The Islamic Bank of Britain, the first sharia-compliant bank in that country will soon open its doors. Ironically, Islamic banks may do better in the West than in the present Muslim world. The natural alternative to interest-bearing loans is a profit-sharing contract but that only works if accounting standards are clear and the courts can enforce the contract. Consider, if Taghi lends Amir money based on interest it’s clear what Amir owes, but if Taghi gives Amir money for a share of a profit-making enterprise then he is at the mercy of Amir’s bookkeeper. Writing in the NYTimes, Virginia Postrel writes:
…Islamic banks learned the hard way that risk sharing does not work in countries where businesses keep false accounting records. “Many people came to borrow money with wonderful ideas, and they just walked away with the money,” Professor Kuran said. The banks could not reliably audit the books, and if they took a client to court, the business would just claim a loss.
Consequently, the banks all started charging what amounted to interest for loans…A minuscule portion – generally well under 5 percent – of the assets of Islamic banks consist of loans based on genuine profit and loss sharing,” writes Professor Kuran..
Substitutes for interest-bearing loans are not hard to find, however.
The most common way around the interest ban is known as murabaha. The bank buys a capital good, a computer, say, for a client, who agrees to buy it back, with a markup, at a particular time in the future. In effect, the markup represents interest.
Islamic banks also invest in debt securities and pay depositors returns that fluctuate with prevailing interest rates. They act like money market funds.
Postrel’s article is based on Timur Kuran’s book, Islam and Mammon. I haven’t read the book yet but I know Timur’s work and feel safe in recommending it to anyone interested in these important issues. Here is chapter one.