An Introduction to Islamic Banking — Issue #17
Exploring the differences between Islamic banking and traditional banking, and how fintech companies in Saudi Arabia address the challenge of creating Sharia-compliant products
Hello dear reader,
This week we (almost) have the same format as before. For now, it feels right.
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The problem
What if I told you that a bank couldn’t make money from interest? It couldn’t give out a loan for a car, a mortgage, and make access money of it.
Net interest income, which is the difference between how much interest a bank earns minus the interest it pays out, in 2023 was responsible for 61% of the top 100 banks’ revenue in the developed world.
But in Islamic finance, also known as Shariah-compliant finance, banks and other financial institutions can’t make money by earning interest. According to the Organization of Islamic Conference, an Islamic bank is:
…a financial institution whose status, rules and procedures expressly state its commitment to principle of Islamic Sharia and to the abolishing of the receipt and payment of interest on any of its operations
Simply put, in Islamic finance, you can't make money through the mere passage of time. This principle is called riba. However, you can make money from investing, but you have to invest in productive assets. Meaning, there should be a link between an investment and an increase in productivity. That also means that every investment is coupled with risk.
There are other principles too:
Gharar — ambiguity or excessive risk in contracts is prohibited, which on its surface is ambiguous in and of itself. But in practice, this means that short selling, futures, and options are not allowed.
Maysir — gambling prohibition. Again, this affects short selling, as well as other forms of excessive risk-taking.
Zakat — this is a simple one: giving 2.5% of your wealth away to charitable causes.
Haram — inability to invest in activities contradicting Shariah-law. Casinos are an example here.
The difference between traditional banking and Islamic banking can be drilled down to three points.
First, a financial institution can't charge interest and instead should share the risk with the client.
Second, money is not considered an asset, so all financing activity is asset-based.
Third, financing should be ethical, so no investing in activities deemed unethical, and no gambling, literally or figuratively.
These limitations present challenges both for financial institutions and for clients.
The consequences
Let’s start with financial institutions.
Profitability limitations: While profit-loss sharing promotes fairness and risk-sharing, it can limit the ability of Islamic banks to generate consistent profits, especially in periods of economic downturn or market volatility. The absence of interest-based income streams also affects the pricing and profitability of Islamic financial products, requiring banks to seek alternative revenue sources.
Additional costs: Islamic banking institutions have to incur additional costs, such as product innovation costs and even paying Sharia scholars to oversee transactions. Moreover, Islamic banks must allocate resources for asset-liability management to ensure that their investments comply with Sharia guidelines and meet the needs of customers.
Limited investment opportunities: Islamic banks have a narrower investment universe compared to conventional banks, which can limit their ability to pursue high-yield or speculative opportunities. While this reduces exposure to certain risks, it also constrains potential sources of profit and diversification. It’s hard to get away from the fact that speculation is a nice way to make money.
Liquidity Risks: Islamic banking institutions face liquidity risks due to the nature of their business model, which involves sharing profits and losses with clients. Profit-sharing contracts expose banks to greater uncertainty regarding future cash flows and profitability. While Islamic banks cannot rely on interest-based lending or borrowing as a liquidity management tool, they can seek liquidity support from other Sharia-compliant actors. However, the number of such institutions is limited. Although not an issue in the GCC, in other countries like Bangladesh, Islamic banks struggle with liquidity.
On the client side there are four main challenges.
Limited product choice: Clients of Islamic banking often face a more restricted range of financial products and services compared to those available in conventional banking. For example, individuals seeking long-term financing for homeownership may have limited options for Sharia-compliant home financing solutions compared to conventional mortgage products.
Higher costs: Sharia-compliant financial products and services may entail higher costs for clients compared to conventional equivalents. Islamic banks share profits and losses with clients, which means they bear a greater degree of risk compared to conventional banks that charge interest. To compensate for this risk, Islamic banks incorporate risk premiums or profit margins into their pricing, leading to higher overall costs for clients. At least on the surface, the difference in (basically) mortgage payments between Alrajhi Bank (Sharia-compliant) and Riyad Bank (non-Sharia-compliant) are massive.
Complexity of Sharia-compliant products: Sharia-compliant financial products and contracts are more complex than conventional equivalents (more on that later). This complexity can make Sharia-compliant products less accessible and less transparent for the general public, especially for clients with limited financial literacy or familiarity with Islamic finance concepts. According to surveys, only 18% of the population in Morocco believed that Islamic banks’ financing products were halal, in Indonesia Sharia financial literacy rate stands at 9.1%, and just 29% of the population in the UAE knew that Islamic banking products existed.
Awareness: Awareness about Islamic banking is also limited. Although there haven’t been recent studies, a 2014 report by PWC showed that only 53% of the Muslim population was aware of Islamic banking.
The solutions
Since there are no loans and other traditional products, Islamic banking had to come up with their own. These products are divided into three groups:
Profit-and-loss sharing (PLS) products where both the borrower and the lender bear the risk. These include:
Musharakah — a joint venture between two or more parties where losses are shared based on the contribution to the partnership.
