Modes of Interest Free Banking

As Islamic banking has evolved over last few decades, the scholars and bankers have had to develop Shari’ah-compliant products which offer means of conducting riba-free transactions. The following is a summary of products:

Musharakahis a venture where all parties involved share the profit or loss. Both the bank and the entrepreneur provide capital and share the results based on an agreed upon formula. This is an ideal business set up as an alternative to interest-based finance since the bank is not guaranteed an interest on the loan. The return in Musharakah is based on the actual profit. A traditional bank can not suffer a loss due to interest, while Musharakah may result in a loss by the Islamic bank. This arrangement is interest free.

Mudarabah is an agreement where only the financier provides the capital for investment in a commercial venture. As opposed to Musharakah, only the entrepreneur is involved in the management of the business. The provider of capital is also liable for all financial losses while the manager loses the effort of his labor. However, the profits are shared by all the parties involved based on the Mudarabah agreement. Along with Musharakah, Mudarabah is also an ideal interest free arrangement because both capital and labor are involved in a just economic arrangement and usually generate better returns. This transaction is interest free.

Murabaha is an instrument where the bank acquires a product upon request from the customer and sells it at an agreed upon profit. This is an extensively used transaction by Islamic banks. There are variations of Murabaha in which the payment or delivery of the product can be on the spot or at a future date. The payment could be at one time or a series of payments. Though Musharakah and Mudarabah are considered ideal transactions for Islamic banking, the scholars have allowed Murabaha due to practical difficulties in other two transactions. This transaction is very similar to interest based transactions and hence requires careful scrutiny before execution to seek assurance that it is not just interest renamed as Murabaha.

Ijara is the transfer of a capital asset from the owner to a user for a specified period of time for an agreed upon amount. The owner, an Islamic bank for this discussion, remains the owner for the duration of the lease and earns the profit or loss from the transaction. In some contracts, the asset is sold to the lessee at the end of the lease. Ijara is an interest free transaction.

Istisna’ais a sale where a product is sold before it comes into existence usually applicable to construction financing. The payment amount or series of payment are fixed in the agreement. The manufacturer or the builder is paid for the raw material, production effort and a profit. A bank may finance a manufacturer and take possession of the product after completion and then transfer it to customer at an agreed upon price. The bank may also lease the product after construction as a variation of the Istisna’a. This transaction is interest free.

Salamis a sales agreement where the seller promises to provide the buyer with an agreed product at a future date in exchange for an advanced payment at the time of contract. This is transaction is interest free with the condition that full price is paid in advance.