When Halal Finance Looks Like Conventional Debt

Islamic finance has spent the past five decades building a parallel financial architecture around a clear religious constraint: capital cannot earn a guaranteed return merely because time has passed. Financing must instead be connected to a legitimate sale, lease, investment, service, or productive economic activity.

The industry has grown far beyond its experimental origins. Global Islamic-finance assets reached approximately $5.98 trillion in 2024, increasing 21% from the previous year. Islamic banking remains the system’s dominant component, accounting for more than 70% of total Islamic financial-services assets, while the global stock of outstanding sukuk has surpassed $1 trillion. Industry assets are projected to approach $9.7 trillion by 2029.

This growth represents a considerable institutional achievement. Islamic banks now finance homes, vehicles, infrastructure, trade, government budgets, corporate acquisitions, and working capital across some of the world’s most important emerging markets.

Yet the industry’s success has also intensified a difficult question.

When an Islamic financing product produces nearly the same payment schedule, pricing sensitivity, creditor protection, and economic exposure as a conventional loan, is it meaningfully different from interest-bearing debt? Or has the transaction simply replaced the vocabulary of interest with the vocabulary of trade?

The answer is more complicated than either side of the debate usually admits.

The Distinction Begins With the Contract

A conventional loan begins with an exchange of money for a contractual obligation to repay more money over time. The lender generally does not need to own, use, or bear the commercial risk of the asset being financed. Its return originates from the debt itself.

A murabaha transaction is legally structured differently. The bank purchases an identifiable asset and resells it to the customer at a disclosed markup, usually with payment deferred over an agreed period. The bank’s profit is therefore recorded as the return on a sale rather than interest charged on a cash loan.

Under a properly executed murabaha, the bank must own the asset before selling it, even when that ownership period is brief. It assumes the ownership risk attached to the asset during that interval and cannot simply lend cash while labeling the additional repayment a “profit.” AAOIFI maintains a dedicated Shariah standard governing murabaha, while regulators including the State Bank of Pakistan formally incorporate AAOIFI standards into their supervisory frameworks.

That distinction is not imaginary. Islamic commercial law has long differentiated profit generated through trade from an increase contractually attached to a loan. Ownership, possession, disclosure, liability, and the sequencing of transactions all carry legal consequences.

Similar distinctions apply elsewhere in Islamic finance. An ijara financier earns rent by transferring the use of an owned asset. A diminishing-musharakah financier holds a declining ownership share in a property or business. An istisna contract finances the manufacture or construction of an asset that does not yet exist. Musharakah and mudarabah allocate returns according to an enterprise’s actual performance rather than a predetermined lending rate.

The contractual form therefore matters. The problem emerges when the transaction’s form changes while its underlying commercial substance barely does.

The Industry Has Moved Toward Debt-Like Structures

Islamic finance is frequently described as a risk-sharing system. In principle, this is most clearly represented by musharakah and mudarabah, where capital providers participate in the performance of an enterprise and accept the possibility of loss.

Modern Islamic banking, however, is not primarily organized around open-ended profit-and-loss sharing. It relies heavily on sale-based, lease-based, and hybrid instruments that generate relatively predictable receivables.

The Islamic Financial Services Board has acknowledged this tension. Its 2025 industry stability report noted that debt-like and hybrid Islamic instruments have helped expand product offerings, but their economic characteristics frequently resemble conventional debt. The IFSB also warned that their growing dominance may contribute to leverage, credit concentration, interconnectedness, and liquidity mismatches, challenging the risk-sharing principles commonly associated with Islamic finance.

The precise financing mix differs considerably across countries. Pakistan offers a useful example because its central bank publishes detailed mode-by-mode data. As of June 2025, diminishing musharakah represented 38.5% of Islamic banks’ total financing portfolio, making it the largest individual financing mode. Musharakah accounted for another 23.1%, while murabaha represented 11.5%. Istisna contributed 11.1%, with the remaining portfolio distributed across ijara, salam, and other structures.

Taken at face value, these figures appear to show that partnership-based financing occupies a substantial role in Pakistan’s Islamic banking system. They nevertheless require careful interpretation. A contract classified as musharakah does not necessarily give the bank the open-ended entrepreneurial exposure associated with private equity or a classical commercial partnership. Diminishing musharakah, which alone accounted for nearly two-fifths of financing, is commonly used for homes, vehicles, equipment, and other identifiable assets. Although it establishes genuine co-ownership, it is normally structured around scheduled rental payments and the gradual purchase of the bank’s ownership units. Its cash-flow profile can therefore resemble an amortizing secured loan even where its contractual foundation and allocation of ownership responsibilities remain different.

Commodity murabaha, often implemented through tawarruq, brings the substance-versus-form question into even sharper focus.

In a typical organized tawarruq transaction, a bank purchases a commodity, sells it to the customer on deferred terms at a markup, and facilitates the commodity’s rapid resale for cash. The customer obtains liquidity immediately and owes a larger predetermined amount later. The commodities may exist legally and change ownership in the required sequence, but their practical purpose is often limited to creating a Shariah-recognized sale around what is economically a cash-financing requirement.