Mudârabah — a contract where one party provides capital, while the other provides labor. In this case, the losses are borne by the financier.
Non-PLS products are debt-like products where money is exchanged for a commodity and vice versa:
Murâbaḥah — a transaction where the bank purchases the good and provides it to the customer in exchange for deferred payment with a markup. Unlike traditional loans, however, a bank cannot charge a customer for late payment. The bank also takes the burden of delivering the good. Such contracts are common in international trade.
Ijārah — a sale of a good for a period of time, similar to a lease. But, again, no interest can be charged if the lessee delays payment. A traditional lease contract differs from Ijārah in some other ways, like asset ownership (in Ijārah, the asset is owned by the bank) or risk (in Ijārah, the bank is responsible for the asset).
Salam — a contract where the good is delivered at a future date in exchange for a spot payment. Such contracts were first introduced for farmers who needed capital to yield adequate returns to return the investment.
Istisna — a forward contract where both the good and the money are exchanged at some later point. Under such a contract, the bank is a mediator between the buyer and the seller. The bank receives the payment from the sellers and makes installment payments to the producer.
Fee-based products where the bank earns a fee for its services. There are three types of fee-based products:
Wakalah — a bank acting as the agent of a customer.
Kafalah — a bank acting as a financial guarantee for its customer, promising to cover any liabilities that a customer might incur.
Ju’ala — an istisna contract, but for services.
Islamic banking institutions are a fairly modern institution, but they have expanded quickly, with total global assets doubling in just six years. Moreover, they are projected to grow at twice the pace of the GDP growth in Islamic countries.
Products in this space are plentiful, so I’m going to give several examples from Saudi Arabia to finally move away from all this boring theory in the preceding thousand words.
Let's start with Lendo, a peer-to-peer crowdlending platform for SMBs, helping them to pre-finance outstanding invoices. In plain English, this means that businesses get money upfront from lenders by using their unpaid customer bills as collateral. The company offers loans from approximately $25,000 up to approximately $750,000.
The application process is fairly straightforward. A business registers on the platform and provides all the necessary information. The application is reviewed in 5-7 days, and then enters Lendo’s platform where prospective investors can look at the business. If approved, the company can get a loan from approximately $25,000 up to approximately $750,000. However, the loan can’t exceed 80% of the invoice value sold to the customer.
Now, where’s the Islamic banking bit? Well, Lendo doesn’t make money from lending, as it’s not the one providing the loan. Lendo charges the business a management fee and also takes a 20% cut from the profit the investor makes. Another interesting part of the product is that investors never transfer the money directly to the business, and businesses don’t pay directly to investors. Everything goes through Lendo.
Since 2019, Lendo has processed over 2,500 transactions with total funding provided amounting to $300 million1.
Next on our list is Circyls. There’s this thing popular in Saudi Arabia called a rotating savings and credit association (ROSCA). A ROSCA is:
…an informal financial institution consisting of a group of individuals who make set contributions and withdrawals to and from a common fund
ROSCAs are popular in countries where there’s limited access to conventional banking, or as is the case in Saudi Arabia, where the banking industry has some non-traditional attributes.
Now, in Saudi Arabia’s case, ROSCAs are usually organized by friends and family. Circyls disrupts this tradition by enabling ROSCAs made up from strangers.
Here's how it works. You download an app and verify your identity. Then, you choose how much you want to contribute and when you want to receive funds. After you've created a booking, your application is checked, and if approved, you can start paying and receiving money. Each member of the ROSCA contributes the same amount as they took, and obviously, with no interest payments attached. Also, each member signs a promissory note, so if someone stops paying into the ROSCA, they can be sued. ROSCA’s members pay subscription fees.
The app has grown from 400,000 users in 2022 to over 2 million now.
Let’s finish with a big one — Tabby, which has received a total of $1.7 billion in funding. Tabby is a buy now, pay later (BNPL) service. But unlike traditional BNPL providers, Tabby doesn’t charge interest or late fees. A Tabby user has the option to divide their purchase into 4 interest-free payments, and that’s it.
How Tabby makes money is by charging merchants a rental amount:
…for enabling them to use the payment gateway.
Tabby amassed over 30,000 brands and 10 million users across Saudi Arabia, UAE, and Kuwait. What’s interesting is that Tabby is profitable, unlike many of its analogues in other parts of the world. The main reason has to do with Islamic banking. The lack of other credit solutions in the region is apparent, with only 15% of the population having a credit card, BNPL acts as a much-needed alternative.
The takeaway
While writing this article, I stumbled upon this interview where the guest implies that not everything is as rosy with Islamic banking as it seems. And even with the companies that we’ve talked about, I’m not exactly sure why they are considered Sharia-compliant, even after reading their Shariah certificate.
I also wonder, how big is the market for all religion-adjacent products, and whether the potential market for such solutions is in the trillions of dollars.