In both Indonesia and Malaysia there are tons of banks, both foreign and domestic, from Citibank and HSBC right on down to little community banks.  One significant part of the banking system in both countries which has grown over the past 15 years or so is the Islamic banking system.  Basically, Islamic banking means banking that follows Shariah law (here, it’s spelled Syariah).  The only thing that Shariah has to say about banking is that interest (rifa) is haram (not allowed).  That means that it’s not permissible to lend or borrow money with interest.  Other than that, things are the same.

That seems pretty straightforward.  But as long as I (TP) have known that Islamic banking existed, I have wondered how Islamic banks do business.  Banks make all of their money by lending and collecting interest, and they attract depositors by providing interest on loans.  That’s, like, the definition of a bank.  So how can you be a bank and not deal with interest?  Do they just not make money?  Today I found out.

The secret is the principle of al-Wadiah, or custody.  As a depositor, you give your money to the bank and the bank holds onto it with a guarantee to pay you back that money whenever you ask for it.  Now, the company at its own discretion can issue a dividend to its savings account holders–it disburses some of its profits to those account holders.  It does this about twice a year.  Normally, the amount disbursed is about equivalent to the amount calculated through an application of the prevailing national interest rate.  But it’s not interest, it’s profits.

What if you want a mortgage?  Here, banks use the al-Bai Bithaman Ajil (deferred installment sale) concept.  Instead of the bank giving you money which you pay back with interest, with the house as collateral, the bank buys the house for you, and you pay the bank in installments. The installments are pro-rated so that the bank makes a profit, but again, that’s not interest.  Note that this means that all mortgages are essentially fixed-rate mortgages in Islamic banking.

What if the bank wants to loan money to a business?  In Islamic banking, instead of making a loan paid back with interest, the bank negotiates a proportion of the profits and/or losses to be paid back, and also negotiates the amount of time under which these payments have to be made.  So, you and the bank could decide that the bank gets 30% of the profits and bears 10% of the risk for 15 years, or 70% of the profits gradually declining over 10 years and bearing all the risk, or whatever.  All of that stuff is negotiable.

In essence, all of these stuff can be worked out to be equivalent to the amount of money to be made through an interest system, but interest is not part of the game. You can imagine that there’s a fine art to negotiating loans and deposits in Islamic banking, just like there’s a fine art to determining interest rates on loans and deposits.  But besides that, the banking systems are the same, offering the same products and services in a slightly different manner.  Pretty cool.