How islamic bank earn profit?

How Islamic bank earn profit?

If you remove the word “Islamic” from the question, what would be the answer?

The banks earn profit from the two main sources: They take money from the depositors at lower interest rate and lend it to the borrower at higher interest rate. For example: the bank receives one million from depositors at 2% interest rate, it lends the amount to the borrower at 7%. So, the 2% will go to the depositors. The remaining 5% is bank’s profit after the deduction of expenses.  

Secondly, they provide services such as remittance, foreign currency exchange, debit cards, ATM services, credit cards, consultancy, bank guarantee and so on. they charge fee on such services.

Coming to the Islamic bank; the services’ sector remains unchanged in a sense that there is no Shariah issue on charging fee on services. most of the services are Shariah compliant therefore, Islamic bank offer those services and charge fee on them. (some services in their conventional form are not Shariah compliant therefore Islamic banks restructure them accordingly)

While on the other hand, the biggest source of revenue of conventional banks is “Interest”. Islamic banks do not lend out the money on interest rather they used “profit based financing contracts”

For example; they take money from the depositors and provide financing on profit based Shariah compliant contracts such as sales-based contracts, equity-based contracts and so on. The activity from both Islamic and conventional banks may look identical but there is a big contractual difference between their products.

For example: Let’s say: Mr A want to buy a car. The car’s price is 1 million. He goes to the conventional bank. The bank lends money to him at 4% interest rate (there are multiple factors to determine the interest). He then purchases the car. So, the relationship between the bank and Mr A is borrower and lender.

Now, look at the second scenario: Mr A wants to buy a car and visits Islamic bank. the bank asks him to select the car first (i.e. model, specification and so on) then the bank purchases the car at 1 million and sales it to Mr A at 1.1 million. Here extra 100 thousand is bank’s profit. (again, there are various factors to determine the profit rate) Now the relationship between the bank and Mr A changes from lender and borrower to seller and buyer.

In conventional, almost all products are interest based while in Islamic banks, all financing products are different. Based on the contractual relationship between the bank and the customer the accounting treatment differs.