Al-bay vs Riba

My previous post talked about Islamic world view as the driver for all Islamic economic activities now financing those activities is imperative, without financing economic activities will not take place; this is where banks and financial institutions come in. Islamic banks need to adhere to the notion of the Islamic world view as well, so let me try and make a fundamental comparison between Islamic banking and Conventional banking.  

Conventional Banks are financial intermediaries that hold capital, borrow from depositors the surplus sector then give out loans to the deficit sector, where these loans are based on interest when doing this bank bares financial risk. Here households, businesses and government bodies makeup both the deficit and surplus sectors. In a conventional bank the market for Deposits that is the demand for deposits and its supply as well as the market for loans which is the demand for loans and its supply are both based on interest rates, meaning that banks pays interest to depositors for borrowing their money and receiving interest from the loans that they give out.  

Like the Conventional banks, Islamic banks are also financial intermediaries, that take deposits from surplus sector and extend financing towards the deficit sector but unlike Conventional banks Islamic banks cannot take or receive interest as it is not permissible according to Shariah (Islamic Law). So if the prime factor that generates profits for conventional banks is interest the question to ask is how Islamic banks and financial institutions make profit? Certainly an Islamic bank is not a charitable organization, in order to answer this question one needs to understand the concept of al-Bay in comparison to riba (interest).  

First what is Riba?  It is predetermined surplus over and above the loan.  Also three conditions must be fulfilled for transaction to constitute Riba 

1.   excess or surplus over and above the loan capital to be returned to the lender;
2.  determination of this surplus in relation to time with definite date of redemption;
3.  stipulation of this surplus in a loan agreement. ¹

From this one can easily conclude that Interest constitutes Riba. Its stated in Quran “O ye who believe do not consume riba with continued redoubling and protect yourselves from God, perchance you may be blissful” (Al-Baqarah:130). In the conventional banking system depositors are promised a guaranteed sum of principle and interest payments. Likewise a bank charges interest with serious legal implications when loan is defaulted. 

This seems all good however, when small businessmen and those who aspire to expand operations but lack the credentials of giant corporations, conventional banks usually close their doors to these group of businessmen, taking them as business partners is taboo in banking. Is causes income disparity².  Its stated in Quran “wealth must not circulate only among the rich ones among you” (Sura 59:7) 

Now that we have established that interest constitutes riba and its implications we can go back to our initial question; what is the alternative that Islamic banks use to generate profits. What then is the key factor that drives deposit market and financing market for Islamic banks? The answer is al bay 

What is al-bay? It means trade which is money exchanged for goods and services meaning that the key principle here is profit sharing and loss sharing in financial terms risk sharing. (I will talk about the concept of risk sharing in detail in my next post). Therefore in Islamic banking, banks are agents (mudarib) and depositors as investors, the banks manage the deposited funds.  So the deposit and financing markets for Islamic banks is based on Trade contracts and not based on lending and borrowing contracts in comparison to how conventional banking is structured.  This means that Islamic banks are faced with business risk, where as Conventional banks are faced with financial risk this another element that differentiates Islamic banks from the conventional. This is because conventional banks face capital loss due to credit default and interest rate volatilities where as Islamic banks faces capital loss due to adverse price movement. (In the next few posts I will talk about risk as it is an important aspect for Banking and financial institutions). 

¹ Murat Cizakca ‘Islamic capitalism and finance’ Page 74-75

² Saiful Azhar Rosly ‘Critical Issues on Islamic Banking and financial Markets’ Page 37-38