This is a guest post by the Secret Muslim Banker

“If you give a man a gun, he can rob a bank – if you give a man a bank, he can rob the world.”

No industry is vilified as much as banks. Probably because of their special status. They have the power to create new money whenever you take out a loan.

Central banks and governments give commercial banks this power.

But what’s the bank’s primary role?

Its main job is to act as an intermediary between those who have surplus capital and those who are in need of capital. The bank acts as the middleman between two parties to prevent money from gathering dust. Money circulates to those who need it. To those who can do something productive with it.

But that’s not entirely right.

Banks operate under a fractional reserve banking system. For every deposit they receive (surplus capital), they can create ten times (yes ten times) that amount in new loans. 

I didn’t pull that number from nowhere. Banks usually keep 10% of their reserves in cash.

So if you deposit $100 at the bank, they only need to keep $10 and can lend out the remaining $90. The borrower of the $90 can deposit that in the bank. The bank keeps $9 and lends out $81. And on it goes. New money keeps popping up magically given the bank only needs to keep a tiny fraction at hand.

That $100 can grow to $1000. That’s $900 of new money created.

As long as you don’t come collecting your entire $100 at once, this can go on. But if you do, the bank finds itself naked. There you have a bank run.

This is risky. Most of the time, banks manage this risk fairly well. But bank runs aren’t as rare as their statistical models would show.

I’m gonna show you why modern Islamic banking isn’t a viable solution. It uses the same principles. A truly Islamic banking model needs to rethink the main principles.

Understanding Commercial Banking

The modern secular banking system poses a few problems from an Islamic perspective.

First let’s look at what a current account actually is. We’ll assume two scenarios:

  1. Current account as a loan from a client to the bank
  2. Current account as a deposit by client to the bank

Current Account as a Loan from a Client to the Bank

Imagine you open a current account with a bank. You go to the bank and lend them $100. The bank now owns that money and has a liability (i.e. a debt) towards you.

You decide to go shopping. You buy a coat and pay the shopkeeper $100 for that coat with a cheque. The shopkeeper has a current account at the same bank. The shopkeeper takes your cheque to the bank to deposit it into his account. This is a simple instruction to the bank to transfer the bank’s debt to you over to the shopkeeper. The bank no longer owes you $100. It owes it to the shopkeeper.

Current Account as a Deposit by the Client at the Bank

Instead of lending money to the bank, you enter into a deposit agreement. The bank is the safe-keeper of your money that remains in your ownership. The bank shouldn’t use the money without seeking your permission.

In the example above where you decide to buy a coat from the shopkeeper with a cheque, the instruction from the shopkeeper to the bank is to transfer the money from your account to the shopkeeper’s account. Money is transferred instead of debt.

If the bank uses your money with your permission, the deposit transforms into a deposit of guarantee. The bank guarantees to repay the amount of deposit from its own funds if necessary.

So a deposit of guarantee is basically a loan that is repayable on demand. The bank owes you your deposit.

But modern commercial banks don’t have sufficient reserves to guarantee deposits. I’ve touched on the fractional reserve banking system above. Banks only need to keep 10% of reserves in cash. So the guarantee isn’t much of a guarantee. If everyone came to the bank to ask for their deposits back, the bank would collapse. That’s a bank run.

Using statistical models, they estimate that the probability of a bank run is extremely low. Because the probability that depositors will come together and withdraw their funds is low.

Notice the ambiguity in the language used by the banks when it comes to marketing and accounting. They use the term “deposit” when marketing (i.e. make a deposit, open a deposit account). But the word “debt” is used when preparing financial accounts.

Using the word “deposit” gives the illusion that the clients’ money is available for immediate withdrawal. But using the term “debt”, it allows the bank to argue that it’s the owner of the money placed in its accounts. That way it can do whatever it wants with the money. 

There’s clearly a paradox. Money can’t be in two places at once. The money can’t be simultaneously available for withdrawal by depositors and also loaned out to the banks’ borrowers.

Therefore there’s a large element of risk in commercial banking activities. They use statistical models to insinuate that this risk is low. But the risks are more common than we think.

Suffice to say that banks are operating with an element of gharar. Gharar means uncertainty. It’s rooted in the Arabic word ‘to deceive’ (gharra). This can happen when the claim of ownership or the outcome isn’t clear. Gambling and the use of derivatives (like futures and options) are examples of gharar.

So what I’m saying here is that the banks are taking a gamble. A huge gamble.

Take Northern Rock for example. The British bank, nationalised by the UK government in 2008 because of a bank run. The only reason depositors didn’t lose their money is because the government stepped in and bailed the bank out. And by government, I mean UK taxpayers. Under an Islamic economic system, a bank couldn’t find itself in such a situation where billions of dollars in losses need to be paid by citizens of a country.

This concept of gharar is an important one. I don’t think this has received much attention from the Islamic banking world. They may have somewhat gotten rid of riba (although this is laughable) but the element of gharar still persists. 

