Islamic banking: A variation of conventional banking?

Mohamed Ariff Monash University

Acknowledgment: I declare my indebtedness to several eminent scholars who contributed, through their writings and in some cases in discussions with me, thus influencing the ideas expressed in this paper: Chris Adams, M. Ariff, Murat Cizakca, Rifaat Kareem; Rodney Wilson; Rafiqur Zaman; Hassan Tanha; and many others. I take personal responsibility for remaining errors. The contributor holds a chair in Finance at the Monash University. His research interest in Islamic banking is aimed at incorporating modern banking and finance concepts and theories into this new form of banking and finance to enrich its contribution to ethical finance. I am also indebted to the three anonymous reviewers for their very useful contributions to this revised paper.

This article is the first of a series to describe the current status of a new form of banking-finance-insurance, which aims to incorporate socially-desirable ethical principles into the design and operation of financial transactions. There are 400 plus so-called Islamic banks with total assets of US$ 7 trillion in some 44 countries, including the major financial centres in the U.K., Singapore and Switzerland. Mohamed Ariff provides an introduction to this new form of banking, and argues that the practice of this form of banking meets a demand from some clients for sociallydesired applications of scarce resource, the accumulated capital of mankind.

What is a bank?
The Encyclopaedia Britannica defines a bank as an institution that deals in money and its substitutes and provides other financial services. Banks accept deposits and make loans and derive a profit from the difference in the interest rates paid.. Islamic bank will fit this description only just even if one replaces interest rates paid with profit-shares and fees.1 Then what is the difference between a conventional bank and this new form of banking under widespread public discussion today? A bank is an institution because, similar to any other societally-sanctioned institutions such as an insurance company, a bank is heavily regulated by a set of laws (see www.hifip.harvard.edu) passed by a society in which the bank operates. The same is also true of the Islamic banks: see Mulijan, Dar and Hall (2004) on capital adequacy as an example of rules. In addition to the normal banking laws and prudential laws, an Islamic bank is supervised by a Shariah Board to enforce the application of fair-dealing and avoidance of a number of prohibited financial transactions. Having thus given a simple but yet satisfactory definition, the motivation for this paper is to introduce the quintessence of Islamic banking in the broader context of conventional banking to lay bare the essential principles and practices involved. First and foremost banking is a modern human invention within the financial sector of an economy - as opposed to the real sector of an economy - with specific aims to fulfil three socially beneficial functions: (i) efficient payment system that expedites payments to be made to parties to economic activities; (ii) intermediation function (see any standard banking book or for Islamic banking, see Chapra, 2002) that is to channel savings of households in an economy to the producer units (businesses and government) for reinvestment as capital, a scarce resource of mankind; and (c) other financial transactions, which are a whole range of specialised activities such as mortgage creation, cross-border trade guarantee (letter of credit), securities trading such as in common stocks and others. The Islamic bank fulfils these three broad functions as well as does a conventional bank: Islamic bank also engages in

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investment financing, which a conventional bank generally avoids. An Islamic bank has a fourth function, which is absent, to a large extent, in conventional banking. The above discussion of what a bank is but brief. In the last 100 years, banks have become more specialised thus complex: it is also the case with the Islamic banks over the last 40 years, which has led to newer specialised entities of Islamic banking-finance-insurance. Broadly defined financial transactions are performed by several specialised bank-like institutions: commercial banks; investment banks; savings institutions; credit unions; bankholding as well as financial-holding companies; development banks; and all of them are regulated heavily.2 In the case of Islamic bank-like activities too, newer form of financial activities undertaken by banks are licensed separately; Islamic Mutual funds; Islamic Index Funds; Islamic Development Bank; Islamic or Takaful Insurance; etc. In this article, not much will be discussed about these specialised forms of banking-financial entities. From a community or societys point of view, an Islamic bank fulfils the same functions in a modern economy as that of a conventional bank plus one more. A big qualification is that an Islamic banks governance structure and the operation are based on fulfilling a fourth function imposed as Shariah regulations compliance That is, the requirement for compliance with three general principles which, under the customary laws of adherents to this religion, are interpreted as promoting socio-ethical purposes in financial transactions. This fourth function loosely translated as socio-ethical function is imposed on this bank, which may be explained as the fourth, which is the ethical principle.

