters, such as Bank Negara Malaysia Governor Zeti Akhtar Aziz, believe that Islamic financial institutions are more stable than traditional banks because they forbid speculation and, in theory, the two main types of Islamic bank accounts—current accounts and profit-sharing accounts (mudarabah)—pose less risk to the bank.

In a current account, customers do not earn any return, and there is theoretically no risk of loss because the bank does not invest the funds in the account.

In a profit-sharing investment account (mudaraba), an Islamic bank faces less risk from loan defaults because it shares this risk with the depositors. If a borrower cannot repay some or all of the money the bank lent them, the amount distributed to depositors decreases by the same amount. In a traditional bank, depositors receive fixed interest payments regardless of whether the bank's income drops due to loan defaults.

Critics complain that this stability comes at the cost of the stability of the account balances for depositors or partners—a term Islamic banks often use instead of customers or depositors—who face risks that those in traditional banks do not. a critic named Mahmoud A. El-Gamal argues:

In these institutions, investment account holders have neither the protection of creditors in an Islamic financial institution nor the protection of equity holders represented on the institution's board. This introduces many other well-documented risk factors to the institution.

On the other hand, Habib Ahmed wrote shortly after the 2009 financial crisis that the practice of Islamic finance has gradually moved closer to traditional finance, which exposes it to the same dangers of instability.

When looking at the practice of Islamic finance and its operating environment, one can find trends similar to those that led to the current crisis. Recently, stock and real estate markets in the Gulf region have also experienced speculative events. Finally, the Islamic finance industry has grown rapidly with the innovation of complex financial products that comply with Sharia law. The risks of these new Islamic financial products are complex because these tools involve multiple types of risk.

In any case, several Islamic banks have failed over the decades. In 1988, the Islamic investment company Ar-Ryan collapsed, causing thousands of small investors to lose their savings. Later, an anonymous donor from a Gulf country covered their losses. This was a heavy blow to Islamic finance at the time. In 1998, the management of Bank al Taqwa collapsed. Its annual report stated that depositors and shareholders lost more than 23% of their principal. It was later discovered that management violated bank rules by investing more than 60% of the bank's assets into a single project.

Turkey's Ihlas Finance House closed in 2001 due to liquidity problems and financial distress. Faisal Islamic Bank also ran into difficulties and closed its operations in the UK for regulatory reasons. According to The Economist magazine, the 2009 Dubai debt crisis showed that Islamic bonds could help inflate debt to unsustainable levels.

Economic recession

According to a 2010 survey by the International Monetary Fund, Islamic banks showed stronger resilience on average than conventional banks during the 2007 to 2008 financial crisis, but they faced greater losses when the crisis hit the real economy.

At the start of the 2007-2009 Great Recession, Islamic banks were unscathed. One supporter of Islamic banking wrote that the collapse of major Wall Street institutions, especially Lehman Brothers, should encourage economists worldwide to look at Islamic banking and finance as an alternative model. However, the impact of the financial recession gradually shifted to the real sector, affecting the Islamic banking industry. According to Ibrahim Warde, this shows that Islamic finance is not a panacea, and a faith-based system is not automatically immune to the unpredictability of the financial system.

Concentrated ownership

Munawar Iqbal and Philip Molyneux believe that concentrated ownership is another danger to the stability of the Islamic banking and finance industry. They wrote:

Three or four families own a large portion of the industry's shares. If anything happens to these families, or if the next generation of these families changes their priorities, this concentration of ownership could lead to serious financial instability and potentially cause the industry to collapse. Similarly, the experience of national-level trials is mostly based on the initiatives of non-elected rulers.

Macroeconomic risks

Harris Irafan warns that the macroeconomic risks of Islamic banking create a multi-billion dollar ticking time bomb of unhedged currency and interest rates. The difficulty, complexity, and cost of hedging these currencies and interest rates in a proper Islamic way are so high that as of 2015, the Islamic Development Bank was losing cash rapidly, as if it were funding a war. Without relying on conventional markets, it simply cannot consistently exchange dollars for euros or vice versa. Regional Islamic banks in the Middle East and Malaysia do not have trained professionals to understand and negotiate Sharia-compliant treasury swaps, nor are they willing to hire consultants with experience in this area.