Modern Islamic Banking

Before we take a look at how Islamic banks operate today, let’s go back in time. During Umar ibn al Khattab’s caliphate. He was a close companion of the Prophet Muhammad (pbuh) and was the second caliph. He ruled from 634 to 644 AD.

Mudarabah is a type of financing contract that was approved during his time. The mudarabah is a simple partnership where one party provides capital and the other party manages the capital using their time and labour. Both parties share in the profits. The investor is referred to as rab al-mal. The one offering management and labour is the mudarib.

A simple example is two people coming together to start a car dealership. One of them will provide the money to purchase the cars, rent out the dealership store and make other office expenses. The other will work to source the cars to be bought, employ a team, manage the day to day activities of the dealership and handle all client relationships.

Musharakah was another type of partnership contract used later on. This is a joint enterprise where all the partners share the gains and losses. It’s an ideal alternative to any interest-based financing. It was a popular form of financing where investment funds were channeled to business operators in larger towns and cities of the Muslim world.

Using these practices, the Muslim world saw massive economic progress without any formal investment banking and commercial banking institutions. 

Looking at it today, it seems impossible to imagine a world without large financial institutions such as central banks. These entities grease the world’s financial wheels. They’ve saved us from tricky economic situations. Even though those situations were created by the very same institutions in the first place.

But I’ll digress. Let’s look at modern Islamic banking. Islamic banking as we know it today.

It started in the 1970s. There wasn’t much of a revolution in the banking world. They simply Islamised the western model of banking. The founders and operators of these early banks argued that Islamic contracts of profit-sharing were unsuitable for a commercial banking operation.

And they were right.

A commercial banking framework needs essential components such as a central bank, a money market (i.e. ability to borrow money safely and quickly), fractional reserves and fiat money. Some went on to admit that Islamic banking couldn’t achieve commercial viability without compromising core principles of Islam.

Some academics were eager to prove them wrong. They were a bit more optimistic, but also naive. The Indian economist Nejatullah Siddiqi was one of them. In the 1970s he argued that Islamic banking could proceed using a two-tier mudarabah.

Remember mudarabah is when there are two parties in a partnership: one of them is the investor and the other manages the investor’s money.

Siddiqi stated that the bank would take funds from customers (i.e. deposits) as a mudarib. The customers would be the investors and the bank would be the manager of the money deposited. The bank would then enter into an investment agreement with companies it wished to finance. Another mudarabah. On this side, it would act as the rab al-mal and share the profits with the entrepreneurs it finances. The entrepreneurs would be the mudaribs.

The role of the central bank, Siddiqi stated, could be to provide liquidity by buying shares in these companies. To free up the bank’s capital. This way the bank didn’t need to tie up its customers’ funds in long-term projects.

It’s an interesting model. But it’s not suited to standard commercial banking practices.

The Islamic banks of today employ the first part of the model. The returns that the depositors receive is a share of the profits that the bank makes. 

But they aren’t using the second part of the mudarabah. So how are they generating money?

They resort to contracts of exchange such as murabahah. A murabahah is a transaction where the seller and buyer agree to a mark-up on the price of the goods being sold. In exchange, the seller agrees to receive the payment from the buyer later on as a deferred payment or in installments.

Take the example of a house that’s on the market for $500,000. A mudarabah agreement is where the seller agrees to sell the house to the buyer at a price of $550,000 and accepts to be paid over a period of 10 years in equal installments of $55,000 a year.

This is the main type of contracts that Islamic banks deal with.

It may be better than using interest rates, but it’s not completely dissimilar.  This is why a lot of scholars consider murabahah as a transitory step towards a true profit and loss sharing financing model. The problem is that we haven’t moved much from this transitory step since the 70s.

The banks are still operating using this model.

And frankly, I don’t see how they could do so otherwise.

You must realise that the bank’s lifeblood is liquidity. It needs access to money from other banks immediately. It needs to deal with large withdrawals. If it doesn’t have the cash on hand because it operates under a fractional reserve system. It’ll borrow funds from other banks in the interbank market. It’s fairly common and it’s an extremely liquid market. Banks can borrow from each other at the lowest rate of interest possible.

Going back to what I said above, if the banking model relies on the core elements such as central banks, money market, fractional reserves and fiat money, then there is not much room for innovation.

How does an Islamic bank decide to tap into liquidity if it needs to? It will borrow from the interbank market. But instead of taking on a loan with interest, it will use a murabahah contract of exchange. To be more specific, a commodity murabahah.

All this does, is that instead of Bank A lending money to Bank B and asking for a slightly higher amount (i.e. an interest rate), Bank A will sell something (usually a metal, like copper) to Bank B at a slightly higher price than the current market price and Bank B will pay for this copper at a later date (depending on when the money is due).

But the banks don’t care about the metal being used. What are they going to do with the copper? It’s pretty evident that the copper trade is a workaround to be able to exchange money for more money at a later time.