Binding principles of financial transactions

Ethical principle 1 is that the profits earned by a bank from its activities and returns made by a bank to the depositors shall be (a) from sharing of risk in the project and (b) profit-share agreements and not pre-agreed fixed interest payments, which is considered as prohibited earnings because pre-agreed interest agreement has no sharing of risk of investment of money.3 Principle 2 is the avoidance of financing any economic activity considered not in the long-term interest of society (examples are prostitution; gambling; production and sale of liquor for intoxication; etc).4 Principle 3 is avoidance of earnings from extremely uncertain risky financial activities bordering closely to a level of risk of loss of money as in gambling: this principle arises from the mandate in Koranic law that requires parties to contracts to avoid extreme risk.5 The first principle is identified as avoidance of interest receipts and payments in financial transactions as agreed among contemporary jurists interpretation since the 1960s.6 In earlier Islamic era, this principle was enunciated as avoidance of usury or excessive interest (riba) and there is a continuing debate about this question among the Muslim jurists as well as lay scholars (a long line of commentators from Aristotle to modern day Benjamin Franklin and a chairman of Bank of England) on how to deal with what is interest and what is excessive interest. Although for practical purposes today, avoidance of any form of interest received or paid is considered as a must in Islamic banking, a position that has led to the devising of Islamic banking as a solution. In place of a pre-agreed interest payment/receipt, a pre-agreed profit-share formula conditional on the outcome of the end-result of financial lending activities by sharing in risk - is considered as permissible in Islamic banking. The second principle is akin to the enunciation of a pro-society social movement in recent history. In the 1970s in the U.S., there was a movement that started ethical investment funds, and created what were then termed ethical mutual funds. That movement also considered financing anti-societal activities (as well as investment by funds in firms producing weapons of mass destruction) as not-pro-society. An Islamic bank will not engage in financing activities that are considered unequivocally as illegal (haram) for an adherent to Islam. Hence, no financing activities considered anti-society are permitted in financial transactions. The third principle is that a contract of financial service must have upfront all dangers pre-announced or declared: that is, as in modern finance, there ought to be transparency in financial contracts that reduces asymmetric information advantage of parties to the contract. Hence, it is considered that a contract that is likely to result in loss of capital, and the level of risk (garar) borders that of gambling (gain always for the game operator, and a sure loss for almost all others), an Islamic bank is not permitted to offer such a financial product.

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Now we can define an Islamic bank as an institution that deals in money and its substitutes and provides other financial services. Banks accept deposits and make loans and derive a profit from the difference in the profits-shares and fee incomes that are consistent with the Shariah common law principles governing such a bank .. Defined this way, it is a modern institution fulfilling the three conventional functions and a fourth ethical function mandated as compliance with a set of socio-ethical principles. Underlying the entire tenet of the financial transactions of this form of banking are two requirements: a reward in a moneybased transaction must be the result of profit-shares from sharing in the risk of the outlay and not pre-agreed and fixed reward regardless of the consequence of investment; and that any financial transaction that is doubtful of ensuring long-term societal well-being is considered disallowed. How does a bank then govern itself and operate?

Operations
First, by practice over many centuries, certain forms of financial transactions have been devised as consistent with this form of banking. The over-riding criteria are: is money begetting money without risk-sharing?; is the socio-ethical value of a financial transaction prosociety? By answering these two critical criteria, new products are being financially engineered in addition to the ones that had existed in historical time. A simple classification of the existing products can now be attempted first by looking at what is the core of a conventional bank first. Later, we will describe the way the items in a typical bank will have different meanings because of these injunctions/requirements. What a bank is as a business can be conceived by reference to a balance sheet of a banklike business: see Chart 1. On the left side of the balance sheet (which describes the financial position of a bank at the end of, say, a year) are the assets that earn income. These are the loans marked A (that offer interest income to a conventional bank and profit-share income to an Islamic bank). Fixed assets are marked B (some of which, for example, the office space, is used to produce the financial products and services while some assets may provide capital gains if owned by a bank while such a building also saves the rent that needs to be paid). While a conventional bank would call loan as shown in the proforma as an earning assets from making loans, an Islamic bank would not call it a loan asset, and may prefer to call it financing or profit-share agreements as loan has the connotation of interest being attached to it. A and B together add up as the total assets of a bank be it a conventional or an Islamic bank: how these items are classified are controlled by the accounting standards: for Islamic banking standards, see Rifaat (2001).
Chart 1: The Sample Balance Sheet of a Banking Business

