Is Islamic banking the model for fairness?

Is Islamic banking the model for fairness?

Alan O'Sullivan, This is Money
4 April 2009

As borrowers and savers call for a fairer banking system, are the principals of Islamic banking the answer? We take a look at the Islamic Bank of Britain

Tired of hearing about fat cat bank bonuses when you have been a bank's loyal saver for decades and received nothing?

Well, there is a new bank in Britain offering out a share of its profits, not just to shareholders, but those who deposit savings into its coffers.

The main aim of the Islamic Bank of Britain is to offer 'Sharia compliant' ways of borrowing and saving for British Muslims, which are in tune with Islamic law.

Non-Muslim bank customers can also benefit from this as Sharia rules – based on ethical trading principles – mean ordinary customers benefit along with the bank in the good times.

But they can also lose if the bank starts to lose funds.

How does it all work?

The method with which savings, loans and mortgages operate can take a while to get your head around.

Central to Islamic finance is the fact that money itself has no intrinsic value. As a matter of faith, a Muslim cannot lend money to, or receive money from someone and expect to benefit: interest (known as riba) is not allowed. To make money from money is forbidden; wealth can only be generated through legitimate trade and investment in assets.

This means its savings accounts cannot offer a guaranteed interest rate, but a proportion of predicted profits expressed as a probable rate.

Of the bank's 47,000 customers, a growing amount of them are non-Muslims who like the idea of being part of its growth, according to Sultan Choudhury, its commercial director.

He said: 'The concept of sharing profits is quite appealing to non-Muslims as well as Muslims. Up until recently, when banks were making huge profits, the shareholders were obviously taking a share but the depositors were not. I think that grated with many people. Here, the shareholders and depositors are more linked.'

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What are the rates like?

Of course, it also means losses get passed on, but the bank stresses it has either met or paid out more than the predicted profit rate over the past year.

It is also important to note that the original capital deposited is not at risk from losses, only the theoretical interest earned.

Studying the bank's monthly 'target' savings rates and 'actual' rates since January 2008, it is perhaps unsurprising there have not been sudden profits above predicted targets across its savings range. However, there has only been one occasion in the last year when rates fell below target, January 2008, when three accounts were 0.25% below the predicted rate. And considering the rough economic climate, that's not all bad.

The rates on its accounts, which include two easy access accounts, a young person's account, a notice account and three fixed-rate accounts, are mostly uninspiring, at just over 0% (there are also accounts for those willing to deposit over £50,000 and £100,000).

However, its one-year fixed-rate account has at times appeared in our best-buy tables and currently offers a decent rate of 3%, just outside of our Top 10.

But I thought the bank couldn't profit from interest?

The bank invests deposits in Sharia compliant investments – avoiding such things as alcohol and arms – and then shares profits with its customers, a 'legitimate trade'.

Generally the same principle applies to mortgages and loans, which the bank refers to as Home Purchase Plans and Halal Personal Finance respectively.

The bank doesn't lend customers money to buy a home, but buys the property along with them and rents its half to the customers until the capital sum is paid off. This is based on the widely used Islamic financing principles of Ijara (leasing) and Diminishing Musharaka (reducing partnership). The house is traded, in a way, so it is not an interest-based transaction.

However, the 'rent' is still expressed as a percentage, which is assessed every six months and stays fixed for that period. The minimum collars on each of the bank's five mortgage offers range from 4.49% to 4.99% and can rise to a ceiling of 3.5% over the Bank of England base rate.

Its latest deal at 60% loan-to-value (LTV) at a rate of 3.99% measures up very well against the rest of the market, but fails to beat the best variable rate offering from HSBC at 2.95% for a 60% LTV deal. When up to 80% of the value of the property is 'borrowed', the rate rises to 4.99%, behind the best variable rates on the market at this level of borrowing from Derbyshire Building Society at 3.49% and Clydesdale at 3.99%.

Significantly, however, the arrangement fees at the Islamic Bank of Britain are markedly below the industry norm of between £800-£1,000 at a bargain £299.

Mr Choudhury adds: 'Once people get over the hurdle of how the contracts are different, they realise these function as conventional mortgages with the usual advantages.'

What about loans?

The bank's loan offering is limited and its lending criteria very strict, which comes as good news at a time when banks are writing down billions of pounds due to reckless lending.

Customers can borrow between £5,000 and £15,000 at 12.9% APR. Although the loan is unsecured, the bank only lends to homeowners.

Again, the tranaction is Sharia compliant as the bank does not actually lend the customer any money.

As its website states: 'We buy and sell commodities and generate profit from these transactions. We do not charge interest, nor do you pay interest to us.'

Confused? Simply put, a customer could agree to buy £10,000 worth of commodities off the bank with a deferred payment. The bank sells them at cost plus profit of £2,000 to be paid over an agreed period, which the customer pays in monthly instalments. A broker then sells the commodities on, releasing the £10,000 at no inconvenience to the