The alternative interest-free banking system - how it works

Economy July 15, 2015 01:00

By Dr Saran Sarntisart

5,432 Viewed

The 2008 sub-prime financial crisis led to protests and criticism on the negative impact of the financial and banking system on the economy and society. Calls were made for a more equal and sustainable system - an alternative one.

One alternative is so-called ethical banking, which puts emphasis on the social and environmental impacts of its investments and loans. Another alternative that should not be overlooked is the Islamic banking system, which has experienced high growth rates over the past decades.

Islamic banking started in Egypt in 1963 under the name of Mit Ghamr Savings Bank. The first commercial Islamic bank, Dubai Islamic Bank, was established in the United Arab Emirates in 1975.

As for Southeast Asia, Malaysia was the pioneer, opening Bank Islam in 1983, while Thailand’s first and only full-fledged Islamic bank, the Islamic Bank of Thailand, opened its doors in 1998.

The main difference between the conventional banking system and the Islamic one is that the latter does not collect or pay interest, as it is against the teachings of Islam. Besides that, the bank cannot get involved with speculation, or receive deposits and give out financing to businesses related to goods prohibited by the religion such as pork, alcoholic beverages, arms, and gambling.

The million-dollar question is, if an Islamic bank is interest-free, how then does it operate?

Let’s first look at the deposit side. There are two types of deposits in an Islamic bank; the wadiah and the mudharabah account. The purpose of the wadiah account is basically safekeeping. Depositors can withdraw their money at any time and hence the bank is not obliged to pay returns. In practice, however, the Islamic bank will give depositors some return, upon its discretion, after profits have been distributed to the mudharabah account.

The second type of account, mudharabah, is an account where the Islamic bank uses the funds for investment and financing. The depositor and the bank share the profit according to a pre-agreed ratio (the bank does not guarantee a fixed amount). In the case of losses, the depositor will be solely responsible.

The mudharabah account can be further categorised into a general account and a restricted one. In the former, the depositor does not have a say in the bank’s investments, while in the latter the depositor can restrict the bank to investing in certain types of businesses or industries.

In both cases transparency is a must, as the bank has to tell the depositor where his or her money is invested.

In short, the deposit side of an Islamic bank acts like a mutual fund. It consists of accounts with different risk-return profiles ranging from the safest, wadiah account (and of course with the lowest return), to ones with higher risk but higher returns in the case of mudharabah accounts, depending on what type of financing the funds are invested in.

Thus customers with different preferences can allocate their savings into each account according to their level of risk aversion.

One interesting point is that compared with conventional banks, Islamic banks have very low costs of funds as they are not required to pay fixed returns to either type of account. This could benefit the bank especially when the economy is in a bad condition.

You may now start to have a clearer picture of how an interest-free banking system could work, specifically on the deposit side. Next time I’ll describe details on the financing methods, how the bank uses its funds to make profit.

Let me give you a hint. An Islamic bank can be described as a type of universal banking.

Dr Saran Sarntisart is a lecturer at the Graduate School of Development Economics, National Institute of Development Administration.