_________________________________________________________ A: LOANS C: DEPOSITS _________________________________________________________ B: FIXED ASSETS D: CAPITAL _________________________________________________________ TOTALASSETS = LIABILITIES + EQUITY _________________________________________________________
Item C on the right-hand side is the deposit from the members of the public either as time/savings deposits or checking deposits In the case of checking deposits for safekeeping and convenience (wadiah), no return is guaranteed: however, an Islamic bank may make ex gracia payments, which is permitted. In that case, in a conventional bank, a time deposit will earn a small interest pre-agreed with the depositor while, in an Islamic bank, the depositor receives a profit share declared at the end of each month on the basis of profits made on the deposits by the bank if the loan is profit-share basis (mudaraba) or joint venture return if on joint venture basis (murabaha). A point to remember here is that, by engaging in profit-sharing funding/financing agreements, the fund provided Islamic banks thereby takes on the character of investment which a conventional bank does not do. Please refer to Footnote No. 1 for elucidation. If the deposit is a checking account, then an Islamic bank ensures its safekeeping and return, but does not guarantee a return although the bank is free to make a donation; most conventional banks used to pay nothing, but since the 1980s

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conventional banks started to pay to the checking account holder a very small pre-agreed interest on the balance amount.7 The final item D is capital: in conventional banking, this consists of interest-based borrowed capital (Tier-2 capital): in an Islamic bank, this will be the same borrowed capital but borrowed based on profitshare principle. An important part of item D is in fact the share capital (musharaka), which is exactly the same in both conventional and Islamic banks. Equity holders earn a return on their capital provided to the bank: return is not pre-agreed, and depends ex post on the profits made by the bank in a year. Besides, the reward to equity is larger the larger the risk of the bank: shareholders of Macquarie Bank, which is a highly risky investment bank, earn twice as much as the shareholders of Commonwealth Bank of Australia, a less risky bank, in a typical year. Thus, the statement made earlier is true that an Islamic bank, in essence, is a conventional bank but for (a) an imposition on a banking restriction to avoid any pre-agreed interest payment/receipt and (b) promotion of risk-sharing leading to profit-shares. Third, and importantly, in addition, an Islamic bank will not have financial transactions that are not promoting socio-ethical financing and investing of accumulated capital. Continuing the example further, the balance sheet of an Islamic bank, in terms of this stylised chart, will have the same items as a conventional bank with one big difference. The item called A (LOANS or more correctly financing) is made to businesses, persons, and governments on the basis of profit-sharing formula judged on the basis of the amount of risk in the funding rather than pre-agreed non-risk-sharing basis. This has important implications in that the reward for loaning or financing activities is decided only after the performance of the loans. This leads to both parties sharing in the ex post risk of the financed activity thus it aims to tie the reward to risk sharing. Because of the infancy of Islamic banking, there is as yet a scoring system (as is the case with the credit rating used in conventional banks) to tie the profit shares to the perceived risk of the financed activity.8 Second point to remember is that loaning activity for a real asset purchase (a house, a commercial aircraft, a business premise, etc.) is considered different from one for a financial asset purchase (buying a common stock or a bond or a bill). Therefore, a bank is considered financing a purchase of a house owned by the borrower, and the periodic payments by the borrower to an Islamic bank are periodic returns (not interest and principal) of the fund in instalment. The consequence of all these is that under this form of financing, the mortgagor starts building equity from the first payment (in conventional bank, interest is recovered first, and mortgagor builds up equity later after all the interest is recovered by a conventional bank). Housing finance may also differ depending on whether it is made on leasing (ijara) basis or on diminishing musharaka basis. Some terminologies used in Islamic banking need to be introduced now. These terms may cause some degree of confusion to the new entrants to the market, but these are simple if interpreted in the context of financial statements. As this article is only about the vanilla type simple banking, not all technical terms are introduced here, to keep the discussion simple. A quick reference to the following Table will introduce the un-initiated to the banking terms (see the footnotes to the Table). Table 1: A Simple Classification of Islamic Banking Using Financial Statements

