Q1. How does Islamic banking work?
The basis for all Islamic finance lies in the principles of the Sharia, or Islamic Law, which is taken from the Qur'an and from the example of Prophet Muhammad (peace be upon him).
Islamic banking operates without interest which is not permitted in Islam, as money in itself is not considered to have intrinsic value. As interest is income generated from money, it is seen as effortless return. Instead money must be used in a productive way and wealth can only be generated through legitimate trade and investment, which involves an element of risk.
Islamic banking therefore uses various principles recognised as Sharia compliant such as Ijara (leasing), Musharaka (partnership) and Wakala (agency agreement). Islamic banks use these principles to develop Sharia compliant financial products, such as savings accounts and home finance, which allow Muslims to conduct their finances in an Islamic way.
Q2. How is Islamic banking different to conventional banking?
The absence of interest in Islamic finance is one of the key factors that differentiate Islamic banks from conventional banks. However, there are other important differences:
a) Islamic banking is asset-backed which means that an Islamic bank does not carry out business unless an asset is purchased to allow the transaction to be conducted according to Sharia.
b) The source of the Islamic bank’s funding, profits and business investments cannot be in/from businesses that are considered unlawful under Sharia, i.e. companies that deal in interest, gambling, pornography, speculation, tobacco and other commodities contrary to Islamic values.
c) The whole premise of Islamic banking is to provide a way for society to conduct its finances in a way that is ethical and socially responsible. Trade, entrepreneurship and risk-sharing are encouraged and these are the financial principles that underpin Islamic finance and the products offered by IBB.
Q3. Why should I consider Islamic banking? Is it really necessary to switch from my existing bank?
The Qur'an makes it clear that interest, or riba, is forbidden. Conventional banking, which is interest based, is therefore not suitable for Muslims.
The Qur’an does permit trade as a method of generating wealth and this is the basis for Islamic banking. It operates without interest to offer approved Sharia compliant financial products. These are based on Islamic finance principles involving trade, such as leasing, investments and partnership. With Islamic banks Muslims can save their money, buy their homes and carry out their day to day banking in a Sharia compliant way.
Some Muslim customers stay with conventional banks and simply do not keep the interest they earn. However, what they may not know is that, indirectly, this can provide funding to other customers for activities that are not permitted in Islam, including interest-based lending. For example, a Muslim customer’s deposits may be partly, or fully, used to provide an interest-based loan to fund a casino or brewery. This is not permitted according to Sharia. Islamic banking, therefore, provides the certainty to Muslim customers that their money, which is with the bank in a savings, current or business banking account, is not being used in a way that is against Sharia principles.
Islamic finance is now widely and competitively available in the UK and consumers have a real choice about how they manage their finances. By choosing an Islamic bank, Muslims have the peace of mind that their money is working for them and still in line with their faith.
Q4. Where can I go if I want to start using Islamic finance for my mortgage and savings instead of banks and building societies that are based on interest?
The UK has quite a well-developed Islamic finance system, especially when compared to other Western countries. According to research from the CityUK Islamic Finance 2011 report there are 22 financial institutions offering Islamic banking. Most of these are wholesale banks that are used by large businesses. Some of these are Islamic finance ‘windows’ offered by high street banks.
Islamic Bank of Britain plc (IBB) is the only wholly Sharia compliant, retail Islamic bank. This means IBB is not part of any other UK bank and every part of its operations is wholly based on Sharia.
Q5. Is my money safe with an Islamic bank? Unlike conventional banks, Islamic banks are quite new and small and I don’t want to risk losing my money or house.
The Islamic banking system uses real trading activities backed with real assets. This means that Islamic banks, such as IBB, do not conduct business unless they have an asset to allow the transaction to be carried out. Islamic banks are also not permitted to use financial instruments that are based on speculation, which introduce a high element of risk to a bank, and the assets and deposits of its customers.
By following this asset-backed approach, IBB, and Islamic banking as a whole, is not exposed to the same risks as conventional banks. This is why the Islamic finance industry proved to be an ethical and resilient alternative to conventional banking after the recent financial crisis.
IBB also offers security and stability to its customers because it is part of a larger Islamic bank called Qatar International Islamic Bank (QIIB). This gives IBB financial stability as well as access to expertise and knowledge in order to continue developing its range of Sharia compliant retail financial products.
Furthermore, as a UK bank, IBB is authorised and regulated by the Financial Conduct Authority and the Prudential Regulation Authority which means it must meet all UK banking regulations. As a result IBB’s products offer customers the standard regulatory consumer protection. For example, IBB savers who place their deposits with the Bank are covered by the Financial Services Compensation Scheme.
