Banks match savers with borrowers. They pool deposits, lend them to households and firms, and bear the risk that some will not be repaid. Their profit comes largely from the gap between the rate they charge on loans and the rate they pay on deposits.

The service is valuable because it lets people spend income not yet earned. Thanks to banks, firms can buy machinery before the profits it generates arrive, and families can buy a home without waiting decades to save for it. Without credit, many worthwhile projects would never be started. But lenders must be coaxed. Most people prefer money now to the same sum later, a trait economists call present bias, and lending exposes capital to inflation and default. Interest is the price of waiting and of risk.

Islamic banking must perform these functions while observing a prohibition. “But Allah has permitted trading and forbidden interest,” states the Quran (2:275). Mainstream Islamic law interprets this prohibition as applying to interest (riba) on loans. Yet it expressly permits trade. The challenge therefore is to find a way to finance present expenditure based on future earnings without charging interest on money lent.

The Islamic banking system is used in over 60 countries, most of them Muslim-majority ones, including Iran, Saudi Arabia, Malaysia, Kuwait, Pakistan, and Turkey. Recent years has seen the trend expand in countries with Muslim minorities, such as the UK, Singapore and Kenya.

Islamic jurisprudence on business transactions (fiqh al-mu’amalat) supplies several loan avenues. A bank can buy an asset and resell it or rent it. In each case its return comes from a real transaction. The bank must genuinely own the asset.

Take a car costing €100,000. Under murabaha, a cost-plus financing mechanism, the bank buys it and sells it to a customer for €115,000, payable over three years. The cost and markup are disclosed. The bank must acquire ownership and bear the associated risk before selling. The customer receives the vehicle immediately and pays from future income. The bank earns a trading profit. The agreed price cannot increase only because payment is late.

Housing can follow another route. Under diminishing musharaka, a type of profit- and loss-sharing mechanism, the bank and customer jointly acquire a property. The customer gradually purchases the bank's share while paying rent for using the portion still owned by the bank. As its share diminishes, so does the monthly rent. Future earnings finance ownership without a conventional mortgage loan. Leasing provides another means of charging for an asset's use.

These arrangements solve the immediate financing problem, but also raise a question. If the payments resemble those on an ordinary loan, how much has changed? Defenders stress the obligations that ownership creates. Critics question how much risk a bank can assume when it owns physical assets only for a brief period of time. Both points deserve attention. A permissible sale can create a fixed debt. Compliance does not necessarily turn a creditor into a lasting business partner.

Other contracts come closer to partnership. In mudaraba, a one-way partnership of profit- and loss-sharing, the bank supplies capital and the entrepreneur manages the venture. Profits follow an agreed ratio. Financial losses ordinarily fall on the investor, except where the manager commits misconduct, negligence or a contractual breach. The manager loses effort and prospective earnings. Through the musharaka option, both parties contribute capital. They divide profits as agreed, but bear losses according to their capital contributions.

Sharing fortunes requires knowing what those fortunes are and how much they are worth. Entrepreneurs who cultivated their businesses from scratch better understand them than financiers They may conceal profits, inflate expenses or take risks the bank cannot readily observe. Monitoring costs money. Proving misconduct costs more. Meanwhile, entrepreneurs expecting large profits may prefer fixed repayments that leave them the surplus. These range of incentives help explain the appeal of sale and lease financing. They do not make every applicant for partnership funding dishonest.

Savers present another challenge for Islamic law. Some Islamic accounts are repayable loans to the bank, but without a promised return. Investment accounts instead offer a stake in profits, with capital exposed to losses under their terms. A family saving for school fees may be deterred by such uncertainty. Banks can retain earnings in profit equalisation reserves to support distributions at a later date. Investment risk reserves draw on account holders' earnings to cushion their future losses. These mechanisms lessen volatility, but cannot remove it entirely.

Benevolent, interest-free lending offers a simpler bargain. Under qard hasan (literally, a “good loan”), the lender requires repayment of principal without a stipulated reward. Such loans can relieve hardship, but inflation erodes the lender’s repaid principal. Someone must absorb that expense. A charity or state subsidies are therefore brought in to cover these administrative and inflationary costs.

A well-functioning financial system requires clarity and transparency about who bears losses and how profits are calculated. Religious principles can facilitate confidence and help shape useful contracts. Nevertheless, enforceable obligations and awareness to risks are still essential. In short, piety cannot make a bad loan good.