Financial Statement items

CONVENTIONAL BANK

ISLAMIC BANK

Panel A: Performance of a bank Profit & Loss Net interest income Financial services income Capital gains Less -Operating expenses -Amortisation of goodwill -Charge for doubtful loans = Gross Profits - Income taxes = Net Profits Net income (profit shares) a Financial services incomea Capital gains Less -Operating expenses -Amortisation of goodwill -Charge for doubtful loans = Gross Profitsa - Income taxes = Net Profitsa

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Panel B: Financial Position of a Bank Balance Sheet Assets: Loans and Advances (after provisions for NPL) Fixed assets Total Assets Total Risk-weighted Assetsc Liabilities and Deposits & other borrowing Bonds, notes & subor debt Floating Rate Notes Shareholder capital Ordinary Shares Equity instruments Total Equity
a b

Loans & Advancesb (after provisions for NPL) Fixed assets Total Assets Total Risk-weighted Assetsc Deposits & other borrowing Bonds, notes & subor debtb Floating Rate Notesb Ordinary Shares (musharaka) Equity instruments Total Equity (musharaka)

Income earned by an Islamic bank is from profit-shares, services fee and the excess over all expenses.

Can be any or all of: profit shares (mudarabah); cost plus services (murabaha); joint-venture (musaraka); safekeeping (wadiah); and leasing of assets (ijarah).

This refers to the requirement of both conventional and Islamic banks to risk-weight the assets as per Basel I or II accord. These accords at the Bank for International Settlements (BIS) in Basel Switzerland requires that the value of assets are adjusted downwards by a system of risk evaluation of the assets so that the adjusted figures could then be compared as assets adjusted to account for risk. Please note that the spelling of the concepts used in this paper vary as in the literature. I have chosen the most simple spelling to keep this readable, thus incurring the mistake of incorrect pronunciation.

The Table includes two financial statements: Panel A refers to the performance of a bank over a reporting period (Profit and Loss); and Panel B is a financial position at the end of a reporting period in a balance sheet. A conventional bank reports net income on loans net of interest paid to the depositors and loan capital providers. An Islamic bank does not accept or pay interest but reports net income from profit-shares agreements (see footnotes a and b to the Table for the Islamic bank terms used) and fee incomes from sale-like or lease-like or banking services fees. Profit share income may be from different forms of lending (more correctly financing) activities such as profit shares (mudarabah) or joint-venture (musaraka) or some specialised form of financing not described here. Or it may be from services fees for safekeeping (wadiah), cost plus services (murabaha, and leasing of assets (ijarah). One final item (not shown in the pro-forma above) is a portion compulsorily deducted from profits for charitable purposes. In practice it amounts to a tiny fraction of the pre-tax profits. Continuing the other items in the Panel A, all items are similar, but for the exception we have noted that the entire report is conditional on income reporting that (i) avoids interest, (ii) financing activities that are not in the long-term interest of society (no funds for liquor production for consumption, no gambling, etc.) and (iii) prohibitions of financial products with extreme information asymmetry bordering near gambling, hence dangerously risky as an investment. Looking at the balance sheet in Panel B, the Islamic bank would have the same type of entries (the actual items will have some technical terms equivalent to them). Deposits and other borrowings would mean that these borrowings are consistent with the three principles discussed earlier: for example a bank may hold a bond, and but it is called a sukuk bond as it is issued with no pre-agreed interest coupons as is the case in conventional bonds that offers a pre-agreed interest payment. There are finer points to consider here. The issuer