High costs and low efficiency

Mohamed El-Gamal believes that because Islamic financial products mimic traditional ones but operate under Sharia rules, they require extra fees for jurists and lawyers, plus costs for multiple sales, special purpose vehicles, and ownership documentation. There are also costs linked to the special structures Islamic banks use for late payment penalties. Because of this, their financing costs are often higher than traditional products, while account returns are often lower.

El-Gamal also argues that another reason for the inefficiency and higher costs of Islamic banking, and why it always lags behind new financial products in the traditional industry, is the reliance on classical nominal contracts like cost-plus financing (murabaha) and leasing (ijara). These contracts follow classical texts written during a time when financial markets were very limited. They cannot untangle various risks, whereas modern financial markets and institutions like money markets, capital markets, and options markets are designed specifically to do that. On the other hand, improving the efficiency of these contracts or products alienates pious customers who believe they should follow classical forms.

In a major part of the financial market—home buying—Islamic finance could not compete with traditional finance in countries like the UK, Canada, and the US as of 2002 in the UK and 2009 in North America. According to Humayon Dar, the monthly payments for Sharia-compliant leasing contracts used by the Islamic investment banking division of Ahli United Bank in the UK were much higher than equivalent traditional mortgages. According to Hans Visser, the cost of Islamic home financing in Canada was 100 to 300 basis points higher than traditional financing, and 40 to 100 basis points higher in the United States. Visser believes Islamic loan financing costs more because Islamic loans have higher risk weights compared to traditional mortgages under international standards for minimum bank capital requirements set by Basel I and Basel II. In some cases, the Islamic profit rate is the same as a traditional mortgage rate, but the closing costs are several hundred dollars higher.

Reports by M. Kabir Hassan in 2005 and 2006 show that Islamic banks dominated by cost-plus financing (murabaha) are not very efficient. The banks studied had an average cost efficiency of 74% and an average profit efficiency of 84%. Although Islamic banks are less efficient at controlling costs, they are generally more efficient at generating profits. A later report on efficiency indicators like cost, allocation, technology, pure technology, and scale noted that, on average, the efficiency of the Islamic banking industry is relatively low compared to traditional banks in other parts of the world.

Other studies found that the efficiency of Islamic banks is, on average, slightly lower than traditional banks in non-Muslim majority regions, measured by bank revenue minus the profits paid to depositors.

This includes studies of Malaysian banks from 1997 to 2003 and Turkish Islamic banks between 1999 and 2001.

In contrast, a multi-country study covering a similar period from 1999 to 2005 found no significant difference in overall efficiency, according to a 2008 study that measured the cost, revenue, and profit efficiency of 43 Islamic banks and 37 traditional banks across 21 countries.

Common explanations for the flaws in the Islamic banking industry from the Islamic finance movement, as noted by M. O. Farooq, are:

Industry problems and challenges are part of a learning curve that will be solved over time.

Unless the industry operates within an Islamic society and environment, it will be hindered by non-Islamic influences and cannot operate according to its true nature.

While the truth of the second explanation cannot be verified until a complete Islamic society is established, Feisal Khan points out regarding the first defense that the industry has shown little evidence of progress since that argument was first made in 1993. That year, critic Timur Kuran highlighted problems in the industry, noting that Islamic banks are basically similar to traditional banks in practice, marginalizing equity-based, risk-sharing models while embracing short-term products and debt-like instruments, while supporter Ausaf Ahmad defended the industry by saying it was in the early stages of transitioning from traditional banking.

Seventeen years later, Islamic finance supporter Ibrahim Warde lamented that murabaha and similar sales products have not disappeared but have grown significantly, and today they make up the bulk of most Islamic banking business.

Most critics of Islamic banking call for more orthodoxy, doubling down on efforts to strictly enforce Sharia law. Some people, like M. O. Farooq and M. A. Khan, blame the industry's problems on treating loan interest as forbidden interest (riba) and the impracticality of trying to enforce that ban.

Finally, I am borrowing an article written by Talha Ahmed Iftikhar on his blog:

Not long ago, my friend wanted to buy furniture from a company that advertised that customers could use interest-free loans for up to 6 months provided by several banks to purchase their products. He decided to get this loan from an Islamic bank to stay compliant with Sharia, but he was shocked when the bank told him his invoice would increase by 30% because it included a profit margin. Then, the deal would be converted into a credit sale contract, and the amount would be paid back in installments over 6 months.

