Islamic Banks operate under Sharia law, which are the religious laws of Islam. Following Sharia law has major impacts on how Islamic banks make money and handle transactions. Islamic finance is commonplace in many Muslim nations and is becoming increasingly popular in secular^[i] countries like the UK.

How do Islamic Banking practices differ from conventional banking?

Islamic financial institutions follow Sharia law, which means they may only invest in morally upright and ethical causes. Islamic banks cannot invest in immoral or unethical vices such as gambling or alcohol. In contrast, conventional banks only aim to maximise profit, so ethical considerations are given less thought.

Islamic banks are prevented from charging interest and usury^[ii]. Instead, they must make money by providing some kind of service for their clients. Conventional banks are free to charge or give out as much interest as they deem necessary. To make money without interest, Islamic banks operate on a profit and loss-sharing basis. If the bank makes a profit, it is expected to share it with its clients instead of giving out a set interest rate on savings. If a client makes profits using the bank’s interest-free loans, it is also expected to give the bank a share of its profits. However, if either party makes a loss, then the other will gain no benefits. As such, Islamic banks tend to be more risk-averse. Legally conventional banks should receive their share or receive compensation even if their client makes a loss.

Sharia law also forbids investing in assets that involve excessive risk and speculation. Islamic banks typically avoid industries that could be related to economic bubbles^[iii]. Conventional banks have no restrictions on trading and are free to speculate and take risks at their own leisure. However, this practice could lead to speculative bubbles or moral hazards^[iv].

Products offered by Islamic banks are usually scrutinised by a supervisory board of Islamic scholars to ensure they are compliant with Sharia law.

Why might Islamic Banking appeal to consumers?

Islamic banks must be transparent with their clients. When dealing with prospective clients, they must disclose all available information guiding them through all the risks and costs associated with a product.

Moreover, Islamic banks cannot invest in unethical practices and must avoid sin stocks^[v]. These stipulations can encourage further transparency and help build stronger relationships between the bank and its clients as they know their savings will go towards good causes.

Islamic banks offer more equitable outcomes for their clients as they operate on a profit and loss-sharing basis and are not as focused on maximising their profits. This means risk is shared between the bank and customers. All customers are also entitled to an equal share of the bank's profits, allowing a more equal distribution of income. Lowering inequalities helps alleviate social issues such as crime and deprivation.

Furthermore, Islamic banks are prohibited from excessive risk taking and speculative behaviour. These practices help minimise the threat of losses and make income more stable and guaranteed. Consequently, this lowers the risk of opening an account with Sharia-compliant banks as well as aiding to maintain confidence in Islamic banks. It also lowers the risk of moral hazards and bank runs.

Importantly, Islamic financial services are open to all. There is no requirement to be a practising Muslim.

What are some concerns regarding Islamic Banks?

Sharia-compliant savings accounts do not pay a fixed rate of interest. Rather, they’ll usually pay out a share of the account’s profits. However, these rates may not be guaranteed as they are based on the estimated profits the bank could make by investing your savings. This can encourage some consumers to overspend their savings since they believe they will receive a share of profits later.

Less risk taking by Islamic banks can lead to lower returns over time, reducing their profitability. Also, since Islamic banks avoid lending to risky business, a lack of access to credit means some businesses invest less and the number of business startups may fall, leading to a less dynamic economy with fewer employment opportunities.

There are also concerns that Islamic banks will be unable to compete on the global stage against conventional banks due to the various amounts of constraints imposed on them. Historically, Islamic banks have been concentrated in Muslim nations where many existed in subsidised environments. Therefore, there are worries that Islamic banks may be less efficient and profitable than conventional banks. Despite these concerns, the Islamic banking industry is expected to grow to $3.5 trillion by 2024, up from $2.5 trillion in 2020.

Footnotes:

[i] Secular - A state not subject to or bound by religious rule.

[ii] Usury - The practice or action of lending money at unreasonably high rates of interest.

[iii] Economic bubble - An economic bubble occurs any time that the price of a good rises far above the item's real value, which tends to create a stream of continued investment.

[iv] Moral Hazard - A moral hazard is a situation in which an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk.

[v] Sin stock - Shares in companies that are considered unethical, such as alcohol, tobacco, or gambling.

Bibliography:

What is Islamic finance? | Bank of England

Islamic banking and other religious bank accounts - Gocompare.com