Islamic Banking & Finance

Islamic Finance: An introduction - Part 3

Mark Andrews ACISI IFQ, has been an investment and retail banker for over 25 years and a qualified specialist in Islamic banking and finance. Since 2007 Mark has worked in most countries in the Gulf and Egypt advising on Islamic banking products and risk. In this third article in a series he considers how an Islamic Bank "advances" its funds, or in old fashioned banking terms, how it "makes its money".

INVESTMENTS

Whilst the terms "loan" or "lending" are commonly used, even by Islamic banks, they are not strictly correct in an Islamic context because an Islamic bank is engaged in mutual trading both with and alongside its clients on both sides of the balance sheet. An Islamic bank has a direct interest in the outcome of all these trading transactions, sharing both profits and losses with its partners/clients. Unlike a conventional bank where depositors are creditors and borrowers are debtors and there is almost no mutuality at all, an Islamic bank has partners, investors, principals and agents at every level.

So an Islamic bank does not "lend", it "invests"!

So how does an Islamic "invest" its funds? The answer is "very carefully" and for this reason only a handful of the Islamic products available are actually used in practice. This has caused Islamic banks - on the investment side at least - to become rather narrow specialists, dealing mainly in two products; split between Murabaha (akin to a loan) and Ijara (akin to leasing operations). Most Islamic banks will advertise a wide range of Islamic investment products, including mortgage funding but most - in fact nearly all - have the lion's share of their investments in either Ijara or Murabaha form. Why is that?

THE COMMON QUESTIONS

Before answering the question and as a preliminary explanation, let us consider Islamic banking from the customer's viewpoint, as an investor (in our language, depositor) in an Islamic bank. During the author's informal discussions with Islamic banking staff, especially those dealing regularly with clients, three questions emerge that are nearly always asked by every prospective investor (depositor) in the bank.

The first is "Promise me this is an Islamic Bank?" This is a particularly common question when a "windows" or "branches" approach is being used by the bank but is also asked of wholly Islamic institutions. Some Islamic banks have questioned the wisdom of operating "windows" as a result of this constant scrutiny and to be frank, there is something "other worldly" about entering a conventional bank and following signs for "Islamic banking, this way!"

The second question is "Is my money safe?" which is interesting, given that for those of us banking with conventional banks, the prospect of an Islamic bank failing would mean we are probably all doomed! In nearly every Islamic jurisdiction either the State or the Regulator has made it clear that investors will not be allowed to lose their money and whilst nothing is impossible, it is hard to imagine an Islamic bank in the GCC in particular, being allowed to fail. The prospect of investors "sharing or bearing losses" as they agreed when they signed up (most don't realise this by the way!), seems as remote as it can ever be.

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