There are so many banks that claim to be "Islamic", that is "Interest Free" banking. Could you explain please which banks are preferable?

Details of the Question
There are so many banks that claim to be Islamic, that is "Interest Free" banking. Kindly explain which banks are preferable by among the best banks in Pakistan, United Arab Emirates and Europe? Thanks...
The Answer

Dear Brother / Sister,

The institutions that function based on the system of profit and loss are permissible because our religion regards them as commercial institutions. Money can be invested in those institutions and the profit share given by them is halal (legitimate).

Interest-free finance houses (Prof. Dr. Hayrettin Karaman)

Interest-free Finance Houses usually carry out the transaction of murabaha (selling on profit) due to the special conditions of Turkey. The term murabaha means buying goods at cash price and selling them at deferred payment price. When the private finance house determines the deferred payment price, it takes some criteria into consideration; among those criteria are inflation, the probable yield of the money in the market when it is invested in other instruments, and some other things... The finance house has to meet the expectations of its shareholders that invest money (the holders of profit and loss accounts). A shareholder (account holder) that invests money with the expectation of profit will withdraw his money if he cannot even receive the inflation difference, that is, the value loss caused by inflation, and the finance house will be unable to operate. It is not enough to compensate the inflation difference; it is also necessary to give some real profit. Since the deferred payment price is arranged based on those necessities, it sometimes becomes a bit lower than the bank interest rates and sometimes more than the bank interest rates. However, it is not possible to say that the transaction is illegitimate only by taking that state (that is, the fact that the profit and the interest rates are close to or different from each other) into consideration. In general, the profit in legitimate trade and the sector of industry is like that; sometimes it becomes equal to interest rate, and sometimes it can be different.

Trade is carried out by buying and selling goods in return for a price. Private Finance houses do the same things in the transaction of murabaha. The buying and selling take place in two forms:

a) The finance house appoints its employee to get the goods and to deliver them to the customer; the invoices are issued in compliance with that transaction (two invoices are issued: one by the seller and one by the finance house).

b) The finance house gives the customer who wants to buy goods (according to some questions the person who wants to use funds) written authority to buy goods; the customer buys the goods on behalf of the finance house and the invoice is issued to the finance house; the customer receives the goods on behalf of the finance house and transports it to the place where the finance house wants (it may be his own store or shop); then he buys the goods from the finance house as the customer; this time the finance house issues the invoice to him.

Both transactions are in compliance with fiqh (Islam). It is necessary to know the intention of the parties in order to call it cheating; if the aim is to give/take credit with interest, it is called cheating; if the aim is to really sell goods through deferred payment sale (if the goods are really bought and sold), it cannot be called cheating.

Private finance houses have two more transactions that are nearer to interest-free system – in terms of their economic and social effects - : mudaraba and musharaka.

In mudaraba, a partnership based on the capital from the finance house and the project and administration (labor, enterprise) from the other party is established. Profit is shared in accordance with the contract. The share of the finance house is shared between the bank and the participation account holders that invested in the finance house. If the enterprise suffers a loss, the finance house and the account holders undertake the loss.

In musharaka, partnership of capital is present; an entrepreneur that has some capital but needs some more asks the finance house to add some capital and become partners; a contract is made; the profit is shared in accordance with the contract and the loss is shared depending on the rate of capital. Interest-free banking has many other transactions and services like financial leasing, lending without interest, money transfer, collection of revenues, etc.

In the private finance houses, mudaraba and musharaka are carried out less in comparison to murabaha. Among the reasons why they are carried out less are the impatience of account holders, the expectation of profit without taking risks, the fact that accounts of the companies are partly off the book, lack of reliance and trust caused by the weakening of the consciousness and feelings of trust, keeping promises, loyalty and haram-halal. The better we, Muslims, get in terms of quantity and quality, the better our institutions will be.

Note: We recommend youto read the following views about the issue too.

Private Finance Houses (Participation Banks) and Prohibition of Interest (Sami Uslu)

Private Finance Houses are institutions that are not regarded as banks and that accept funds in accordance with Islamic principles and allows using funds, that functions based on profit-loss partnership instead of interest for the methods of making use of savings and providing loans. The institutions that are named as “Islamic bank”s in the world are called Finance Houses in Turkey.

