How does an interest free bank work?

By: Shahana MV

The pathways in the development of alternative financial institutions or interest-free banks were discussed in the previous part. let’s see the theoretical aspects of an interest-free bank.

 How does an interest-free bank work?

There are mainly two methods of operation following Interest-free banks.

Musharakah and Mudarabah

Mudarabah

Mudarabah is a kind of partnership where one partner lends money to another for investing in a business. The first partner here is called Rabbul maal, while the other called Mudarib has the responsibility to manage the works related to the business. The liability of Rabbul maal is limited to the amount of his investment. The owner of the business’s assets shall be Rabbul Maal, and the Mudarib cannot claim his share over the assets of the business but will be entitled to profit share.

Rabbul mal may specify a type of business (Restricted Mudarabah) to Mudarib or may leave his opportunities open (unrestricted Mudarabah). The Mudarib is authorised to do everything required in the normal course of business, but any extraordinary work to be done beyond the normal routine of the traders, the express consent of the Rabbul Maal should be sorted.

Musharakah

Musharakah in Arabic means sharing, and in a business context, it means partnership. The financier lends money to the businessperson, and the businessperson engages in a contract to share profits or losses of such business in a determined ratio applicable on the profits accrued or loss incurred. It is not allowed to fix a lump sum, or any rate tied up with his investment, or to keep an agreement banning the sharing of losses.

This contract is more like a joint venture, and both parties will share their responsibilities in the business.

Murabaha

a cost-plus financing contract where the seller provides the cost and profit margin of an asset.  It’s a sharia – complied credit sale, not a loan.


Ijarah

The other method of financing by the bank called Ijarah is similar to leasing. A bank buys an asset for its customer and gives it out on lease for a certain period at a fixed rental. Sharia permits renting of assets with a precondition that the ownership shall lie with the bank.

Bai Bithaman Ajil

This is a deferred payment sale system where the buyer pays the seller, the price of goods after sales with an agreed profit margin. The bank buys the goods from its seller on a cash basis and assigns the trader with goods with a deferred payments sale contract.

Sukuk

A kind of bond in Islamic finance used to buy assets that derive benefits in the future.

Thakaful

Insurance contract complied with sharia laws where money is pooled and invested.

Istisna

Contract to manufacture, assemble or process goods or to build a house or other structure according to exact specifications in a fixed timeline.

Attractions/Merits

  1. Financial inclusion – access to useful and affordable financial services and products delivered in a responsible and sustainable way
  2. Reducing the impact of harmful products and services- usury, speculation, and gambling
  3. Principle of financial justice – the western financial system is profit based and makes the beneficiary liable for risk while the Alternative financing system (or an Interest-free bank) is dependant on sharing of profits/losses and risk involved in a proportional manner.
  4. Encouraging stability in investments – Interest-free banks perform detailed audit and analysis of companies and keep away those with risky financial practices and operations. This reduces investment risks and improves stability.
  5. Accelerate economic development – ALternate finance companies drive on growth objectives and they choose investments that assure greater growth in comparison with their competitors in order to attract fund from more depositors. This ultimately contributes to economic growth.

 Risks involved/Demerits

Rumoured Allegations:

The main accusations faced by Interest-free banks is that they have always been funding terrorism. The allegation found its root from the fact that Interest-free banks transact a lot of Zakat money; which happens to be the tax on the rich to be distributed to the poor. This Zakat money is pooled in the banks and they later transfer them to charitable institutions for purely charitable purposes. Some of those institutions had later evolved into terrorist groups, and the banks were indirectly accused of funding terrorism. Nonetheless, this allegation is considered to be false.

Other important direct disadvantages are:

  1. High transaction or issue costs
  2. Extra compliance requirements.
  3. Risk minimisation is impossible since hedging is prohibited.
  4. Some Alternative finance products may not be compatible with international financial regulation.
  5. Interest-free debts are practically not considered as debts and WACC is affected.
  6. Lack of awareness among the public.
  7. Indian political atmosphere and banking laws.

Interest-free banking solutions are gaining popularity worldwide and is in its embryo stage in India. Many people in India are reluctant to mobilise their funds because of its non-compliance with sharia principles and opening an Interest-free banking window will help release those immobile funds into the economy.  However, the RBI needs more clarity in provisions related to alternative banking. Since these principles still contain grey areas, it will take a bit of time to get implemented.

Earlier part: Interest-free Banking, the precedent pathways.

Next Part:Interest-free Banking in India – Challenges

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