"We wish we were Obi-Wan Kenobi, and for the most part we are, but there's a little Darth Vader in all of us." -Chris Stevens
Question #92853 posted on 01/22/2020 5:56 p.m.
Q:

Dear 100 Hour Board,

How does the banking industry work in Islamic countries like Saudi Arabia if their religion prohibits the charging of interest? Do they re-label effectively interest as something else to compartmentalize it away?

-Frank

A:

Dear Frank, 

This is a really great question! Thank you for asking it. 

First, I think it is important to understand more principles behind Islamic banking and money law than just the idea of riba (usury, or exploitative means of making money). You should also know that many who follow Islamic law consider money not to be power, but a medium of exchange. The idea is that money should not be used to generate more money (hence, no interest). Additionally, you have to work for the money you earn, and lending money doesn't really count as working. Thus, as theconversation.com (read the article here, it's quite informative.) puts it, "...banks must provide some "service" to earn its profits."

Often, that means that you put your money in an account and the bank will invest your money in assets for you, and gradually those will increase in value. Islamic banks avoid situations of uncertainty and high risk, because that would also be dishonest.  That's how it works for you. 

However, in terms of loans or that sort of thing, they basically just make the original price of the loan higher. I think the top answer on this quora.com question does a spectacular job of explaining it. For those who didn't click the link, a summary: 

With a non-Islamic bank, you have an interest rate and an initial payment, things are very flexible, and sometimes the rates and how long you will pay for it will change. You can miss payments, and sometimes the arrangement shifts. With an Islamic bank, they will charge you slightly more on the initial payment (typically about the same as you would end up paying if you did the interest option) and just have a much more fixed system. You must make each payment, the amount you will pay will never change, and you know exactly when it will change.  

Their principles of investment and money management make Islamic-based economies some of the most stable in the world. When the rest of us suffered in 2008, they barely budged. 

Of course, this isn't the most wildly popular idea because it isn't as profitable (because you can't count on people to fail to make their payments so you get to charge them more, you can't manipulate the terms, etc.). There isn't negative interest, only slightly higher up-front costs. This is because they aren't trying to exploit and rapidly expand since that's against the principle. Instead, the more general idea that replaces positive interest is that the bank makes a profit with you as you make a profit, and takes a loss if you take a loss. 

One way they do this with more commercial loans is through an idea called equity participation. In this, banks get a share of the stocks in a company being created. Then, as the business gains ground and is more successful, the banks also make a profit through the stocks. (Read more here).

In short, they just don't charge interest. You may pay slightly higher fees in other places to ensure the bank's function, but there isn't really "compartmentalization."

In my opinion, Islamic banking is much more ethical, transparent, and stable than other forms of financial management. I was greatly impressed to learn about this! Two other sources you can read to learn more for yourself are 1) Wikipedia (duh. Keep in mind though, this is a pretty complicated one, I spent a LONG time clicking nearly all of the related links.) and 2) A great summary from Tough Nickel.

Cheers, 

Guesthouse