I asked the CEO how an Islamic bank could charge a 30% profit to someone who did not have the money to pay the full amount at once. Isn't this the strong exploiting the weak? Is this the same as the riba or usury that is condemned? His answer left me very confused: "We charge the same fees as the market." For those in need, we have a charity department. They call it a transaction. I left the meeting right away.

Murabaha is not a form of trade, but a banking product designed to trick Muslims into interest-based debt traps. Using it as an Islamic financing model must stop immediately, or at the very least, banks should be banned from using Islam to sell this product. Usury, or riba, is at the heart of an unfair economic system where the strong get stronger at the expense of the weak. Top officials at Islamic banks admit that this product hides the same interest rates used by other banks, which clearly shows these products will never help achieve social justice. view all

Reposted from the web

Summary: This Muslim knowledge guide compares Christian and Islamic debates over charging interest on loans, covering biblical arguments, church history, loan types, riba, bank interest, Muslim scholar opinions, and the wider question of finance ethics in daily life.

This article has two parts. The first part covers how Christian scholars view interest, and the second part covers how Muslim scholars view it. You will find that both religions have similar diverse conclusions on interest, but their followers took different paths. This depends on which clergy members have more influence.

Original Title

Is It Wrong to Charge Interest on a Loan?

Author: Kevin DeYoung, Professor of Systematic Theology at Reformed Theological Seminary and Senior Pastor at Christ Covenant Church.
Last week, I posted some content from the Westminster Larger Catechism related to economics. In a place where the doctrine forbids usury, I added a note about loan-sharks. This drew sharp criticism from commentators:

Kevin, you know very well that usury in the Bible and 17th-century church doctrine was not defined as loan-sharks. It was defined as charging any interest rate greater than zero. You are free to think the Bible is outdated and wrong on this point. But please have the courage to stand up and say you think the Bible is wrong. Do not redefine words in the Bible to mean something they do not, just so you can claim you believe in the Bible when you actually do not accept it.

These words are powerful. This gentleman claims that the Westminster clergy opposed charging any form of interest under any circumstances, and he insists that I am wrong and the Bible is wrong.

I removed the notes because I could see that the points I tried to make in parentheses should not be taken as the correct interpretation. My views need a more substantial explanation.

What is at stake here?

Before we discuss the accusation that interest is not biblical, let us first understand everything at stake in this discussion. We might think that making money from interest is a unique profession for bankers, Wall Street people, and other seemingly super-rich bad guys.

But charging interest on loans is what your credit card company does.

It is what the big stores do when you buy a refrigerator.

It is what car companies do when they let you drive a new car off the lot with almost no down payment.

It is what your mortgage company does to make home ownership possible. It is how the government issues student loans, and essentially, it is what you do when you deposit money into a bank or buy government bonds.

You let others use your money because they promise to keep it safe and return it to you with interest.

None of this proves that charging interest is allowed by religious law, but it does mean that people who use the Bible to oppose interest should be ready to oppose and give up almost every part of the modern economy.

A brief history of usury

For most of church history, Christians have opposed charging interest on most loans. This makes sense when you consider the Bible's prohibitions.

According to Leviticus (25:37), you must not lend your money to your brother. Exodus (22:25) states that if you lend money to any poor person among you, you cannot act like a moneylender toward him, nor can you charge him interest.

Deuteronomy (23:20) says the same thing about loans within the Israelite community, but it includes an important warning: you may charge interest to a foreigner. We can understand why charging interest was often opposed.

But it would be wrong to think the church always opposed interest on every type of loan. Usury has always been considered a sin, but not all interest-bearing loans were seen as usury. There is a long history of defining usury as loans for survival rather than loans for capital. Loans in the Old Testament were for those who were destitute and poor, which is the clear context for the passages mentioned above in Exodus and Leviticus. When someone in a covenant community hits rock bottom, the best approach is to give them what they need, followed by a loan. One thing you cannot do is give them an interest-bearing loan. This situation calls for charity, as it is not an opportunity to make money at the expense of someone else's misfortune.

