Why Islamic Banks Lend Like Conventional Banks?
Why do Islamic banks rely on murabahah, not profit sharing? The cause is an information problem, and tax e-invoicing data could fix it.
Suppose you know a small auto-parts supplier in your area. He needs 500,000 to buy a second machine. He wants Islamic financing, so he goes to an Islamic bank.
The bank offers murabahah: it buys the machine and sells it to her at cost plus an agreed mark-up, payable in 60 monthly instalments. The contract is valid. The mark-up is priced off a benchmark that moves with conventional interest rates. And if orders dry up next year, the instalments stay exactly where they are.
He asked for Islamic finance and received something that behaves, in every month that matters, like a loan.
Students of Islamic finance meet this problem early. The textbooks teach that the ideal contracts are musharakah (partnership) and mudarabah (one party provides capital, the other provides work, and profit is shared by agreed ratio). Then the annual reports show that most Islamic bank financing is murabahah, ijarah and tawarruq: sale- and lease-based contracts with fixed payments.
The usual explanations are moral ones. Bankers are timid. Regulators are conservative. Shariah boards are too accommodating. These explanations are tempting, and there is some truth in each. I think they miss the main cause, which is an information problem maybe with a practical fix.
If you just want to watch and here
Why debt wins: the economics
In 1979 the economist Robert Townsend published a paper in the Journal of Economic Theory with an unexciting title: "Optimal Contracts and Competitive Markets with Costly State Verification". Douglas Gale and Martin Hellwig extended the argument in the Review of Economic Studies in 1985.
Their question was simple. A financier gives money to an entrepreneur. The entrepreneur knows how well the business did. The financier does not, and finding out costs money: audits, inspections, lawyers. What contract should they sign?
Their answer was standard debt. Under debt, the entrepreneur pays a fixed amount and the financier does not need to know the true profit at all. The financier only pays to look inside the business when the entrepreneur fails to pay. Verification happens rarely, so it costs little.
A profit-sharing contract needs the opposite. The financier must know the true profit every single period, because the payment depends on it. If verification is expensive, profit sharing costs more to run than debt. It also gives the entrepreneur a standing reason to report less profit than he earned.
Seen this way, the murabahah problem changes shape. The dominance of debt-like contracts in Islamic banking is roughly what economic theory predicts whenever verification is costly. Banks that choose murabahah are responding to a real cost.
The diagnosis is shared. What remains open is where cheap, trustworthy data on a firm's performance could come from.
Maybe the tax authority already has the data
Governments have spent the last decade solving a version of the same problem for a different reason. They wanted to stop firms under-declaring sales to avoid tax.
Their solution is mandatory electronic invoicing. Saudi Arabia runs its Fatoora system through its tax authority, ZATCA. Malaysia's Inland Revenue Board (LHDN) has been phasing in e-invoicing through its MyInvois platform since 2024. In systems of this kind, each business invoice passes through the tax authority's platform, which validates it and records it.
Consider what that record contains for a single firm. Its sales invoices show revenue. Its purchase invoices show what it paid for materials and inputs. Subtract one from the other and you have the firm's gross profit, confirmed invoice by invoice by an independent third party.
Where payroll runs through a pension fund, such as Malaysia's Employees Provident Fund (EPF), the wage bill can be confirmed the same way.
The financier's verification problem, the one that made debt the rational choice, has largely been solved for formal businesses by an agency that had no interest in Islamic finance. The data exists. Then why not use it to verify profit-sharing contracts?
What the contract would look like
Take the auto-parts supplier again. Instead of Murabahah, the bank enters a Mudarabah-style partnership with the business, with below design choices.
Share gross profit, as verified from invoices. Net profit depends on overheads such as rent, marketing and management salaries, which are hard to verify. Gross profit can be traced invoice by invoice. Revenue alone would be the wrong base: a business with thin margins could hand over its entire margin and still owe more.
Step the ratio down as profit rises. The bank's share falls in higher profit bands. The harder the owner works, the more of each extra profit he keeps.
Make dishonesty expensive. In classical fiqh the working partner is a trustee (amin). He is not liable for honest losses. He becomes liable for the capital if he commits misconduct or negligence. Under this contract, a proven gap between what he declares and what the invoice record shows counts as misconduct. The partnership stays a partnership while he is honest. It turns into a capital guarantee only when he is caught cheating. That is the incentive the economic theory calls for, and fiqh already provides it without any penalty interest.
