Prof Abdelhafid Benamraoui, Professor of Finance, University of Westminster
At the heart of Islamic finance is a key principle: the prohibition of interest, known as Riba. Both the Qur’an and the sayings of Prophet Muhammad (Peace Be Upon Him) clearly forbid it. In Islam, Riba is considered one of the seven major sins. As a result, Muslims are expected to refrain from all financial or banking transactions or products which entail any form of usury. Islamic law, or Shariah, also prohibits risky financial dealings, known as Gharar, and investments in industries considered harmful or unethical, such as tobacco, gambling and weapons manufacturing.
In response to these principles, efforts have been made to develop financial services that comply with Shariah principles. One of the earliest examples of Islamic banking began in 1963 in Mit-Ghamr, Egypt, with a savings bank that operated without interest and focused on social goals. This was then followed by the creation of Nasser Social Bank in Egypt in 1971 and the opening of the Islamic Development Bank in 1975, established by the Organisation of Islamic Cooperation. Islamic banks then began appearing in other countries such as Saudi Arabia, Pakistan, Malaysia, Iran and Sudan.
The most significant growth, however, happened in the 1990s and 2000s. This was driven by new regulatory bodies, such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB), and by major conventional banks like Citibank and HSBC, which launched Islamic banking divisions. Since 2010, Islamic finance has grown further, including in non-Muslim countries like the UK, USA and Germany. Examples of the Islamic banking products offered include Musharakah, which is a partnership or joint venture contract; Murabaha, a cost-plus sale; Mudarabah, a profit-sharing partnership; Ijara, which is leasing; Istisna, manufacturing-construction-finance; Salam, a forward-sale-financial contract; and Wadia, which refers to safekeeping deposits.
While Islamic finance has grown significantly, questions remain about the extent to which some products comply with Shariah principles. A study by Benamraoui et al. (2020), published in the Journal of Islamic Business and Management, suggests that many Islamic banks closely imitate conventional banks. As a result, some products may not fully meet Islamic legal standards. For instance, while Islamic mortgages are structured differently from conventional loans, their rental rates often follow conventional interbank interest rates rather than actual market rent—undermining the aim of creating an independent, Shariah-based financial model. The current Islamic mortgage contract also places most of the risk with the mortgage holder, rather than being shared with the bank, a key principle of Shariah law that places high emphasis on shared responsibility.
Similarly, in Mudarabah contracts, the person providing the money (rabb-ul-mal) faces more financial risk than the manager (mudarib), who contributes only time and effort. The unequal distribution of information between the parties could result in mistrust or disputes over profit or loss declarations, and on some occasions, there is also a lack of collateral in Mudarabah contracts.
Current Musharakah contracts also have challenges. Calculating and verifying profits can be complicated, and disputes may arise over how profits are divided. There is also a chance for one partner to contribute less than expected or become a free-rider, yet still receive part of the profit. An early exit by one of the partners could further result in disputes and additional costs due to the selling of assets at a low price. In addition, there are issues around the lack of standardisation with the contracts, which tend to vary across institutions.
For Murabaha contracts, the fixed markup could be seen as de facto for interest rates, and the structured payments set over time are similar to conventional loans. Besides, the bank often holds the asset only briefly, reducing the real risk for the bank and keeping the customer exposed. On many occasions, Islamic banks apply penalties for late payments, which contradicts Shariah ruling, as this benefits the lender and puts the client at a financial disadvantage. Moreover, there is an element of complexity around Murabaha contracts’ legal documentation and the failure to truly apply the profit-and-loss sharing, a core principle of Shariah financial law.
To address these concerns, scholars and practitioners suggest several improvements, such as greater standardisations of Islamic banking and financial contracts, providing more clarity about the rights of the users, fully employing profit-and-loss sharing principles and avoiding the mimicry of conventional banking in passing the real risk(s) to the clients.
Photo: Billboard promoting halal banking on Barking Road, East Ham, London.
(Credit: Nico Hogg/Flickr, CC)