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of sukuk (say a central bank) has some real assets, which provides periodic rental incomes, which income is then used to provide returns to the investor in a sukuk bond. Similarly, the equity may be referred to as the musaraka fund but it means exactly the same as equity. The identical nature9 of the column entries to explain the terms in Table 1 for the conventional and the Islamic banks may convince once again that the latter is a newer form of banking. As such it is yet another specialised bank offering newer products in the same way as investment banking started to offer opportunities for securitisation of assets some decades ago. Newer forms of banking fulfil the demand by clients who would not otherwise participate in the banking activities of a typical conventional bank. Islamic banks provide for their clients secular satisfaction that their financial activities is carried out in a manner that is socio-ethically consistent with their beliefs of avoidance of interest (riba), pro-societal financing (non-haram) and avoidance of extreme risk (garar). The nature of profits therefore takes a different form from than the pre-agreed, pre-fixed, non-risk-shared rewards that has been promoted by the financial institutions for four centuries. Over the historical time, banks have tended to seek profits by distancing their monitoring function by going from fixed to variable interest, and switching from engaging in monitoring aggressively to securitising their risky products and taking such products off the balance sheet. This results in firms with bank loans relaxing their management oversight or in some famous cases engaging in outright fraud unknown to the bank that lends! These modern innovations have tended on the other hand to reduce the burden imposed by modern and complex societies on banks to perform the function of delegated monitors. It must also be said that the same forces have diminished the social responsibility of modern banks, and helped them to be more focused on profits without due consideration of the end-use to which the humanitys accumulated scarce capital is being deployed. From the outset historically, banks have not been conditioned to promote broader social goals.10 Is ethical banking the wedge that would make banking more socially responsible?

Contemporary scene
In this context, Islamic banking with its orthodoxy may appear to be a revisionist banking. Yes, it is and if the customer requires that, the banks are willing to provide that service wholeheartedly. Islamic banking is growing at a rate of about 15% per annum, about four times faster than conventional banking: see Islamic Development Bank website and Internet sources. From just a handful of institutions mostly in the Arab countries in the 1960s, it has innovated itself to be accepted by the bastions of banking in England and Switzerland. Both these countries appear to be doing the big-ticket Islamic banking and their major banks have begun to join in the chase for a slice of the business: Citigroup; HSBC; UBS; DresdnerBank; ABN-Amro are the big ticket banks doing large-ticket banking and, importantly, having the expertise to financially engineer new products that are exciting for the customers with deeper pockets but demanding Islamic financial products. There are about 400-over banks licensed as Islamic banks or many have operating divisions with a Shariah Board in about 44 countries or more. The total assets of these banks are estimated at around US$ 7 trillion with an equity capital base of some US$ 400 billion.11 A number of institutions have been organised to supervise these banks. Apart from their compliance with the laws (licensing-operation laws; prudential supervision laws; international supervision rules), these supra-national bodies provide a degree of standardization in accounting treatments of numbers (Accounting and Auditing Standards Organisation for Islamic Financial Institutions, AASOIFI); in financial service provision (Islamic Financial Services Board, which also works with the BIS on Basel II, and on capital adequacy). The Islamic Development Bank (IDB) is another organisation that promotes this new form of banking. An international body named General Council for Islamic Banks and Financial Institutions (GCIBFI) is a self-regulating information gathering body that promotes some degree of homogenisation of this new form of banking-finance-insurance. On the training of human resources, not much has been done till recently as the provision of Islamic finance expertise has been left to the private sector with very few countries or institutions (exception are Indonesia, Malaysia and Islamic Development Bank) allocating resources for the very specific purpose of training in this new form of banking. The scholars trained in religious studies have adequate training to define what are allowable financial