It’s not hard to see that this is practically the same thing as a loan with interest. 

It doesn’t matter what metal is being used. Banks are just exchanging cashflows.

So what should an Islamic bank look like?

What should an Islamic Bank look like?

“Trust, as one of the Islamic values, has deteriorated and its reliability, as a form of security, has been weakened because we [financial institutions in Muslim societies] have adopted Western security techniques which depend exclusively on material forms of guarantee without lending any importance to moral guarantees. Nevertheless, our society still believes an individual would normally not deceive others who deal with him relying completely on moral guarantees.”

That’s a quote from Ahmed Al-Najjar, the founding father of the first real modern Islamic banking experiment: Mit Ghamr Savings bank.

The city of Mit Ghamr, in Egypt, was doing well. It was an industrial town producing more than 70% of the country’s aluminum. So there was a lot of excess capital that needed to be directed efficiently.

The bank was established in 1963. The idea was simple: collect the surplus savings from people in the region and use those savings to invest in rural activities in the area. For example, funds were being invested in house repairs, buying machines, tools for handcrafts, buying animals and other agricultural activities. 

The main caveat was that the funds had to be invested in the same city.

The bank would offer two types of credits:

  1. Non-investment credit: these are loans with zero interest. You can think of them as charitable loans. They’re hard to replicate today with a large bank given the bank’s focus on profitability. This works better in smaller communities.
  2. Investment/partnership credit: this is where the banks provide funds and invest alongside the recipient and share in the profits and losses. In other words, a musharakah.

The bank acted as an investment partner with the recipient of the funds for whatever venture they were undertaking. A real musharakah contract. A real profit-and-loss sharing agreement.

The bank only operated for 4 years. In those 4 years it saw staggering growth. The number of savers from 1965 until 1967 increased by 400%. On top of that, it opened 8 more locations around Egypt. 

I wish we had more data to see what the profitability was like. But with more savers and more branches, we can assume that things were going well.

So why did it close?

There were both political and legal reasons. 

The government at the time was hostile towards Islamic movements. It’s one reason why Mit Ghamr never had the word ‘Islamic’ in its name. So Najjar hid the Islamic identity of his project under slogans of socialism.

The legal reason was due to not having the right approvals from the Central bank of Egypt. Given the bank was under the umbrella of a Savings Association, it needed the green light from the Central bank to collect savings.

Some point to economic reasons. Even though the situation of certain borrowers became better, they didn’t need to pay anything when taking on personal loans. That meant that the bank was losing out on potential returns when giving away charitable loans.

But in any case, Mit Ghamr is the closest thing we’ve seen to a real Islamic bank. A real Islamic bank cannot operate on a fractional reserve system. It cannot be linked to a central bank and the money market system. This whole system is fuelled by interest rates. Interest rates are the lifeblood of this system. The system that generates liquidity from a central bank to the banks and between the banks. And from the banks to its clients.

It’s no wonder that Harris Irfan refers to the term “Islamic banking” as an oxymoron. I couldn’t agree more. 

The current banking system is in direct opposition to Islamic principles. 

We have to think differently about banking. 

If banking is to act as an intermediary between savers and borrowers, between those who have surplus capital and those who need it, then a savings bank a la Mit Ghamr is what we need.

Savers deposit their funds and receive returns based on the investments made by the bank. Here the bank becomes more of an asset manager. It will manage the assets on behalf of its clients and invest it into different ventures.

We could imagine different pools of investments based on the risk appetite of each saver. One bucket could be as simple as investing in the safest shariah-compliant companies listed on the stock market. Another bucket could be focused on tech start-ups where the investment horizon is a minimum of 5 years. Another could be invested in real estate. And so on.

Here, the bank needs real skill to know how to allocate capital. They will also do their work diligently to make sure that those requesting investments are worthy of investment.

But banks today prefer low-risk commercial activities. They take as little risk as possible. Why take risk when you can profit from the interest rate?

The interest rate provides the incentive to not innovate banking practices.

They may act as an intermediary to begin with but they can quickly become financial monsters. They grow as they control the flow of money. 

Does it seem fair that a particular industry is able to grow because they have certain powers? The power to create money? Yes, it’s regulated. But every other industry can only profit from producing a product. Or by giving a service. 

The banks create money and charge for it. But no equivalent output is produced. Well not directly. They may say they are helping the economy by extending money to those who need it. But their profit isn’t tied to the output. It’s tied only to the repayments of the loan.

Islamic banks aren’t any different. And they won’t be. Because they operate using the same mechanics.

A real Islamic bank will need to rethink everything from the ground up.


About the Author

The Secret Muslim Banker manages a $100m private investment fund and explores Islamic finance and economics through his personal lens. He helps simplify financial markets from a Muslim perspective.

His blog is a personal exploration of Islamic finance and economics. There he unpacks complex concepts, and shares insights on the financial market from a Muslim perspective.

You can also find him on 𝕏 at https://twitter.com/SecMuslimBanker

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