Q6. How does IBB ensure its activities are Sharia compliant?
By following Islamic finance principles laid down in Sharia, Islamic law. To ensure the rules are followed as closely as possible, IBB has a Sharia Compliance Officer (SCO) and a separate independent body called the Sharia Supervisory Committee (SSC).
The SSC is comprised of Islamic scholars and experts in the interpretation of Islamic law and its application within modern day Islamic financial institutions. The SCO is also trained to the highest standards, set down by The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). It is recognised as the highest Sharia compliance standard in the Islamic finance industry. The combined works of the SCO and the SSC ensure that both the IBB’s products and its activities comply with Islamic rules at all times.
Q7. Why are Sharia compliant finance products benchmarked to conventional indices such as LIBOR and the Bank of England Base Rate (BBR)?
It is important to understand that Sharia does not prohibit the use of benchmarking as long as it is a commonly recognised and easily accessible benchmark. A benchmark is an important tool in Islamic finance; Islamic banks must ensure that their products, and the prices that are charged, avoid uncertainty for the customer and are consistent with the prices of the local market. Islamic banks therefore use BBR or LIBOR to price their products, as they are very widely recognised and enable them to meet these important criteria).
For example, a benchmark is usually used by Islamic banks to determine the rental rates for Home Purchase Plans. It does not have any bearing on any other aspect of the product. An IBB HPP is based on the two Islamic finance principles of Diminishing Musharaka (diminishing partnership) and Ijara (leasing). The benchmark does not impact these principles or the way in which a HPP works.
Q8. Why do Islamic banks advertise % rates for products if they do not charge or pay interest?
It is important to remember that Islamic banks are based on Sharia. Therefore, they pay profits rather than interest on savings products, and charge rental not interest on their home finance products.
As a UK bank regulated by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA), IBB is required to display its charges in this way so that consumers can judge the value of what it offers and charges. Customers must be able to compare IBB’s rate and charges against what they would receive or be charged by conventional financial institutions.
By expressing the rental rate as a % the charge is not converted into interest. It simply expresses how much rental IBB is charging the customer as a percentage of the property purchase price. It also allows the customer to compare this charge with other providers in the market, including conventional mortgage companies, and to make a decision on which product is most suitable for them. Whilst the HPP is Sharia compliant and the conventional mortgage is not, the % rate is a common measuring tool that makes the two products comparable.
Displaying % rates for products from Islamic banks therefore benefits the customer and their ability to make a choice about the products they wish to take.
Q9. Why are Sharia Scholars paid a fee by an Islamic bank for their work? Does this affect their ‘independence’ and is it permissible?
Sharia Scholars are appointed by the shareholders of an Islamic bank as an independent committee. Their role is to ensure that the bank carries out all of its transactions in compliance with Sharia requirements. They are required to audit the bank’s work from a Sharia point of view and review the bank’s products. In return for the Scholars’ time and effort they are entitled to remuneration. This is no different than for any other trained professional, such as a solicitor or an accountant, who carries out work for an organisation.
This is permissible according to Sharia and the fee paid to the scholars does not cloud their work or negate the impartiality of their advice. It merely recognises the level of expertise the organisation is receiving, which is fundamental to it carrying out its business.
Q10. How do Islamic finance products such as savings accounts work? Will I be paid interest? What will I earn and is it Halal for me to earn from my savings?
IBB, and other Islamic banks, will not pay interest to customers that open a savings account with them. However, it is permissible for customers to earn a profit which is generated from the deposits they make with their Islamic bank.
IBB’s savings accounts are based on Islamic finance principles and pay profits. For example, the IBB Fixed Term Deposit Account is based on the Islamic financial principle of Wakala (Agency Agreement).
Under the Wakala Agreement, a customer deposits their savings with IBB and the Bank becomes their agent. IBB uses the cash deposit to invest in Sharia compliant and ethical trading activities and generate a target profit for the customer over a fixed term. The Bank manages and monitors the performance of the investments on a daily basis to minimise the risk and ensure that the customer receives the projected target (‘expected’) profit rate.
Customers are given a guarantee that their funds will only be invested in Sharia compliant and ethical investments, which will exclude all interest-bearing transactions and non-Sharia compliant business activities such as gambling, speculation, tobacco and alcohol. Currently investments take place in trades of low risk commodities (metals) and in the Bank’s Home Purchase Plans, whereby the rents received by the Bank for investing the customers’ funds are paid as profits, after deducting the Bank’s fees.