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contracts based upon the interpretations of legal schools in Islam. There are plenty of resources in this regard since Arabic studies and religious studies have been adequately catered for in major universities. However, training in banking, finance and insurance remains inadequate. In 2006, a body has been formed (INCEIF for International Centre for Education in Islamic Finance) with a mandate to provide adequate training materials and a body of welltrained finance people to certify the practitioners through self-study with materials provided in universities and in the web sites that leads to examination and certification. If successful, this will fill the void as the expansion of this form of banking is takes off. About 20 or so institutions and in some cases universities mostly in the Arab region as well as Malaysia-Indonesia region and occasionally in the UK, Switzerland and Singapore are engaged in providing some small scale introduction to the specialisation. It is expected that there will be a boom in this subject area of training and research as the market grows in the next decades. Studies of performance of Islamic banks have provided a canvas of findings although such studies and their findings are conditioned by the early phase of this new market growth: see Ariff (2006), Skully and Brown (2006), and Zaidi (1991). Preliminary results show findings worth noting. First, the growth rate is picking up fast, and more of the resources-rich banking groups in the World are fast entering this business and expanding it even faster than before. This is partly because of the fact that not only are the Muslims finding the products attractive, but also non-Muslims: Islamic bank products are sold to any one. Second, the broader indicators of financial performance shows that the banks studied (not all of them have been studied yet) appear to be doing a good job as measured by return on assets, return on equity and other measures also are faring well. Third, studies of production efficiency show that the banks have positive total factor productivity scores, although the size of the scores are small because of the lack of scale economies in such banks, given its infancy. There is a lack of standards in reporting (see Rifaat, 2001) which is likely to be remedied as more and more Islamic banks adopt accounting standards now available for them. Finally, the true contribution of Islamic banking is in devising a way of making a truly profit-sharing financial market place: most banks are still lacking in vision and expertise and the will to make advances in this direction is yet far away. Some serious scholars have criticised Islamic banks for this very lack of vision and accuse them of currently engaged in subterfuge to make conventional banking products as Islamic banking. Overall, this new form of banking is likely to enrich community efforts to control the banks from being more concerned with profits only, by redirection some attention to their broader societal impacts from what they do as banking business: see Divany (2002). A caveat to be added is that this article may give an impression that the contemporary Islamic banks have the flavour of a true prototype Islamic bank risk and return flavour. Far from it, at this early phase of development, Islamic banks are considered by some critics to be merely an approximations bordering on a legal fiction (hiyal) of what it should truly be. Further, there have been several new products that have been introduced inside more innovative bank circles, truly risk-sharing instruments are being designed and offered. The author has deliberately kept the paper simple to avoid a more technical treatment of the more advanced aspects of Islamic Finance to be avoided in this journal.

References:
Aggarwal, Rajesh K., and Tarek Yusoff, 2000, Islamic Banks and Investment Financing, Journal of Money, Credit and Banking Vol 32 (1): pp. 93-120. Ariff, M., 2006, Islamic Banking in Southeast Asia: A comparative Study of Performance, Research paper presented at the Institute of Islamic Research and Training, IRTI, of Islamic Development Bank, organised by the SEACEN central bank consortium, Jakarta, 2005. Chapra, M. Umer, 2002, Islamic Banking: An Alternative Model for Financial Intermediation, Staff Paper, Islamic Development Bank, Jeddah, presented at the Arab-Italian Chamber of Commerce, Rome, Italy, 2002. Divany, Tarek El, 2002, History of Banking: An Analysis, Proceedings of International Conference on a Stable and Just Global Monetary System, International Islamic University Malaysia, August, 2002. Mieroop, Marc Van de, 2005, The Invention of Interest: Sumerian Loans, in William N Goetzmann and K. Geert Roewenhorst (ed) Of Value: The Financial Innovations that Created Modern Capital markets. Oxford University Press, USA.

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Mulijan, Dandang, H. A. Dar and Maximilian J. B. Hall, 2004, A capital adequacy framework for Islamic banks: the need to reconcile deposits risk aversion with managers risk taking, Applied Financial Economics Vol. 14: pp. 429441. Rifaat A. A. Kareem, 2001, International accounting harmonization, banking regulation, and Islamic banks, The International Journal of Accounting Vol. 36: pp. 169-193. Skully, Michael, and Kym Brown, 2006, Financial Performance of Islamic Banks, paper presented at the 17 Asian Finance Association meeting, Auckland, 2006. www.hifip.harvard.edu. Sixth Harvard University Forum on Islamic Finance: Current Legal and Regulatory Issues, Cambridge, Mass., USA, 2005. Zaidi, Nawazish Ali, 1991, Performance of banks under a non-interest system, Journal of Islamic Banking and Finance Vol. 8(1): pp. 42-50.
th

