Handling Delinquency and Default in Islamic Banking

Failure to pay finance obligations when due is not uncommon even in Islamic banking. The fact that mudarabah and musharakah, which are not debt based modes of finance, are used doesn’t ghard an Islamic bank against this possibility. The problem is that charging a penalty (late charges) is not permitted in Islamic Shari’ah. Only actual cost f debt collection may be imposed. The reason is that such penalties fall under the definition of usury in Islamic jurisprudence. This is quite problematic in Islamic banking because it makes delinquency “costless” to bank clients. The problem is many fold: firstly it prevent to the Islamic bank from being compensated for lost time and opportunities of profit. More importantly, however, it creates an incentive for the clients not to pay on time. Furthermore, it increases the cost of finance in an Islamic bank compared to conventional banking. This is because the effective cost of delinquency would have to be born by those who pay their obligation with delay. Such people will refuse to pay the higher cost, which means that the Islamic bank will end up with the “bad risks” clients.

Islamic banks differ in handling delinquency cases. The most common form in changing penalties on those who fail to pay on time. Rather than taking this as an income to the bank, it is donated to charity. This way the effect and pressure of late charges in orientated what falling into a luscious transactions. This is because such penalty will be considered “riba” if it has become an income to the creditor, which not so here. The basis of such penalty in the consent of the debtor in the contract that originate the cost.

Source: An Introduction To Islamic Banking, Shaykh Dr Mohamed Ali Elgari. Republished with permission.