Loan Pricing in Islamic Banks [How Interest-Free Loans Priced]
Islamic Banking Business means such banking business, the goals, objectives and
activities of which is to conduct banking business/activities according to the
principles of Islamic Shariah and no part of the business either in form and substance
has any elements not approved by Islamic Shariah.
According to Islamic Shariah;
- Islamic banking cannot deal in transactions involving interest, called riba in Islam.
- Islamic banks cannot deal with transactions having the element of Gharar, which means an excessive level of uncertainty or ambiguity is created due to the lack of information or control in a contract).
- Islamic banks cannot invest in something called Maiser, which means the game of chance.
- Islamic banks cannot deal in any transaction, the subject matter of which is invalid (haram in the eyes of Islam).
Islamic banks focus on generating returns through investment tools that are Shariah-compliant as well. Islamic Shariah links the gain on capital with its performance.
This is why Islamic banks price loans differently than conventional interested based banks.
There are three main board categories that Islamic banks use for loan pricing.
There are a total of 12 methods under all these categories.
12 Methods of Pricing Interest-Free Loans Islamic Banking
Loan Financing By Lending
Service Charge-based Interest-Free Loans
Loans with service charge, on which the bank may recover a service charge not exceeding the proportionate cost of operations, excluding the cost of funds and provision for bad debt. The Central Bank will determine the maximum service charge permissible to each bank from time to time.
Loans are given on compassionate grounds free of any interest and service charge, and repayable if and when the borrower can repay.
Trade-Related Modes Of Financing
Purchase goods by banks and sell to clients at appropriate mark-up prices on a deferred payment basis. In case of default, there should be no markup on the markup.
Purchase of trade bills and notes of credits based on mark-down in price.
Purchase of moveable and immovable property by the banks from their clients with buyback agreements or otherwise.
Rental or equipment for a fixed amount over a predetermined period to project sponsor by the banks.
Rental/ price in installments over an agreed period of the project.
Based on Charge
Financing for property development by the banks based on the development charges, fees, – commissions, etc.
Investment Types Modes Of Financing
Bank financing for investment is based on sharing the enterprise’s profit and loss.
Musharaka is a Shariah-compliant mode of investment wherein the bank and the client jointly provide the capital. Here no pre-fixed profit is earmarked like in Bai-Murabaha or Bai-Muajjal. Profit, if any, is distributed as per agreement between the client and the bank, while the loss, if any, is shared according to the capital ratio.
- The Musharaka agreement shall clearly lay down the amount of capital investment to be provided by the bank and the client and the profit/ loss sharing ratio as agreed between them.
- The actual profit of the business is to be distributed between the bank and the client as per the agreed ratio. But the loss, if any, is to be borne by them as per the ratio of the capital.
- The client shall properly maintain the ledger, register, books of accounts, etc., and have to show those to any authorized person of the bank on demand.
- For the success of the client’s business, the bank shall have the right to make any decision and supervise the business activities.
Equity Participation would allow banks to purchase shares of the listed corporations.
Participation Term Certificates (PTCs) and Mudaraba
Companies can issue participation Term Certificates (PTCs) and Mudaraba certificates within broad guidelines provided by the government regarding governing maturity, profit and loss sharing, and repayment as agreed between the company and the purchaser.
Rent sharing will allow banks to form partnerships with their clients to purchase the property based on sharing in the rental or any other income from the property.