A worked example
The numbers below are illustrative only.
The bank provides 500,000. The supplier's invoice-verified gross profit has averaged 2 million a year. The bank takes 4% of gross profit up to RM2 million and 2% of anything above.
| Year | Verified gross profit | Bank's share | Under murābaḥah |
|---|---|---|---|
| Good year | 2.4 million | 80,000 + 8,000 = RM88,000 | Fixed instalments |
| Normal year | 2.0 million | 80,000 | Same fixed instalments |
| Bad year | 1.2 million | 48,000 | Same fixed instalments |
In the bad year, gross profit falls by 40% and the Murabahah customer pays the same amount. The partnership customer pays 40% less. The risk is shared, which is what the textbooks promised.
The owner buys back the bank's stake over time, as in diminishing musharakah, where the customer buys the financier's share unit by unit until she owns the whole. The price would follow a formula agreed at the start, based on trailing verified gross profit.
The Shariah basis for sharing a gross figure (not mine to answer, just to share)
Some readers will object that mudarabah shares profit, and gross profit is not profit in the full sense.
There is also a closer precedent. Sharecropping and Orchard partnership share the gross harvest between landowner and worker. The schools differ on these contracts: Abu Hanifah rejected Sharecropping, while his two leading students and the Hanbalis accepted it. The disagreement is old and well recorded, and it shows that sharing gross output is a recognised category in classical law rather than a modern invention.
What changes beyond the single contract
Three effects would follow if this worked at scale.
The first is a benchmark free of interest. Islamic banks currently price against conventional interest benchmarks, largely because no widely accepted alternative exists. Pool enough of these partnerships into investment certificates representing ownership in the underlying partnerships (Musharakah Sukuk), publish their realised returns, and you have a reference rate drawn from real business profits. It could price investment accounts first, and other products later.
The second is a reason for businesses to be honest with the tax authority. A firm that invoices every sale builds a verified record, and a verified record earns cheaper partnership finance. Governments would have their own reason to support the scheme.
The third concerns the economy as a whole. Irving Fisher, writing in Econometrica in 1933, argued that fixed debt payments during a downturn force firms to sell assets and cut spending, which deepens the downturn. Hyman Minsky later built a theory of financial instability on similar foundations. Payments that fall automatically when profits fall work against that spiral. Islamic economists such as M. Umer Chapra have long linked interest-based debt to this kind of instability.
Where it could fail
The design has real weaknesses.
The wrong firms may apply. Stewart Myers and Nicolas Majluf showed in 1984 that firms confident of high profits prefer debt, because they do not want to share the upside. Partnership finance can therefore attract weaker firms. Years of verified invoice history let the bank price for this, but they do not remove it.
Cash sales can still be hidden. Invoices cover business-to-business trade well and retail cash sales poorly. A pilot should start with firms that sell mainly to other businesses, such as suppliers to large manufacturers.
Purchase invoices can be inflated. A firm could buy inputs at inflated prices from a related company to shrink its reported gross profit. Tax identification numbers make such links traceable, but the contract needs clear rules on them.
Capital rules favour debt. Under the capital adequacy frameworks Islamic banks follow, equity-type exposures carry heavier capital charges than financing receivables. Until supervisors calibrate a treatment for exposures backed by verified data, banks will find the partnership expensive to hold. This is probably the hardest barrier.
Tax data is confidential. Tax secrecy laws generally stop the authority from sharing a firm's data with a bank. A consent-based legal route would be needed, possibly through new legislation.
Depositors may not want variable returns. Investment account holders in many markets expect returns that look like deposit rates. Whether they would accept returns that move with business profits is untested.
Informal businesses are left out. Firms that do not issue electronic invoices gain nothing from this design. Microfinance needs a different solution.
How to test it
The test could be modest. One Islamic bank with the tax authority's cooperation inside a regulatory sandbox, could finance firms in one sector that sells mainly to other businesses. Three-year contracts would be enough. At the end, compare realised returns and losses against the same bank's murabahah book for similar firms.
If the losses come out comparable, the case for changing the capital treatment becomes hard to ignore. If they do not, we learn that verification cost was not the main barrier after all, and the moral explanations deserve a second look.
Either way, the supplier would finally be offered the contract the textbooks described. Would he take it?
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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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Sometimes I just write randomly about whatever I feel like writing. I passionately learn about financial freedom, investing, Islamic finance, technology, and new inventions.
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