Islamic Bank Finds a Conventional Interest Formula Embedded in a Profit-Rate Schedule

Background¶

An Islamic bank's model governance programme included a periodic structural review of financing schedules across its portfolio, sampling models built for different Shariah-compliant contract types — murabaha, ijarah, and mudarabah facilities among them.

The Problem¶

A murabaha financing schedule selected for review calculated an installment payment stream that, on its face, resembled a standard amortizing repayment profile. The review examined the underlying formulas to confirm the schedule represented the murabaha contract's actual cost-plus sale structure — the bank purchasing an asset and reselling it to the client at a disclosed marked-up price, per Islamic Banking Models.

Findings¶

The review found that the schedule's underlying calculation was structurally identical to a conventional amortizing loan formula — a principal balance, a periodic rate, and a period count generating a periodic interest charge — with the resulting charge simply relabelled "profit" in the model's row and column headers. The model did not represent the actual cost-plus sale mechanics of a murabaha contract (an asset purchase price, a disclosed markup, and an installment sale price), nor did it reflect the asset ownership timing a murabaha structure implies.

Root Cause¶

The schedule had originally been adapted from a conventional lending template used elsewhere in the bank, with labels changed to reflect Islamic banking terminology, but without rebuilding the underlying calculation logic to match the murabaha contract's actual structure. The relabelling had made the model's outputs look consistent with Islamic banking presentation standards while its internal mechanics remained those of a conventional loan.

Risk¶

Had this gone unaddressed, the bank's own internal model would not have reflected the actual legal and economic structure of the contracts it was managing — a mismatch that could surface in scenarios where the underlying structure genuinely matters, such as early settlement calculations (which differ between a cost-plus sale and a conventional interest-bearing loan) or asset ownership questions in a default scenario. This is a structural modelling risk distinct from, and prior to, any question of Shariah compliance itself.

Resolution¶

The bank rebuilt the murabaha schedule around the contract's actual cost-plus sale structure — an explicit asset purchase price, a disclosed markup, and an installment sale price — rather than an interest-rate-driven amortization formula with relabelled outputs. The bank's model governance programme also added a specific structural check, confirming that financing schedules for each Islamic contract type reflect that contract's actual underlying mechanics rather than a relabelled conventional formula, as part of its routine review process.

Lessons Learned¶

• Relabelling a conventional formula's output does not make a model structurally consistent with the Islamic finance contract type it claims to represent.
• A structural review of an Islamic banking model should confirm the model's actual mechanics match the contract type — murabaha, ijarah, mudarabah — it is labelled as representing, not only that outputs look plausible.
• Structural mismatches of this kind can remain latent until a scenario (early settlement, default) where the underlying contract structure genuinely produces a different result than a conventional loan would.
• This type of review addresses model structure, not Shariah compliance itself, which remains a determination for a Shariah board or scholar.

Continue Reading¶

Related Technical Guides¶

• Islamic Banking Models

Related Pillars¶

• Banking Financial Modelling