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The price of money in Islamic finance and conventional finance

The two can differ, but only in ways that give Islamic finance customers a bad deal

Summary

Posted 20 May 2021

When I lecture on Islamic finance, those new to the subject often ask me one question. "Why does Islamic finance not have its own independent price for money instead of using the conventional finance interest rate?"

I have always responded with the simple answer that arbitrage is what stops the two from differing. However in my May column for the magazine "Islamic Finance News" I decided to look at the question more closely.

I concluded that the two prices can differ. But not in a good way!

You can read the article below.

Can the price of money in Islamic finance and conventional finance differ?

When a UK Islamic bank finances you, whether short-term or long-term, the bank will always price the finance by:

The same approach is used wherever Islamic finance and conventional finance exist side-by-side.

This way of pricing Islamic finance irritates many new to the subject. They ask: “Why does Islamic finance not have its own basic price for money, instead of being based on conventional interest rates?”

(My article “Murabaha and the time value of money in Islamic finance” in the 11 January 2017 issue of Islamic Finance News showed that Islamic finance incorporates the time value of money in the same way as conventional finance. Accordingly, when writing I use plain language such as the “price for money.”)

The answer to the above question is very simple – arbitrage.

In any country where Islamic finance and conventional finance exist side-by-side, the population can be divided into two groups:

  1. IF-only-users: they will only deposit in, and borrow from, Islamic banks.
  2. CF-users: they are happy to transact with both Islamic banks and conventional banks, depending upon price. (For simplicity, I ignore entity-specific factors such as the credit risk of particular institutions or particular customers.)

While I would expect IF-only-users to all be Muslims, the CF-users will comprise both non-Muslims and Muslims who do not object to conventional finance.

Deposit rates

If an Islamic bank offers higher deposit rates than conventional banks, it will be flooded with deposits, attracting them from both IF-only-users and CF-users. Excess deposits that cannot be profitably lent are a nuisance for a bank. Accordingly, the Islamic bank would reduce its deposit rate until it no longer exceeded the conventional deposit rate.

The Islamic bank could however offer lower deposit rates than conventional banks, since the IF-only-users have no alternative place to deposit.

Lending rates

The mirror image situation arises. An Islamic bank offering to lend money more cheaply than conventional banks will be flooded with loan demand which will rapidly exhaust its available lending funds. It could only attract enough extra deposits to meet the loan demand by offering higher deposit rates than conventional banks, but the combined effect of its lending and deposit rates would be to seriously squeeze its profitability.

Again, the Islamic bank could offer lending rates higher than conventional banks, since the IF-only-users have no alternative source to borrow from.

To summarise, Islamic banks’ rates can differ from conventional banks’ rates, but only in certain ways:

Deposit rates – these can be lower, but not higher.

Lending rates – these can be higher, but not lower.

This is probably not the scenario that advocates for a separate price for Islamic money are seeking!

It helps to consider how one might prevent the arbitrage discussed above. That would require the Islamic financial system to be hermetically sealed off, so that anyone willing to use conventional finance was prohibited from depositing money in, or borrowing from, an Islamic bank.

I do not regard such a sealing off of the Islamic finance sector as feasible. Even if the country concerned had laws permitting discrimination on the grounds of religion, Islamic banks would still need to find a way of identifying and excluding those Muslims who were willing to use conventional finance.

I do not see that as realistic in a free society.

Mohammed Amin is an Islamic finance consultant and former tax partner at PwC in the UK.

 

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