It is likely that Islamic finance in Canada will increase in popularity given the number of potential households it could serve. It is also likely that as the regulatory framework for such institutions solidifies, more entrants into the market will help satiate the desire for economies of scale. Many emerging markets around the world with relatively large Muslim populations already have significant Islamic banking institutions. Needless to say, Islamic finance still remains a mystery to many in the Western world.
One of the fundamental tenets of banking is known as interest. There are several historical accounts of interest payments being made as far back as several centuries BC. Interest exists in two general types: a) a fee that is paid by a borrower of money; and b) a fee that is earned from the deposit of money. The difference between b) and a) is often referred to as “the spread.” The spread is how most financial institutions make revenue. Take for example a bank that takes a deposit from a customer of $100 and pays that customer interest of 2 per cent or in this case $2 after a year’s period. The bank will then take that same $100 and lend it out to a different customer who must pay borrower’s interest of 5 per cent or $5. In this case, the bank has made a spread (or profit) of $3.
Islamic banks adhere to religious law — called “sharia” — which affects how they operate. Under sharia law, Muslims do not pay or receive interest. This practice is known as “riba” in Arabic. When gold currency was used for normal transactions, it was acceptable for a loan of 100 gold dinars to be paid back as 110 gold dinars because it was considered tangible value. However, when economies moved toward the use of fiat (or government regulated) money, the practice of riba was inconsistent with Islamic principles and therefore, not permitted. Riba is defined as surplus value without counterpart. This distinction between tangible (gold) and intangible (fiat) transactions is at the root of what makes Islamic banking unique.
If Islamic finance prohibits charging interest (riba), how do they function? Ensuring fair play is at the core of Islamic banking. As such, the principle of “risk-sharing” is a critical component. In essence, the Islamic bank becomes a business partner with the customer. For example, a car lease is appropriate because the bank has a stake in the ownership of the car. There are two principle financing arrangements offered to borrowers: murabaha (instalment sale) and ijara (redeemable lease). In the murabaha example, the bank buys the asset (e.g. large screen television) and then resells it to the customer at a higher price while the customer still uses it. In this case, the customer will have an instalment plan of those repayments. In the ijara example, the customer would use the asset (e.g. large screen television) over a number of years and at the end of the agreement pay cash to own it outright.
When it comes to deposit accounts, Islamic banks have a similar philosophy to credit unions. They will both share in the profits of the organization. The main difference in Islamic finance is that the profits that will be distributed are at a rate agreed to when the account is initially opened. As such, if the Islamic bank does not make any profit, the depositor will not receive any payment. This is an example of the risk-sharing principle outlined earlier.
Islamic finance is an interesting topic of study. There are courses now offered in business schools across the country including ours at DeGroote. A handful of Islamic credit unions are popping up across Canada, although some have struggled to survive. A well-regulated and beneficial Islamic financial infrastructure is indeed possible, and most importantly, necessary for long-term viability in Canada.
Nick Bontis is a professional speaker, management consultant, business adviser, McMaster University professor and author.
NickBontis.com | @NickBontis