The distinction between Islamic and conventional banking is supposed to be structural: genuine Islamic finance risk sharing rather than pure credit intermediation.

A diagnostic framework proposed in recent academic work reduces this distinction to a single question, and a significant share of products on Islamic bank balance sheets cannot answer it favourably. The question is whether the bank bears any economically material risk beyond credit risk, and when it does not, the Islamic banking economic substance of the arrangement becomes indistinguishable from what a conventional lender would recognise as its own business model.

What a Conventional Lender Bears, and What an Islamic Bank Should

A conventional bank extending a loan faces two major risks: credit risk (the borrower defaults) and interest rate risk (funding costs shift before the loan matures). It does not bear asset ownership risk, commodity price risk, property value risk, or business performance risk. Its return, interest, compensates for credit risk.

For Islamic bank, was it supposed to act as trader, lessor, partner, or investor, each carrying exposures a conventional lender never faces? A trader bears inventory and market risk; a lessor bears maintenance and residual value risk; a partner bears business performance risk; an investor bears capital loss risk.

The economic question and the Shariah question converge into one diagnostic: what risk is the Islamic bank being compensated for? If the answer is credit risk alone, the arrangement has no economic substance distinguishing it from a conventional loan.

This convergence is the foundation of a taxonomy.

• Arrangements where the bank bears genuine non-credit risk, where it can lose money because an asset depreciates or a business underperforms, are "asset-linked."
• Arrangements where all such risk has been neutralised, leaving credit risk identical to a conventional lender's, are credit-linked arrangements.

The contractual label does not determine which category applies. A Murabaha can be asset-linked or credit-linked depending entirely on which structural mechanisms overlay the base contract. But how does one test which category a given product belongs to?

The diagnostic can be decomposed into three sub-tests. Cash flow identity asks whether, once contract labels are stripped, the resulting cash flows can be distinguished from those of a conventional loan. Economically material ownership risk asks whether the bank bears asset or business exposure that could realistically produce a loss.

The third sub-test is return justification: is the bank's margin compensating for bearing risk beyond credit risk, or solely for credit risk and the time value of money? If the core question (can the bank lose money for reasons other than the customer failing to repay?) returns a negative answer, the arrangement is credit-linked regardless of its nominal contract.

How Risk Gets Stripped: Testing Islamic Banking Economic Substance

If credit-linked arrangements are those where all non-credit risk has been eliminated, the practical question becomes mechanical: how does the elimination happen? These mechanisms are not inherent to Islamic contracts; they are overlaid through deliberate structural choices, and they are modular enough to apply across contract types.

The Binding Purchase Undertaking

A binding purchase undertaking is a legally enforceable promise by the customer to purchase the asset at a pre-determined price. In sukuk, the originator undertakes to repurchase underlying assets at face value on maturity; in musharakah mutanaqisah, the customer promises to buy the bank's share at pre-fixed prices. This mechanism eliminates both asset ownership risk and residual value risk in a single stroke.

Without the undertaking, a bank purchasing a vehicle for resale faces genuine exposure. The customer might reject the vehicle, the asset might depreciate during the holding period, or no alternative buyer might appear at the same price. These are ownership risks a conventional lender never carries.

With a binding undertaking, the customer must buy at the agreed price regardless of the asset's condition or market value. The bank's economic position becomes identical to a lender holding a receivable. The ownership risk that would justify the bank's return has been contractually eliminated.

Reference Rate Benchmarking and Customer-as-Agent

Reference rate benchmarking prices the Islamic instrument's return as a conventional reference rate plus a credit spread. When a Murabaha mark-up, an ijarah rental rate, or a mudarabah "expected profit rate" is calibrated to a benchmark rate rather than to the performance of the underlying asset, the return becomes compensation for the credit.

In a genuinely asset-linked ijarah, the rental rate would track the market rental value of the specific leased property. In an asset-linked mudarabah, the expected return would reflect actual portfolio performance. Reference rate benchmarking severs both connections, replacing asset performance with benchmark rate movement as the determinant of the bank's return.

The customer-as-agent mechanism (wakalah) removes the bank from physical or constructive possession of the asset entirely. The bank appoints the customer to purchase the asset from the supplier, with title passing through the bank momentarily before the murabahah sale executes. The bank never inspects, manages, or bears economic exposure to the asset; its role reduces to providing funds.

Organised Tawarruq: The Paradigmatic Case

Organised tawarruq is the most structurally revealing example of credit-linked arrangements. The bank purchases a commodity, sells it to the customer on deferred payment terms, and the customer immediately sells the commodity to a third party for cash. All three legs execute within seconds on an electronic commodity trading platform with pre-arranged counterparties.

The probability of material price movement during seconds of ownership is zero. No risk manager at any Islamic bank monitors commodity price exposure during this interval. The ownership is legally real but economically empty.