IBB therefore offers its customers a personal, highly managed service for their savings to ensure that they receive a competitive return based on ethical and Sharia compliant principles.
Q11. Is it permissible under the Sharia to quote a profit rate for Fixed Term Deposit savings accounts?
It is important to clarify that this Sharia compliant savings product(s) is called ‘Fixed Term’ and not ‘fixed return’. It is usually offered under the Islamic principle of Wakala (an agency agreement). With this product, the Islamic bank provides an expected profit rate over a set period of time as a ‘target’ based on the investment activity it will undertake with the deposits. The ‘Fixed’ element relates to the length of time the bank will undertake the investment activity for the customer. For example, two years for the Two Year Fixed Term Deposit Account.
These savings products do not offer a fixed return in the same way that conventional banks that pay interest do. Under Sharia, the bank cannot guarantee a rate of return, because with investment there is always an element of risk.
However, Islamic banks mitigate this risk for the customer in many ways, so that the customer’s deposits and return do not suffer. To date, for this type of savings product, IBB has always achieved the expected profit rate offered to its customers.
Q12. If I buy a home with a HPP, I will be charged rental and not interest. Can you explain how an IBB HPP works?
IBB has developed the Home Purchase Plan as a Sharia compliant alternative to a mortgage. The principle difference between a HPP and a conventional mortgage is that the lending/borrowing relationship does not exist. For this reason interest does not form part of the arrangement.
As a Sharia compliant product, IBB’s HPPs are based on joint ownership and lease agreements arranged using two separate principles of Islamic finance:
1. With a HPP, of say 20 years, IBB and the customer buy the property jointly. The customer then has 20 years to buy the Bank’s share for the same initial purchase price. This is based on the Diminishing Musharaka (diminishing partnership) principle of Islamic finance.
2. At the time of completing the joint purchase, the customer will live in the property even though a large share of it is owned by the Bank. Therefore, until the customer becomes the full owner, they will lease the portion of the property still owned by IBB and pay a monthly rental to the Bank. This is based on the Islamic financing principle of Ijara (leasing).
When all acquisition payments have been made and the finance has been settled, ownership of the property transfers fully to the customer and they now own their home outright, without having paid any interest.
It is also important to note that the money IBB uses to buy homes jointly with its customers is from Sharia compliant sources. The Bank does not use any interest-bearing products to finance customer’s homes. Instead it uses its own funds, or the savings deposits from its customers, creating a virtuous circle for everyone involved.
Q13. Aren’t HPPs more expensive compared to conventional mortgages?
This is a very common misconception. In reality Islamic home finance products, such as HPPs from IBB, are very competitively priced when compared to the market overall. Rental rates, whilst not the cheapest in the market, are often found in the mid-range of comparison website tables.
However, customers should not simply look for the lowest headline rate when considering a finance product for their home purchase. Islamic home finance products, such as IBB’s HPPs, offer customers a great overall package with other attractive features.
An example might be the low administration fee that is charged to customers, which reflects the actual cost incurred by the bank. Also, Islamic banks, such as IBB, often allow customers to make extra capital payments without imposing large, arbitrary, charges for doing so. Finance to Value (FTV) ratios are also improving and in IBB’s case its HPP products are available to customers with 20% deposit.
Overall, therefore, Islamic home finance has become more affordable and gives customers a real choice when deciding which type of product is most suitable for them.
Q14. Why don’t Islamic banks use the rental market rate for Home Purchase Plan products?
Islamic banks use BBR or LIBOR to price their products as these are the most accurate, widely accepted and consistent benchmarks for financing. This allows Islamic banks to meet the important Sharia criteria of ensuring consistency and avoiding uncertainty.
If rental rates were to be used as a benchmark, there would be too much variation. To illustrate this, rental rates fluctuate depending on a number of factors such as the condition of the property and location; rent charged for a property in London would be three or four times more expensive than a similar property in the North. Consequently, the Islamic bank would not be able to offer a fair and consistent rental rate for its products. Not only is this against the Sharia but it would also be more costly for the customer.
The use of a well recognised benchmark therefore allows the Bank to offer better value for the customer by pricing products that are in line with the local market.
Q15. If a customer of the HPP wishes to sell a property during a negative equity situation, can they do so and are there any conditions surrounding this?
