Islamic Finance: How Does It Make Money Without Interest?

Many of the products offered by Islamic financial institutions are comparable to Western or conventional finance even though interest and speculation are forbidden. Banks are by far the biggest players in Islamic finance—some of them are exclusively Islamic while others offer sharia-compliant products but remain mostly conventional.

Aside from the absence of interest rates, the key concept of Islamic finance is risk sharing between parties in all operations. Here are some of the key sharia-compliant products offered by banks—they have Arabic names but in most cases we can find an equivalent in conventional Western banking.

Murabaha or cost plus selling: This is the most common product in asset portfolios and applies only to commodity purchase. Instead of taking out an interest loan to buy something, the customer asks the bank to purchase an item and sell to him or her at a higher price on instalment. The bank’s profit is determined beforehand and the selling price cannot be increased once the contract is signed. In case of late or default payment, different options are available including a third-party guarantee, collateral guarantees on the client’s belongings or a penalty fee to be paid to an Islamic charity since it can’t enter the bank’s revenues.

Ijara or leasing: Instead of issuing a loan for a customer to buy a product like car, the bank buys the product and then leases it to the customer. The customer acquires the item at the end of the lease contract.

Mudarabah or profit share: An investment in which the bank provides 100% of the capital intended for the creation of a business. The bank owns the commercial entity and the customer provides management and labor. They then share the profits according to a pre-established ratio that is usually close to 50/50. If the business fails, the bank bears all the financial losses unless it is proven that it was the customer’s fault.

Musharakah or joint venture: An investment involving two or more partners in which each partner brings in capital and management in exchange for a proportional share of the profits.

Takaful or insurance: Sharia-compliant insurance companies offer products comparable to conventional insurance companies and functions like a mutual fund. Instead of paying premiums, participants pool money together and agree to redistribute it to members in need according to pre-established contracts. The common pool of money is run by a fund manager.

The fund can be run in different ways when it comes to the surplus distribution and the fund manager’s compensation.

There are three big models:

  • The wakala—where the fund manager receives a fee and the surplus remains the property of the participants.
  • The mudarabahadapted from the banking system where profits and losses are shared between the fund manager and the participants.
  • The hybrid modelA mix of mudarabah and walkala.

In some cases, the fund manager creates a waqf, or a charity fund.

Sukuk or bonds: Sharia-compliant bonds began to be issued in the 2000s and standardized by the AAOIF—a Bahrain-based institution that promotes sharia-compliant regulation since 2003. Today, over 20 countries use this instrument. Malaysia is the biggest issuer, followed by Saudi Arabia and issuers outside the Muslim world include the UK, Hong Kong, and Luxembourg.

Sukuk issuance took off in 2006 when issuance hit $20 billion. Apart from a drop in 2015–2016 volumes then grew steadily to reach an all-time high of $162 billion in 2019, up 25% from 2018. This record number was backed by strong appetite from Malaysia, Indonesia, Gulf Cooperation Council (GCC) countries and Turkey.

That was before COVID 19. According to credit ratings agency Standard & Poor (S&P), the volume of issuance should drop around $100 billion.

“The market was, in fact, poised for good performance in 2020 but the pandemic and lower oil prices changed the outlook. Amid tougher conditions, we also don’t see core Islamic finance countries using sukuk as a primary source of funding despite their higher financing needs,” says S&P in its 2020 report on Islamic Finance.

Other industry experts beg to differ. Refinitiv research says sukuk issuances will continue to grow and could reach $174 billion in 2020 backed by government funding requirements.

Like conventional bonds, sukuks are very appealing to governments for raising money to spend on development projects. Their main challenge remains standardisation; buyers tend to find it more difficult to assess risk than with regular bonds.

Islamic finance also exists in the form of investment funds.