A caution is needed in adopting this definition. An Islamic bank is not exactly equal to a conventional bank even with no pre-fixed interest payments in that a true prototype Islamic bank is both a bank and an investment company. True prototype Islamic bank (this entity has yet arrived at this early phase of Islamic banking development) will engage project financing under various principles of financing, which makes an Islamic bank also an investment company. To keep the definition simple, in order to discuss Islamic banking to a lay audience in this paper, the writer has deliberately chosen to side-step a need for more rigorous definition by focusing on a key characteristic of promoting profit sharing financing agreement and consideration of risk-sharing by lender/financier. There are three layers of regulations in any country: regulation of what a bank can and cannot do as laid out in laws, regulations and accounting standards relating to banking and investor protection; laws relating to inspection by a central authority such as the Australian Prudential Regulatory Authority or the UKs Financial Regulation Authority; and international regulatory institutions such as the Bank for International Settlement and Basel Accord. Islamic banks also have to conform to the same regulations. In a sense, this principle arises from the ancient world practice among all religions that considered profits from trade in goods-services as permissible, but not profits from possession of money: Catholic religion (see Psalm 15: 5 for about dozen prohibiting interest) took a similar view in the Middle Ages, and, when the church itself got into banking business later, this precept was eroded in practice in later centuries.
4 3 2

This principle is applied to all forms of financial activities such that the avoidance of engaging in anti-societal activities are forbidden, not merely advised against. The Dow Joness Islamic Index eliminated about 40% of the firms in U.S. market as not complying with this precept.

Avoidance of extreme risk is mandate as a religious duty to ensure survival of the community: it is called extreme risk or gharar. In modern financial terms, it may be interpreted as engaging in a financial transaction where there is a great deal of asymmetric information such that a prudent person, in the absence of that information, would engage in a self-destroying activity The word interest appears in recorded history as far back as 2400 BC in the records of Babylon: see Marc Van de Meiroop (2005). In most countries where banks pay a small interest payment, that payment is about a quarter of the interest on a one-year time deposit: in 2006 in Australia, checking account and savings account on demand gets about 1.5% interest in some banks while the same banks pays about 6.2% for a 1-year savings deposit. In Germany, one of the constituent states of that country has engineered a borrowing contract in 2005 for Euro 400 million on a profit-share basis. It is not impossible, for example, to devise a system of risk-rating of borrowers, and then deciding the profit share ratio. The important point still remains for practice is that the profits to be made are contingent upon the profits being earned although the ratio of sharing could easily be pre-determined based on modern concepts in financial/credit risk analysis.
9 8 7 6

One has to be very careful here. For purpose of illustration, am using the terms of a conventional bank to drive the point that Islamic bank is a variation of the conventional bank. In reality, the actual terms they use will reflect the terms peculiar to this new form of banking. An example will suffice to drive this point: An Islamic bank Profit & Loss statement may have an entry mudaraba financing by which is meant that this is a loan made using profit-share agreement; musaraka financing is meant to convey that this loan contract is also a profit share agreement but with joint ownership.

This is an oversimplification to drive a point. There have been attempts for example during the time of the US Independence and the time of Abraham Lincoln to wean the banks from their aggressive search for profits, and to bring in reforms to introduce community consideration. But these attempts are cursory attempts to satisfy some other interests rather than aimed at denying capital for anti-social usages, or ignoring the power that banks come to exert as a lobby against equitable order.
11

10

Two countries (Saudi Arabia and Sudan) have adapted their domestic banks to fully become Islamic banks: foreign banks operate as conventional bank for international transactions. Pakistan took steps to introduce Islamic banking throughout the economy some years ago: however, it operates both Islamic and conventional banking today. In other countries, Islamic banks exist side by side with conventional banks (some of which offer Islamic financial products as well): examples are those of Indonesia, Gulf countries, Malaysia, Thailand, etc. Despite all this, at this early stage of the market growth, Islamic banks will not account for more than 1-2% of the total assets of all banks: if the full potential is reached in the future, then it will still account for no more than quarter of the assets in banks. The source for the US$ 400 billion is Islamic Development Board web site and conference paper citing Internet sources.

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