Islamic banking

Islamic banking refers to banking practice that is in line with Muslim written and unwritten law, the Sharia. Generally, three main differences between mainstream and Islamic banking are observed (Khan and Mirakhor, 1992; Dhumale and Sapcanin, 2004): (1) interest rate payments are prohibited in Islamic banking transactions; and (2) so are collateral requirements; (3) a compulsory charitable tax, zakat, must be paid on profits. While the last point is not unfamiliar to Western bankers because of ethical banking practices, interest- and collateral-free banking seems incompatible with mainstream financial instruments and underlying economic models. Conventional economic theory often uses the concept of asymmetric information to explain the need for collateral and interest rates in bank lending (Bernanke and Gertler, 1989). The idea is that the bank has limited information as to what its client intends to do with the borrowed money, whereas the debtor has perfect knowledge of this.