What risk is the bank being compensated for in tawarruq? Not commodity risk, because the commodity is immediately resold, and not market risk, because the onward sale is pre-committed. The only genuine risk remaining is whether the customer will repay.

The commodity in organised tawarruq serves no economic purpose; it functions as a legal conduit for generating a cash advance against a deferred obligation. This makes tawarruq the clearest illustration: the contract form (commodity sale and purchase) is entirely disconnected from the economic reality (a cash loan against a deferred repayment). Tawarruq-based products have become among the most widely used credit-linked arrangements in Islamic banking, particularly for personal financing and liquidity management.

Net Lease and Nominal Residual Price

Two further mechanisms operate within ijarah structures. Net lease structuring transfers all burdens of ownership (major maintenance, insurance, property taxes, and operational costs) from the bank to the customer. The bank retains legal title but bears none of the economic obligations that normally accompany it.

The nominal residual purchase price eliminates residual value risk at the lease's end. When the asset transfers to the lessee for a token amount regardless of its market value, the bank has zero economic interest in the asset's terminal condition. The total payments the lessee makes (rent plus nominal purchase price) are calculated to cover the bank's capital outlay plus a return, a structure that mirrors a conventional hire-purchase amortisation schedule precisely.

The Deposit Side: Profit Smoothing

Credit-linked structuring does not stop at the financing side. Two mechanisms convert what should be volatile investment returns into stable, deposit-like outcomes for investment account holders (IAH), stripping the Islamic finance risk sharing that theory assigns to the capital provider.

Profit smoothing works through two reserves: the Profit Equalisation Reserve (PER), which retains a portion of gross investment profits before distribution, and the Investment Risk Reserve (IRR), created from the IAH's profit share to absorb future losses. The bank retains profits in strong quarters and supplements returns in weak ones, delivering a "profit rate" that closely tracks conventional deposit rates.

In a genuinely asset-linked mudarabah, an IAH would experience actual returns: 8% one quarter, 2% the next, negative 3% in a third. With profit smoothing, the IAH's position converges with that of a conventional depositor: predictable returns, no capital exposure, no meaningful participation in the risks and rewards of the investment portfolio.

Profit smoothing introduces intergenerational inequality: current IAH may subsidise returns for earlier or later cohorts through the reserve mechanism. This is an artefact of converting volatile returns into stable ones, and it has no analogue in the theoretical mudarabah structure that Islamic finance risk sharing is supposed to deliver.

When Both Sides of the Balance Sheet Converge

Islamic banking economic substance exists when the bank bears risk beyond credit risk: asset ownership, commodity price, property value, or business performance risk. When risk-stripping mechanisms neutralise these exposures, the arrangement is credit-linked, and the bank's risk profile becomes identical to a conventional lender's regardless of the Shariah-compliant contract form employed.

The stacking effect makes convergence concrete. Consider a home financing Murabaha: in the asset-linked version, the bank identifies and purchases the property, holds it bearing risk of damage or price decline, and the customer has the option, not the obligation, to purchase. The mark-up reflects actual acquisition cost and property-specific risk factors.

In the credit-linked version, four mechanisms apply simultaneously. The customer identifies the property as the bank's agent, a binding purchase undertaking is signed before acquisition, the mark-up is calculated as a reference rate plus a credit spread, and the bank's ownership is momentary. The bank never inspects, manages, or insures the property.

In the second scenario, the bank bears no risk that a conventional mortgage lender would not also bear. Every non-credit exposure has been neutralised. The arrangement is a Murabaha in contract form and a mortgage in economic substance.

When credit-linked arrangements populate both the financing and deposit sides of the balance sheet, the theoretical loss-absorption capacity of Islamic banking erodes substantially. Credit-linked financing exposes banks to credit and benchmark rate risk identical to conventional lending. Credit-linked deposits create fixed obligations with no loss absorption.

The stability advantage frequently attributed to Islamic finance risk sharing becomes nominal rather than operational. This creates a classification problem: a Murabaha where the bank holds inventory for weeks and a Murabaha where the customer-as-agent buys on the bank's behalf carry the same contract name but should not receive the same risk treatment. Current frameworks that classify by contract type rather than risk profile will systematically overstate the differentiation between Islamic and conventional banking.

The opening question this piece raised, why products fail the diagnostic, has a mechanical answer. They fail because the risk-stripping mechanisms, from binding purchase undertakings to organised tawarruq platforms, are engineered to ensure that outcome. Each mechanism is a deliberate structural choice, not an accidental byproduct of market evolution.

The convergence with conventional lending is not a drift; it is a design outcome. Reversing it requires removing the mechanisms that produce it, which returns the question to where the paper's framework places it: what risk is the bank willing to bear, and does its Islamic banking economic substance survive the answer?

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

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