The fact that the population of Muslims who regard interest as haram have reached a great number in the West have increased the number Islamic finance institutions and caused the other banks to serve those people with the units that they have established.

Islamic banking” is the fastest-growing finance sector in the world. Now, more than 200 Islamic finance institutions that are active in the world, direct a fund with an investment size of 200 billion dollars.

Furthermore, some of the banks that have established interest-free banking units within their organization are as follows:

Citibank-USA, Goldman Sachs-USA, HSBC- England, Deutshce Bank-Germany, Union Bank of Switzerland- Switzerland, Amro Bank-Holland, Kleinwort Benson, ANZ Grindlays Australia, United Bank of Kuwait and Arab Banking Corporation.

All of those institutions, which are among the greatest banks in the world, have interest-free banking in their organization. The list of banks that are starting interest-free banking is getting longer day by day.

Key Characteristics of Private Finance Houses:

1- They are interest-free:

The most distinguishing characteristic of those banks is that they do not carry out transactions with interest. That is, they do not pay interest for the funds that they obtain; they do not collect interest from their customers for the funds that they provide their customers with.

After all, the reason why they have been established is to serve the people who do not carry out transactions with interest due to their religious beliefs and to serve the companies of those people. Islam accepts that capital is one of the production factors and that it has a cost. However, it rejects the idea that the capital should demand a pre-determined yield, that is, interest. In other words, it is forbidden to earn money for money.

2- They are trade-related:

The fact that interest is forbidden, trade and profit are legitimate in Islam urges those institutions carry out trade related transactions with their customers. Since money trade is forbidden in Islam, it is necessary to carry out trade of goods in order to earn money.

3- They are equity related:

It is a generally accepted truth that pure Islamic banking includes loss-profit partnership (mudaraba) or capital participation (musharaka).

The capital owner can share the profit with the entrepreneur obtained thanks to his expertise and effort. The rate of the profit, which is the yield of the capital, that is, in what percentages it will be shared is determined beforehand but the amount is not certain.

4- The investments should be ethical:

The investments should be made within the framework of legitimate fields in terms of Islam. In this context, Islamic investments should be environment-friendly, alms-giving, enabling the participation of the community, respectful to humanitarian values, excluding pornography, armament, alcohol and gambling.

Primary products and services of private Finance Houses

1- Mudaraba and Musharaka:

They are the basic methods that form the essence of the Islamic banking in terms of fund using. However, since the yield comes in the long term, those transactions are not used sufficiently. It is indisputable that mudaraba and musharaka are in accordance with Shariah.

2- Leasing Transactions:

In the transaction of leasing, the finance house buys the machinery and equipment, rents it to the customer and collects the price of them in the form of installments. In our opinion, it is outside the prohibition of interest.

3- Murabaha:

In this method, the finance house buys the machinery, etc that the customer needs on behalf of the customer and sells it to the customer by adding some profit to them. The price of the goods is repaid to the finance house by the customer in the form of installments.

It is claimed that murabaha contains covered interest and that it resembles interest rather than commercial profit because it does not contain the risk factor that should be present in normal trade and the yield is predetermined. We do not think that those criticisms are right due to the following reasons:

• Murahaba is a kind of trade that is carried out upon ordering and that kind of trade is widespread in every market.

• The cost plus method used in pricing is a frequently used method in trade. It is completely normal that the seller adds a certain percentage of profit to the cost. That is, the profit margin is predetermined.

• The claim that murabaha does not contain the risk of the normal trade is not true. There exists the risk that the customer may not pay the price just as in the normal trade. It is called market risk or counter-party risk in terminology.

One of the most criticized issues is that the rate in the deferred payment price in murabaha is about the same as the rate of interest of the other banks and therefore it is covered interest.

In our opinion, that criticism is groundless because every merchant in the market has to consider the rate of inflation when he prices the goods for deferred payment. A deferred payment rate under the rate of inflation will inflict a loss on the seller. Similarly, private finance houses have to add a difference to the cost at least equal to the rate of inflation. The rate of inflation is the primary element that determines the rate of interest and it is generally in parallel with the rate of interest. Therefore, it is natural even necessary in terms of economy that the rate of deferred payment and the rate of interest is close to each other.

