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Source: The Conversation (Au and NZ) – By Md Safiullah (Safi), Senior Lecturer in Finance, RMIT University

Islamic banks have become an integral part of the financial system in many Muslim-majority countries, as well as in nations with sizeable Muslim minorities such as the United Kingdom, South Africa, Sri Lanka and Thailand.

Australia is poised to join them. From mid-2024,
Islamic Bank Australia is set to offer Australia’s 813,000 Muslims a banking service aligned with their religion’s strictures against profiting from interest or investing in harmful industries such as alcohol or gambling.

The fundamental distinguishing feature of an Islamic bank is its adherence to Islamic, or Sharia, law. As such, Islamic banks differ from their counterparts in four main ways: they do not charge or pay interest; they don’t engage in property speculation or activities such as derivatives trading; they do not invest in businesses that are deemed unlawful by Islam; and they typically appoint a second board specifically to oversee their compliance with these rules.

Why do these rules and conventions exist, and how do they work in practice?

1. No interest

For devout Muslims, conventional banking services are problematic because of the main way most banks make profit – by charging interest on loans.

Islam’s holy book, the Quran, prohibits all transactions associated with interest. The third chapter (the Surah Al-Imran, verse 130) says:

O’ you who have Faith! Do not devour usury, doubled and multiplied, and be in awe of Allah; that you may be prosperous.

Usury refers to lending money at unreasonable interest rates, but the term is sometimes used to mean any charging of interest at all. Judaism and Catholicism have also traditionally outlawed usury, although historically they have allowed more wiggle room in how this is applied.

Sharia law prohibits banks from charging any interest on loans at all. But that doesn’t mean Islamic banks are opposed to earning profit.

To comply with Sharia law, an Islamic bank enters into a joint venture or partnership agreement with depositors and borrowers, which allows sharing of profit and loss between bank and customers.

Islamic banks provide loans under a profit-and-loss contract rather than one involving interest-based repayments. In this arrangement, borrowers pay an agreed share of their profits to the bank.

Similarly, deposits with the bank don’t earn interest, but instead they earn a return that will rise or fall in line with the bank’s overall profits.

Read more:
Islamic finance provides an alternative to debt-based systems

One potential pitfall of this model is it might encourage borrowers to take unnecessary business risks, knowing their bank will share the losses. This, in turn, would potentially reduce the returns to those who have deposited funds with the bank and also increase the credit risk for banks.

To help guard against this risk, borrowers typically agree to allow the bank to act as a partner in the business, rather than simply as a creditor. This lets the bank monitor the business’s performance more closely, and share directly in its profits and losses.

Hands using laptop showing blurred spreadsheet and graphs
Rather than paying interest, business borrowers typically share a portion of their profits with the bank.
Campaign Creators/Unsplash, CC BY-SA

2. No speculative assets

The Quran (Surah Al-Baqarah, verse 275) says:

…Allah has permitted trading and forbidden usury.

From this, Islamic scholars infer that purchasing land or property purely for speculation is not permissible, but buying it to undertake economic activities is allowed. This means Islamic banks cannot engage in the kind of debt-based financing that underpins the home or business loans offered by many Australian banks.

Instead, an Islamic bank can finance a home purchase by taking part-ownership of the property, according to the proportion of the purchase price that was provided by bank finance rather the buyer’s own funds.

Similarly, Islamic banks can provide loans to buy land that will be used for economic activities, but cannot profit purely from land price appreciation.

Shariah law also prohibits Islamic banks from engaging in derivatives trading (trading in financial products such as futures contracts, options or swaps) because this involves speculating on an asset’s market performance, rather than on economic activity itself.

3. No ‘socially harmful’ business

Sharia law does not allow an Islamic bank to finance economic sectors that are deemed harmful to people’s wellbeing, such as alcohol, tobacco, gambling, adult entertainment, pork products, or arms production.

4. Islamic corporate governance

Islamic banks typically appoint two boards: a regular board of directors similar to those that govern most banks, and a Sharia supervisory board to oversee compliance with Islamic laws.

What are Islamic Bank Australia’s prospects?

The main challenge for Islamic Bank Australia will be to gain accreditation from the Australian Prudential Regulatory Authority (APRA), which regulates Australia’s commercial banking industry. The bank says it is planning to apply for this in mid-2024, after which it can open to the public.

Next, it will need to attract a significant client base. As of October 2022 it reportedly had almost 8,000 prospective customers on its waiting list.

The arrival of Sharia-compliant banking will bring some new issues for Australia’s banking sector more broadly.

Australia does not yet have any supervisory body for monitoring Sharia-compliant banking, meaning all responsibility in this area would fall to the bank’s own supervisory board. In many Muslim-majority countries, such as Malaysia for example, a separate Sharia Advisory Council, typically appointed by the country’s central bank, oversees the Islamic finance industry.

Islamic Bank Australia’s Sharia committee has three members: Malaysia-based Ashraf Md Hashim, who also sits on that country’s Sharia Advisory Council; Mohamed Ali Elgari, an Islamic economics academic in Saudi Arabia; and Australia-based Islamic banking scholar Rashid Raashed.

Many other Islamic banks worldwide also have overseas Sharia scholars sitting on their boards. But given the complexity of the role, these appointees will need to be familiar with current practices in Australia’s financial landscape too.

Read more:
Is Islamic banking more risky compared to conventional banking?

A related issue is the question of how Islamic Bank Australia will interact with Australia’s existing banks. Besides adhering to Sharia law, it will also need to comply with all of Australia’s banking regulatory requirements. In doing so, it will inevitably come across interest-based transactions.

For example, Islamic Bank Australia must maintain an account for settling any transactions with the Reserve Bank, and will have to refer to existing benchmarks, such as the underlying interest rate, as references for the dividends and charges applied to customers under its profit-and-loss contracts.

Islamic Bank Australia and existing banks will have to get used to adapting to the rules and customs, but it has been done successfully in other Western countries and so Australia should be no exception.

The Conversation

The authors do not work for, consult, own shares in or receive funding from any company or organisation that would benefit from this article, and have disclosed no relevant affiliations beyond their academic appointment.

ref. Australia will soon have its first Islamic bank. What does this mean, and what are the challenges? –