The Mirage of Interest-Free Islamic Finance

The promoters of Islamic finance claim that it is “interest-free.” My observation is that interest rates run through Islamic finance in the same manner blood runs through the veins of the promoters of Islamic finance.

There appears to be some confusion about whether the prohibition in Islam is against usury (excessively high interest rates) or against interest rates generally. I recall a conversation with two central bank governors from the Middle East soon after BNM had launched its Financial Sector Masterplan, which contained a strong push to develop interest-free Islamic finance in Malaysia. Both were adamant that while there is a prohibition in Islam against usury, there was no prohibition on interest rates. One of them even called the prohibition on interest rates a “Malaysian interpretation.”

The interpretation that usury makes interest rates bad and that consequently, investment is preferable to debt, creates multiple problems in finance, which the proponents of Islamic finance must deal with. The truth is that there is no more efficient mechanism to compensate for the time value of money than interest rates. Islamic finance has not found a better alternative to interest rates, as claimed by its proponents, but rather, has come up with various ways to disguise interest rates.

A lot of what goes as innovation in Islamic finance are just elaborate schemes to disguise the role of interest rates in the products and services of Islamic finance. It is necessary because most products offered by Islamic financial institutions merely reflect similar products from conventional finance. I see many of these retrofitted products as being merely an exercise of the “hall of mirrors." When you look at the reflections in the mirrors, Islamic finance products look different. However, they are merely the distorted reflections of what is standing in front of the mirrors: interest rates. It is an optical illusion. Through what amounts to subterfuge, the interest rate is hidden deep inside the products so that it is not obvious from the outside.

I will illustrate by looking at specific Islamic finance products. Let me start with the Sukuk bond.

I recall going on road shows to market Malaysia’s sovereign Sukuks to international investors. Listening to the investment bankers and watching their PowerPoint presentations to investors, I can still remember thinking that it all appeared like a presentation for some funky derivative product. The complexity arose from the need to obscure the interest rate element, the creation of various special purpose vehicles to make the asset appear relevant, and at the same time not being obvious that bond holders will be paid a specific rate of return from the coffers of the government.

An intelligent person should think that when you issue a bond that is based on an asset, the return on that bond should be tied to the profitability of the underlying asset and should you fail to repay the investors, they should have recourse to the underlying asset. Not in Islamic finance. The underlying asset for one Malaysian international Sukuk issuance was a bunch of government hospitals. And I was told by the investment bankers that Sukuks have been issued based on all sorts of non-profitable and non-commercial assets. What was also interesting was that apart from a couple of investors from the Middle East, I don’t recall any investor asking questions about the quality of the asset underlying the Sukuk, which would indeed be strange if the asset was a critical component of the Sukuk. When I asked the representative of a large international insurance company on this, he said that everyone understood that the Sukuk was really an instrument of sovereign risk and that the expected return would be determined by that and not the asset. If that is the case, then a Sukuk must be seen as a conventional bond given an Islamic dressing. The role of assets in Sukuks is more about appearances and form rather than substance.

What about the profit that is paid to Sukuk holders? When was the government ever a profit-making institution? Politicians are, but not the government. The pricing of the sovereign Sukuk is based on a certain margin above the equivalent US Treasury Bills rate. How is that different from a conventional bond? Despite all the complex mechanizations of the investment bankers, the return on the Sukuk is completely unrelated to the underlying asset. After all the fancy flow charts, when it comes to pricing, the sukuk is no different than any run-of-the-mill conventional bond. So, if the underlying asset is meaningless and the profit is an interest rate, how is the Sukuk an Islamic instrument and how does it differ from a conventional bond? The reality is that what is called innovation in the Sukuk space has in fact driven the sukuk further and further away from what an asset based/backed security should be.

A number of Islamic products offered by banks involve the buying and selling/leasing of some asset, often with pre-agreed cost and markup determined at the beginning. The real question that is not answered is what is the economic value of the buying/selling transaction? In normal trade, the buying and selling of goods entails some transformation of form, time, place, size and convenience to justify the profit that is earned by the seller, and that profit is by no means the same for every transaction. Also, both the buyer and seller have an economic interest in the good. In Islamic banking, when a commodity murabahah transaction is undertaken, is there similar economic value created by the buying and selling of commodities? There is no underlying value as neither party in the transaction has an economic interest in the underlying commodity. The commodity component of the transaction is merely concocted to facilitate the placement of a deposit or the granting of a loan. The real economic transaction is that the bank wants to lend money and the customer wants to borrow. Finally, after all the buying and selling of commodities, how different is the final pricing from a more conventional cost-of-funds plus interest margin approach? I suspect not very much. Again, a case of form over substance?

In the early days, I attended some courses in Islamic finance. But I soon discovered that after a lengthy description often accompanied by flow charts, the easiest way to end the conversation was to point out that there was still an element of interest rate in the product. I also never got a proper response on the issue of why usury (excessively high interest rates) condemns interest rates, but profit is not similarly condemned by profiteering (excessively high profits).