However, loans made as business or investment risks have historically been viewed as a different type of loan. In his book Banking, Justice, and the Common Good, Samuel Gregg examines the history of usury and the church: 'It seems no one seriously objected to people lending money to others.' There is even quite a bit of evidence showing that clergy provided a form of 'banking service' to their peers. To be sure, throughout most of Christendom, the church forbade Christians from charging interest, which is why banking became a business dominated by Jewish people. They were permitted to charge interest on loans (Deuteronomy 23:20). Consequently, Jewish people were often accused of being 'moneylenders,' and their unique role in the financial industry became a contributing factor to centuries of antisemitism.

However, over time, Christians became more careful in how they defined usury. The Fifth Council of the Lateran (1512-17) defined usury as 'nothing other than gain or profit acquired from the use of a thing that is essentially barren, without labor, cost, or risk.'

This means that if a lender provides money with labor, cost, and risk involved, they can charge interest without committing the sin of usury. Similarly, Calvin also spoke about acceptable and unacceptable usury. Making money off the poor is one thing, but if we must do business with the rich, usury is allowed. He believes that besides the principal, high interest should be paid to the creditor to make up for his losses. In short, reason does not lead us to admit that all usury should be condemned without exception (Commentary on Exodus).

Similarly, Ursinus points out in his Commentary on the Heidelberg Catechism that all fair contracts, including paying rent, fair compensation for any loss, partnerships, and purchases, are exempt from being called usury. In other words, not every kind of interest is usury. Some are, and some are not. It depends on whether the loan helps the borrower or is most likely to harm them. Ursinus wrote that there are many questions about usury, and we can judge them based on the rule set by Christ: do to others what you would have them do to you.

Given this history of the Christian church, especially the Reformed churches, it is unlikely that Westminster Theological Seminary would condemn every type of interest-bearing loan. What has been condemned—and will continue to be—is predatory lending. There is no doubt that some people in the financial industry have committed sins in their lending practices, and just because we cannot say every loan is usury does not mean that nothing is usury. For example, in many poorer communities, you will find institutions that charge astronomical interest rates to provide people with cash advances. Given the risks involved, are these higher interest rates reasonable? Or is this exactly the usury that Christians have always condemned—squeezing the last penny from the poor and driving them into bankruptcy? In the book The Ascent of Money, Niall Ferguson argues that the early days of banking were made up of such usurers, which is why I used the phrase in parentheses last week.

Conclusion

For most of human history, charging interest on loans has been controversial, as Jay Richards explains:

By modern standards, almost everyone was poor, and only a very few rich people had money to lend. So, any loan would involve a rich person lending to their poor neighbors, who might be their relatives, to meet basic needs like food. People hid their extra money away, so while a person might have the right to ask for their money back, charging a poor person a fee for the temporary use of money that would otherwise just gather dust seems immoral. Charging huge interest rates that cannot be repaid only makes things worse, because it takes advantage of a person's misfortune and ignorance. Therefore, given the historical context and the belief that money should not be valued above all else, banning usury makes sense. (Money, Greed, and Allah, page 140).

So, has the church changed its view on usury? No, but its definition has become more precise. Usury is not charging interest on a loan to offset the risk of the loan and the cost of giving up other uses for the money; it is unfairly charging fees on a loan by taking advantage of someone when they are in trouble. Considering the context of Old Testament provisions, this seems like a fair distinction.

I do not believe the Bible or the Westminster Confession forbids charging any interest under any circumstances. This is not the universal position of the church. Instead, it teaches that it is wrong to charge interest based on the issuance of a loan, rather than as a basis for providing fair compensation based on factors related to the loan. Bad banks, bad lenders, and bad loans still exist, but neither the Bible nor church tradition requires us to think that banks, lenders, and loans are bad simply because they are banks, lenders, and loans.

The following are the views of Muslim scholars, taken from the book Islamic Finance and Banking System:

Saleh argues that interest-related activities occurred while the Prophet was still in Mecca, at a time when there were very few Jews there. most Jews in Medina at that time were engaged in agriculture rather than commerce, and those who engaged in interest-based transactions were among the Emigrants (Muhajirun) and the Helpers (Ansar). O you who believe! Do not consume interest, doubled and multiplied, but fear Allah that you may succeed. (3:130) The prohibition above was revealed during the Battle of Uhud. The funds for the Battle of Uhud were raised through interest. Abdullah ibn Salam said that interest practices were widespread in Medina, and this happened after the Prophet passed away.