The IBB HPP is based on Diminishing Musharaka (Partnership) and Ijara (Lease) agreements. One of the important conditions for Musharaka, under Sharia, is that the partnership is formed with the objective of making a profit. It cannot be formed, by either party, with a hidden intention to create a loss for the partner.
Under the IBB HPP the customer has the right to request the sale of the property at any time, without incurring any penalties. The Bank will, in normal circumstances, agree to sell. Any profit made from the sale will go entirely to the customer. IBB will forgo its share in any profit made from the sale.
However, sometimes a negative equity situation may arise when the sale price is lower than the initial purchase price. In this instance, since the sale is resulting in a loss, the Bank, as a partner in the property, has the right, under Sharia, to refuse the sale. Nevertheless, if the customer has special circumstances and really needs to sell, they can purchase the Bank’s share for the same initial purchase price. They may then sell the property to a third party at any price they are willing to take. This, however, may result in a loss for the customer.
Q16. Is it true that Sharia does not permit contracts to be interdependent or to have ‘two contracts in one’? Please elaborate on this and explain the relationship between the Ijara and Musharaka contracts in your HPP plan?
What Sharia does not allow is clauses in two contracts which make them interdependent on each other with a complicated outcome that is not Sharia compliant. This is not the basis for an IBB HPP.
The HPP from IBB is based on two independent contracts, the outcome of which is straightforward for both the customer and the Bank, i.e. it allows the customer to purchase their home in a Sharia compliant way. The existence of two such simultaneous contracts is accepted as standard and Sharia compliant.
An IBB HPP is based on a joint partnership contract (Diminishing Musharaka) with its own set of clear rules, and the leasing contract (Ijara) with its own set of clear rules.
When the customer decides to purchase a house in a Sharia compliant way, they approach IBB to finance the house that they want to live in. The Bank and the customer jointly purchase the property and become partners. As the customer wants to live in the property, they will need to lease the Bank’s share and consequently the Bank and the customer sign the Ijara contract. Therefore, these two contracts allow the customer to purchase their home gradually, over a fixed term, whilst also living in it.
When the Diminishing Musharaka contract ends, as a result of the customer purchasing IBB’s entire share of the property (or due to the sale of the property to a third party), the Ijara contract expires as the bank no longer owns any part of the property.
Q17. Under a HPP contract the property is ‘owned’ by the bank. If this is the case, as tenants why do the occupiers have to pay for buildings insurance and general maintenance? Is this permissible?
The Home Purchase Plan is a product which enables the customer to buy their own home in a Sharia compliant way, without interest. The overall objective of the HPP, therefore, is to allow the customer to purchase the property over a period of time, so that, ultimately, they become its owner.
In order for an Islamic bank to be able to offer the HPP at a competitive rental rate, it does not take on the responsibility of maintenance and insurance as part of the Ijara agreement. If the bank were responsible for carrying out maintenance, procuring buildings insurance and the subsequent administration, the rental rate would need to be higher. This would therefore affect the customer’s long term objective of buying their home in a Sharia compliant, and affordable way.
With an IBB HPP, the Bank appoints the customer as a Service Agent responsible for maintenance of the property and ensuring that it is covered by appropriate insurance. This is permissible according to Sharia and is beneficial for the customer; it means the Bank can charge a lower rental rate that is competitive with conventional banking and ultimately enables the customer to buy their home without paying interest.
Q18. Under a HPP contract why does the customer have to pay the Stamp Duty?
When a consumer buys a property in the UK, they automatically have to pay Stamp Duty, if applicable. Under the IBB HPP, the customer and the Bank jointly purchase the property. However, the ultimate owner will be the customer after they have bought the Bank’s share over a period of time. As such the Stamp Duty cost will also, eventually, have to be passed to the customer.
In order for IBB to be able to offer the HPP with a competitive monthly rental rate, it is more practical if the customer pays the Stamp Duty when the property is initially purchased. Some Islamic banks do offer to share the costs when the property is first bought. However, this results in a subsequent higher monthly rental rate to cover the bank’s extra costs. Thus, with IBB the customer pays the Stamp Duty at the outset of the joint purchase in order to enjoy a lower rental rate over the long term.
It is interesting to note that in 2003 the UK Government acted to end the double stamp duty incurred by customers buying their homes under the Murabaha Islamic finance principle. Under Murabaha purchases, the Islamic bank buys the property, but on the day of completion it is immediately sold on to the customer at a higher price. This led to the imposition of a double stamp duty. However, this was eventually abolished by the Government to introduce a level-playing field for Islamic banks offering this type of mortgage.