If there is any banking product where interest rates approach usurious levels, it is probably for credit card balances. However, Islamic banks have also gotten into issuing credit cards. It would be interesting to see if the profit rates that Islamic banks earn on these products are as high as the interest rates of their conventional brethren. If so, then those profit rates could meet the definition of profiteering. So, is profiteering a lesser evil? The point is that the business of banking is the same. Whether you call it interest rates or profits, they are not going to deviate substantially: the reality is still going to be a lending rate that reflects your cost of funds, your expected return and compensation for the risk of lending to a particular customer. The business of conventional banking is also about debt and debt products. Islamic banks operate in the same arena but claim to provide investment products. Islamic banks will never be investors in the true sense of that word; if they were, they will be the equivalent of investment funds. They are not. As it is, much of Islamic finance is still very much about debt, no matter how the Islamic financiers cast it.

If the deposit and lending profit rates that are offered to depositors and lenders, respectively, are truly based on the profitability of individual Islamic financial institutions, they would be subject to significant variation both across institution and across time. However, they are not. Those profit rates closely follow interest rates. If they did not, monetary policy would have a problem influencing conditions in the Islamic banking system to support its policy objectives. When the Central Bank changes its policy interest rate up or down, the profit rates offered by Islamic banking institutions dutifully move up or down in a similar fashion (Chart 1). During my time in the Central Bank, I saw various proposals by Islamic scholars for non-interest rate based monetary policy, but all lacked realism, being either based on some version of the already abandoned monetary aggregates or some complex index of various prices including the stock market and various commodities. So, I would assert that fundamentally, Islamic banking products are still priced based on interest rates.

The essential problem for Islamic banking if it was to be truly based on profit sharing is that it leads to a whole series of issues related to incentives, motives, risk-appetites and complexity – for bankers, their customers and the bank shareholders. For instance, when depositors put money in banks, they are looking for a safe asset that would offer them a predictable return. They do not want to take on the risk of banking business. Those who have a higher risk-appetite would be more inclined to put their money into equities, properties or even online forex trading and crypto currencies. But depositors are generally not willing to take on the uncertain risk of the bank's operations and the associated uncertain return on their money (they may be willing to take a share of their bank's profits, but certainly not the losses). In the same manner, borrowers want a predictable way of determining their future stream of payments, and to not have the surprise of having their payments increased because the bank had lower profits or suffered losses. This is a problem for Islamic banks. Hence, the deposit rates and base financing rates of Islamic banking institutions. Placing a conventional fixed deposit (FD) and an Islamic fixed deposit (FD-i) is similar – you get the rate of return on your FD receipt. I have placed FD-i’s and I do not recall any bank every coming to me later to say that I am entitled to a higher or lower return due to their profit outcomes. There is no profit-sharing with holders of FD-i. Your profit is what is stated when you place your FD-i, which is the case with a conventional FD.

Chart 2 shows the trend in the average rates on Islamic and conventional fixed deposits, as well as savings deposits, since 2015. Looking first at the overall trends, it clearly shows that average deposit rates of Islamic and conventional banks show the same overall trends. In terms of levels, rates offered on FD-i's have tended to be higher than those offered on conventional FDs. I do not have enough information to determine if this is due to Islamic banks facing challenges in attracting deposits or due to other factors. However, for savings deposits, the rates of Islamic banks have tended to be substantially lower than those of conventional banks.

Chart 3 compares the lending rates of Islamic and conventional banks. Again, the broad trends between the average financing rate and average lending rate are the same. However, the average financing rate of Islamic banks is significantly higher than the average lending rate of conventional banks. Assuming that the quality of borrowers is the same for Islamic and conventional banks, the implication of this is that it is on average more expensive to borrow from Islamic banks. It could be the outcome of their higher cost of funds as shown in Chart 2. The fact that Islamic banks tend to provide higher cost financing could have implications on the cost competitiveness of the economic sectors that rely on Islamic financing.

The key point here is that Islamic banks offer products that are similar to those of the conventional banks, and as can be readily seen from the trends in the charts, the pricing of these products trend closely with the interest rates of conventional banks. It is an expected outcome.

There have been attempts by regulators to push Islamic banking institutions away from pseudo-Islamic products, but it is not easy. The investment accounts (IAs) were one attempt at this. The idea being that the funds provided by depositors will be used to fund a specific portfolio of loans set aside by the banks, and depositors/investors will then share with the bank the profits and losses arising from that portfolio of loans. I recall walking into a local bank and out of curiosity allowing myself to be persuaded by the counter staff to consider opening an IA. After being assured that the return would be higher than conventional fixed deposits, I was handed a 11–12-page document that explained the product and contained all the caveats. The complexity for IAs is even more than that of the other structured products that banks try to sell their customers. For this reason, I would say that IAs are probably only appropriate for corporate customers that have the ability to assess the underlying risks, assuming that these IAs have maintained their original form and purpose.

To conclude, the claim that Islamic finance is interest-free has been a deception since its inception. The jargon and flow charts cannot obscure that fact. For a start, the promoters of Islamic finance have not made a clear case of why the possibility of usury makes conventional finance unacceptable, but the corresponding risk of profiteering does not similarly condemn Islamic finance. They must explain the optical illusion of products that appear on the surface to be interest-free but fundamentally are not. More importantly, can Islamic finance ever be truly interest-free with a strategy of retrofitting the debt and interest rate based products of conventional finance? From the customers' perspective, if there is not much differentiation in products and pricing between the conventional and Islamic financial system, apart from pandering to religious beliefs, how is the Islamic financial system in any way superior to the conventional financial system, as claimed by its promoters? As long as these issues are not addressed, it will be the case that there is less to Islamic finance than meets the eye.