Shaltut (1974) argued that the Quran only forbids excessive interest. To him, it is the 'doubled and multiplied interest' that Allah condemns. The term for interest (riba) that existed before the founding of Islam did not mean turning 100 into 200, but referred to the different ages of camels.

Syeikh Muhammad Abduh was the Mufti of Egypt. In the December 1903 issue of Al-Manar magazine, he published a statement: 'Prescribed usury is not allowed under any circumstances. However, the post office does not view the funds it collects from people as loans for profit. Under the principle of safekeeping, these funds can be used.' (Homoud, 1985, p.122)

Jawish (1908) suggested that the interest mentioned in the Quran refers to interest on delayed payments that has multiplied, not interest on loans.

Redha (1929) believed that a person could borrow 100 dollars and sign a check for 120 dollars, and this practice is absolutely not interest. Interest arising from deferred payment only occurs when the due date of a debt is extended.

Maruf Dawalibi believed that reasonable interest rates should be allowed for production loans. Scholar Syeikh Abdul Jalil Isa also supported this view. At the 1951 International Congress of Comparative Law in Paris, Dawalibi said: 'The forbidden usury refers to usury on consumer loans, not production loans. Usurers exploit the needs of the poor in the former and make them poorer by imposing excessive usury on them.' Now that economic systems are established and many companies have been formed, most loans are issued for production rather than consumption. As civilization develops, it is necessary to consider how these legal provisions should be improved. (Homoud 1985 p.120)

Syeikh Tantawi published a fatwa in the newspaper Al-Ahram stating that interest from investment certificates issued by the National Bank of Egypt (Al-Ahli Bank) is not illegal.

Syeikh Tantawi issued two more legal rulings in November 1989 and 1991, declaring that bank interest is permissible under Islamic law. (Al-Zuhayli, 2003)

In a 2004 study on Indonesian views toward interest, Antonio surveyed 45 influential scholars. Among them, 24 believed that interest paid or charged by banks is not illegal. They argued that interest is only forbidden if it harms the recipient, and only excessive interest should be called usury. Scholars who supported the legality of interest included Ibrahim Hosen, former Indonesian President Abdurrahman Wahid, and Hasan Basri.

These are the views of Muslim scholars who support the legality of interest. In contrast, opposition to interest is represented by Al-Azhar University. At its second annual conference in 1965, the university resolved that any form of interest is illegal. Given the poor state of Egyptian society in modern times and my own observations while visiting Al-Azhar, the Egyptian people have not gained a better life because of the university's presence. In fact, their lives have become harder. Therefore, any statement issued by Al-Azhar holds no authority for me and is for reference only.

We often say the root of the modern Islamic world's backwardness is that we do not follow the teachings of the Quran, but it is worth thinking deeply about exactly where we went wrong. Banks play a decisive role in the development of modern civilization, and where there are banks, there is interest. You cannot imagine someone living in society today without using a commercial bank. Even Islamic banks, which claim not to charge interest on loans, collect fees from borrowers under other names. Otherwise, why would a bank lend you money for free? Even those internet preachers who talk big about how one can live in this world without touching interest still need to use commercial bank accounts to receive donations from their followers.

I found some inspiration while looking into Christian views on lotteries and gambling. Christianity clearly opposes gambling, but they have a different explanation for lotteries, which work on similar principles. The Nanjing Union Theological Seminary believes that lotteries with a public welfare nature are acceptable, while gambling-like lotteries such as the Mark Six (liuhecai) should not be bought. It depends on the motivation and the consequences. However, some Islamic scholars take a one-size-fits-all approach to the same issue. They not only forbid any lottery behavior similar to gambling but even ban games like chess because they suspect gambling. This makes me worry about our future.

Although I do not believe Islam restricts the development of civilization, we must admit that some outdated rulings keep some people in a backward position. On the surface, some rulings seem like minor details, but in reality, they deprive people of the ability to think. If you do not allow people to try and fail, you cannot have innovation.

Finally, I have a question I would like to sincerely ask the scholars: Have you ever thought about whether the zakat, where Muslims give one-fortieth (2.5%) of their surplus wealth every year, counts as interest demanded by Allah from the believers? view all