Therefore, the fact that the deferred payment rate is close to the rate of interest does not make murabaha an interest transaction. As it is explained above, private finance house function in an economy based on interest; it is not possible for the pricing of the funds to be unaffected by the current rates of interest.

Those explanations are also valid for leasing.

4- Buying and Selling Documents in Return for Goods

It is a method of providing funds by Private Finance Houses that form a “grey field”. Documents belonging to an export party realized thorough deferred payment sale are bought from the exporter in return for cash; then, they are sold to the same exporter by adding a difference of deferred payment and the money is collected in the form of installments. For instance, documents having a value of 50 thousand dollars are bought by the finance house from the customer in return for 45 thousand dollars and that amount is paid to the customer at once; simultaneously, the customer sells the documents to the finance house for 50 thousand dollars with deferred payment sale. 5 thousand dollars is the profit of the finance house and the cost of the customer.

It is very difficult to ignore that it is a transaction of discount no matter how good-intentioned you are. As a matter of fact, it can be claimed that those documents represent the goods and that they are tradable goods as in murabaha. However, it is very disputable to regard that defense as valid because the export subject to that transaction is a finished export. The goods have left the Turkish customs and probably have reached the country where the buyer is; at least, they are on the way somewhere outside Turkey. At any rate, the ownership of those goods is not in the exporter. However, the exporter is the debtee and a policy or bond among those documents proves that he has the right to receive the money. The document that the finance house buys and sells back is not the goods but the proof that the customer has the right to receive the money. The deferred debt that the exporter will receive in the future is paid to him now and an amount of money is collected from him. In other words, the customer is sold the time. It is called the time value of the money in finance and it is interest.

A policy or bond that bears the signature of the foreign importer and sometimes also the signature of the guarantor bank is a finance instrument. That document is arranged by the importer as an alternative for cash payment. That is, the importer has arranged a debt document in return for the transfer of the ownership of the goods to him.  That bond has two uses:

a- It proves the debt relationship that originates from the foreign trade transaction in question.

b- It enables the exporter to transform the price of the export into cash by discounting it in a bank or finance institution without waiting for the redemption date.

The conclusion to be drawn from it is that the Private Finance House has a structure that is suitable to support exports before shipment not finished exports. The raw materials and intermediate goods to be used in the goods to be exported can be provided for the exporter through murabaha. When the export of ready-made goods is in question, those goods can be sold to the exporter through murabaha.

Pricing Services and Products

We sometimes observe that the services and products presented by Private Finance Houses are expensive and that they discontent and disappoint customers due to the prices higher than those of the commercial banks. Some people put forward that high pricing harms the Islamic characteristic of those institutions and puts them in the same level as banks with interest religiously.

First of all, we should state that high pricing does not transform a sound transaction into a transaction with interest religiously. For instance, a letter of guarantee given by a Private Finance Institution does not have any drawbacks religiously. The commission taken in return for that service is naturally legitimate. The fact that the rate of the commission is high does not turn the transaction of the letter of guarantee into a haram transaction.

However, criticisms stating that the customer is misused in terms of high commission and price that the trust is abused and that the amount taken for the service is high.

On the other hand, excessiveness in pricing can be regarded as an indication that the private finance house works with a high cost or that it carries out a wrong marketing policy.

What determines in which level the commissions and prices are regarded as reasonable is the market conditions and competition. In theory, a private finance house that charges more money than its competitors will fall behind and its market share will decrease. It is the punishment given to that institution by the market. Although what we have stated is true in theory, it is difficult to say that there exists real competition between the private finance houses and commercial banks in terms of customers because what determines the preference of the customer is the religion. The customers of those institutions do not actually go to private finance houses in order to receive cheaper service; the peace and comfort of acting in accordance with Islam plays an important role in preferring the bank that they need for banking services.

Therefore, the competition can be only among the private finance houses. Thus, the private finance houses should take that aspect of the issue into consideration when determining the prices for their customers and they should carry out pricing policies that will make them gain normal profits.

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