Islamic finance: banking without interest

Omar needs a €200,000 home and does not want a loan with interest. Fatima wants to invest in shares without earning money from interest. Both follow Islamic principles. How can finance work without interest?

The principles

Islamic finance follows sharia, Islamic law as interpreted by scholars. Each institution has a board of scholars that checks its products. The main rules are:

• No riba: any increase agreed in advance on a loan of money, which means interest. Returns must come from trade, ownership or sharing business risk.
• No gharar: excessive uncertainty, for example selling something you do not own or cannot describe.
• No maysir: gambling, where the gain depends on chance alone.
• Asset-backing and risk sharing: financing is tied to a real asset or activity, and the financier shares the risk.
• No harmful activities: no financing of, for example, alcohol, gambling or conventional interest-based finance.

Two bodies set international standards: AAOIFI in Bahrain for accounting and sharia standards, and the Islamic Financial Services Board (IFSB) for prudential standards.

The main contracts

• Murabaha: a cost-plus sale. The bank buys the asset and sells it to you at a disclosed mark-up, paid in instalments.
• Ijara: a lease. The bank owns the asset and rents it to you, often with ownership passing to you at the end.
• Musharaka: a partnership. Both sides put in capital, share profit as agreed and share losses by capital. In a diminishing musharaka, you buy out the bank’s share step by step.
• Mudaraba: one side provides the capital and the other the work. Profit is shared by agreed ratio, and the capital provider bears the financial loss unless the manager was negligent.
• Sukuk: certificates of ownership in assets, often called Islamic bonds. Holders receive rent or profit, not interest.

Takaful, the insurance version, appeared in the insurance module.

Two worked examples

Investing with a sharia screen

Fatima’s fund screens shares in three steps. First, it excludes companies whose main business is not allowed. Second, it applies financial limits: index providers cap debt and cash at roughly 30–33% of a company’s value or assets, and income from non-compliant sources at about 5%. Third, it purifies the dividends. If a fund pays €500 and 3% of the companies’ income was non-compliant, Fatima gives 3% × €500 = €15 to charity.

The industry is large. The IFSB counted US$3.88 trillion of Islamic financial assets at the end of 2024. The Gulf countries held 53.1% of it. Banking was 71.6%, sukuk 23.3% and takaful 1.4%.