What Are the Different Types of Islamic Financial Institutions?

There is a wide range of Islamic financial institutions that provide services similar to those of traditional financial groups. Such groups are able to operate commercially and make profits even though technically, no interest changes hands. Banks and investment firms offer services such as personal loans and mortgages. There are even facilities and markets for Islamic companies to borrow money via an equivalent to bonds.

Islamic financial institutions face a variety of restrictions in how they operate. Most of these relate to the idea that riba — as a literal term, equivalent to the English words increase or excess — is forbidden. As a concept, riba means money without something of equivalent value. This specifically applies to finance because of the Islamic interpretation that a lender being without his money for the period it is with a borrower does not count as something requiring compensation. This therefore means that in principle, Islamic finance cannot use interest.

It was not until the 1970s that Islamic financial institutions began to emerge. Until this time, most financial arrangements among followers of Islam were informal. Since the 1970s, institutions emerged that aimed to follow the concepts of traditional interest-based banking while following Islamic principles.

There are numerous Islamic consumer banks, which use a variety of techniques to provide loans and mortgages without breaching the no-interest principle. Usually these require a loan to be linked to buying a specific asset. One technique is for the bank to buy the asset itself and hand it over to the customer, but retain legal ownership. The customer than buys the asset from the bank, paying in installments. The total price will be more than the original purchase price paid by the bank, but this additional money is legally considered as the bank making a profit on the resale, rather than the difference being an interest charge.

Similarly, Islamic banks can offer mortgages. This is technically accomplished by the bank and the customer buying the property as joint owners, though the bank supplies most of the money and thus has a majority share. As with a traditional mortgage, the customer makes regular payments over time. These payments are not classed as interest or repayments, but rather as a combination of rent to cover the exclusive right to live in the property, and installments toward buying out the bank's share of ownership, until eventually the customer takes full ownership of the property.

Another area involving Islamic financial institutions is the market for businesses to issue debt-based products and for investors to trade these products. This is done through sukuk, an equivalent to bonds but without interest payments. The flow of money back and forth works in the same way, but from a legal perspective, the issuing company sells the sukuk certificate to the investor; the investor then rents the certificate back to the bank, thus creating an income stream equivalent to bond interest payments; and eventually the issuing company buys back the certificate at its face value.