Guide to Shari’ah Banking

What is Shari’ah banking?

Shari’ah (or Sharia) banking is a form of finance that follows Islamic law, also known as Shari’ah law. In order to be Shari’ah-compliant, the banking institution must:

• Be ethical. Any money held won’t be invested in anything that could cause harm to others, including things like gambling, alcohol and tobacco.
• Comply with Islamic principles of monetary value. A core principle of Shari’ah law is that money itself doesn’t have any value, and it’s forbidden to pay or charge interest (or “riba”).
• Encourage partnership. Any profit and risk should be shared between the parties involved – in this case, between the individual and bank – to ensure fairness.

How does Shari’ah banking work?

Shari’ah banking works in much the same way as any other banking institution, the difference being that it will always be guided by the core principles of Islamic finance. In practice, this means that you won’t be charged interest on mortgages or earn interest from your savings, but instead, you’ll be charged or earn a certain amount of profit (we’ll discuss this in more detail below).

Strict rules around where money can be invested means any deposit you make will only be used to fund industries that comply with Shari’ah principles. This means Islamic banks will never buy assets involved in alcohol, pornography, gambling or tobacco, and nor will they invest in other trading strategies such as shorting, options and currency options.

Another key aspect of this form of banking is the panel of advisers at each Islamic bank. Known as the Shari’ah Supervisory Board, members are required to oversee all banking activities and offer advice to ensure that the provider is fully compliant with Shari’ah law.

Yet Islamic banks still offer the same products you’d expect from any other institution – including savings accounts, mortgages, investments and current accounts – and in many cases they can be highly competitive as well.

What makes Shari’ah-compliant banking different?

The core difference – at least the one that’s most noticeable for consumers – is the way in which interest is charged and paid. Under Shari’ah law, interest is forbidden, as it is seen as a means to promote unfairness in society. So, while non-Islamic banks pay interest on your savings, a Shari’ah-compliant bank will instead use your funds to buy and sell different assets. This will generate a “profit”, which will then be used to fund your return.

Another key difference is the ethical nature of Shari’ah-compliant banking, which can make it very different to a lot of traditional banks. This makes it ideal for those who value ethical banking practices, regardless of religion.

How do Shari’ah banks make money?

Because Shari’ah banks aren’t permitted to earn interest in traditional ways, they have to make money a little differently. They still make investments, but it’s more of a profit share arrangement – they use their customers’ savings deposits to invest in Shari’ah-approved ways, and any profits are shared with the customer (that’s why you’ll see “expected profit rate” advertised on savings accounts instead of “interest rate”).

They can also earn money through providing mortgages, though again, not in the traditional way of charging interest. Instead, they can “lease” the property to the mortgage-holder who will then effectively pay rent, or they can agree to lend at a higher property price, and the profit they make from that is seen as a reward for the additional risk they’re taking on. We’ll discuss this in more detail later.

Shari’ah savings accounts

With a Shari’ah-compliant savings account, you’ll deposit money as you normally would, and will also receive a return on that money. However, it won’t be interest – it’ll be a share of the profit the bank has earned from investing your deposit. This is known as the expected profit rate.

An expected profit rate is the money you will likely earn over your investment period. In reality it operates like interest, but is calculated differently in order to comply with Shari’ah banking regulations. Note that there’s a certain level of risk with this type of investment, as the term “expected” means that, in theory, a bank can fail to match the agreed amount if their investments don’t perform as they’d expect.

However, such instances are scarce, with banks such as Al Rayan and Gatehouse Bank yet to default on their agreed expected profit rate. In some cases, investments could even exceed it, which means some savers could be paid out more.

What happens if I do not receive my expected profit?

In the unlikely event the bank does not reach its profit target, savers have the option to withdraw their investments plus any profit earned to date or accept a lower expected profit rate. Since UK regulation states that savings accounts must have their capital guaranteed, savers will never lose their deposit.

Do you pay tax on Shari’ah savings?

Any returns earned from Shari’ah-compliant savings will be treated as income and taxed accordingly, much in the same way as for all other forms of savings. However, you’ll only pay tax on it if you breach your Personal Savings Allowance (PSA).

In order to avoid tax altogether, you might like to consider an ISA instead, and Shari’ah-compliant banks offer a range of ISAs to offer a tax-free alternative for your savings. Again, these cash ISAs will offer an expected profit rate to comply with Shari’ah law, which will be paid tax-free.

Shari’ah-compliant stocks & shares ISAs are also available to the public. As mentioned above, these funds will be invested into Shari’ah-compliant ethical practices, not companies involved in practices such as alcohol and arms.

Shari’ah bank accounts

There are also Shari’ah-compliant current accounts on offer which function in a similar way to other current accounts on the market, but because Islamic law forbids the charging of interest, Shari’ah-compliant bank accounts will not offer an overdraft facility.

They also operate according to the Qard principle, which sees any money in your account being lent to the bank in the form of an interest-free loan. However, you’re still free to withdraw your funds at any time, and will be able to manage the account as you normally would.

Shari’ah mortgages

Some Shari’ah-compliant providers also offer a form of mortgage lending, but these products function a little differently to traditional mortgages. Rather than borrowing money that you pay interest on, you effectively buy the property together with your bank as a form of joint ownership. Your monthly payment is then “rent” on their stake, which allows you to buy your property back over time.

This is what’s collectively known as a home purchase plan, but there are a few variations. These are:

• Ijara. This type of home purchase plan functions like a lease, where the bank or building society purchases your chosen property under its own name. You pay the lender a fixed amount each month until the end of your agreement, at which point the money is used to pay off the house and it’s transferred into your name.
• Musharaka. In this arrangement the customer and provider are joint owners of the property, and your monthly repayments are used to buy back a small share of the bank’s stake each month. Over time this will reduce the provider’s share of the property and increase your own, and your monthly repayments will reduce accordingly until the property solely belongs to you.
• Murabaha. Under this plan, the lender purchases your home and sells it straight back to you at a higher price, thus making a profit. You pay it back in instalments – the monthly repayments – which factors in this profit.

How is this different from an interest rate?

These home purchase plans almost act like a regular mortgage, with a payment being made over time until the customer owns the property outright. However, the key difference is that Shari’ah-compliant banks are not making money from other money. Under Shari’ah law, this is seen as a profit from a purchase.

Are Shari’ah banks safe?

Islamic banks adhere to the same regulations as other providers in the UK, and so are as safe as any other. They’ll be authorised by the Financial Conduct Authority (FCA) or Prudential Regulation Authority (PRA) which means they’re covered under the Financial Services Compensation Scheme (FSCS), whereby the first £85,000 of savings per person is protected in the event a bank fails or goes bankrupt.

If your Shari’ah-compliant bank isn’t based in the UK, make sure to check what protections are in place.

Who can use Islamic banks?

Muslim and non-Muslim alike, Shari’ah-compliant banks are open to everyone in exactly the same way as other providers.

Indeed, regardless of religion, a lot of people are likely attracted by the ethical principles of Islamic banks, not to mention the expected returns on many of their savings accounts. You’ll still need to ensure you meet the eligibility criteria of your chosen product, but there are no overriding restrictions.

Shari’ah-compliant banks in the UK

There are several specialist Islamic banks that offer Shari’ah-compliant savings accounts right now, including:

• Al Rayan Bank
• Bank of London & the Middle East (BLME)
• Gatehouse Bank
• Qatar Islamic Bank (QIB UK)
• Habib Bank AG Zurich