Bank Negara Malaysia describes commodity murabaha through tawarruq as one of the prevalent structures in contemporary Islamic finance. Recent Malaysian capital-market records continue to show multibillion-ringgit murabaha and tawarruq programs, including corporate sukuk and asset-backed securitization facilities.

This does not automatically make the contracts impermissible. It does, however, explain why critics argue that parts of the industry have become exceptionally effective at reproducing conventional financing outcomes through a sequence of technically valid sales.

Benchmarking Makes the Similarity More Visible

The resemblance becomes most obvious in pricing.

An Islamic bank must compete for deposits, manage liquidity, meet capital requirements, compensate shareholders, and price credit risk within the same macroeconomic environment as conventional banks. It cannot ignore the central bank’s policy stance or the prevailing cost of money simply because its contracts do not formally charge interest.

As a result, Islamic products are commonly priced by reference to conventional financial benchmarks. A dollar-denominated financing facility may use SOFR plus a profit margin. A Pakistani facility may reference KIBOR. Similar arrangements use local interbank rates in Malaysia, Saudi Arabia, the United Arab Emirates, and other jurisdictions.

In June 2025, for example, Pakistan arranged a PKR1.275 trillion Islamic financing facility for its power sector at three-month KIBOR minus 0.9%. The structure was Islamic, but its pricing remained explicitly tied to the conventional interbank benchmark.

This practice is often misunderstood. Using an interest-based benchmark to calculate a sale price does not necessarily convert the sale into an interest-bearing loan. A merchant can price an asset by reference to inflation, a competitor’s price, Treasury yields, or any other observable market measure without changing the legal nature of the sale.

The benchmark determines the number. The contract determines what the payment represents.

Nevertheless, repeated benchmark dependence creates a genuine strategic problem. When an Islamic mortgage rises and falls with the same reference rate as a conventional mortgage, carries a similar credit spread, requires comparable collateral, and leaves the customer with nearly identical monthly obligations, consumers may reasonably question what has changed beyond the documentation.

The problem is therefore not simply jurisprudential. It is institutional and reputational.

An industry that defines itself through an alternative theory of finance remains heavily dependent on pricing signals generated by the conventional interest-based system. Even after LIBOR’s replacement, Islamic contracts have generally transitioned toward conventional risk-free rates such as SOFR rather than developing widely adopted benchmarks based on rents, asset productivity, trade returns, or profit-sharing performance. SOFR itself measures the cost of overnight borrowing secured by U.S. Treasury securities, placing it firmly within the conventional wholesale funding system.

Similar Cash Flows Do Not Necessarily Mean Identical Ethics

Critics sometimes reduce the entire debate to a simple comparison: if the customer pays $500,000 over time under both structures, then the contracts must be economically and morally identical.

That conclusion is too broad.

Two transactions can generate similar cash flows while allocating legal rights and responsibilities differently. A lease payment and a loan payment may be numerically equal, but the lessor’s ownership responsibilities, treatment of the asset, and remedies may differ. A fixed-price deferred sale and a floating-rate loan can produce similar installments while relying on different contractual foundations.

Islamic finance also imposes restrictions extending beyond the method used to calculate profit. Financing cannot support prohibited sectors. The underlying asset must be identifiable and permissible. Contracts should avoid excessive uncertainty, deception, and the sale of what a party does not own. Late payment generally cannot become an unrestricted source of compounded income for the financier. Debt cannot simply be traded at discounts and premiums under the same conditions as conventional bonds.

These constraints can influence institutional conduct even where the final payment schedule resembles conventional finance.

At the same time, contractual differences should not be exaggerated. If ownership exists only momentarily, the asset contributes nothing to the economic purpose of the financing, the financier bears negligible commercial risk, and every material exposure is transferred back to the customer, then the transaction’s claim to substantive differentiation becomes weaker.

Islamic finance cannot rely indefinitely on the argument that any structure is sufficiently distinct once the correct contracts have been signed in the correct order.

Sukuk Reveal the Same Tension at the Capital-Market Level

The debate extends beyond bank financing into the sukuk market.

Sukuk are commonly described as certificates representing interests in assets, usufruct, services, or investment activity. In practice, many widely issued sukuk are “asset-based” rather than fully “asset-backed.” Investors rely primarily on the issuer’s creditworthiness and contractual payment undertaking, while their ability to claim or liquidate the underlying assets may be limited.

This allows sukuk to function efficiently as fixed-income instruments. It also means that their risk and return characteristics can closely resemble conventional bonds. The World Bank has observed that, depending on their structure, sukuk frequently carry debt-like characteristics despite being organized around Shariah-permissible assets or transactions.

AAOIFI’s proposed Shariah Standard 62 brought this issue to the center of the market. The draft sought to strengthen investors’ legal ownership of underlying sukuk assets and make structures more consistent with substantive asset ownership. Market participants warned that the proposal could increase transaction costs, complicate sovereign issuance, weaken credit ratings, reduce liquidity, and fragment a market now exceeding $1 trillion in outstanding value. The standard remained subject to revision and consultation through 2025, illustrating how difficult it is to reconcile stronger Shariah substance with the operating requirements of modern capital markets.

The controversy exposed an important trade-off.

The more sukuk behave like genuine ownership instruments, the more investors may be exposed to asset performance, enforceability risk, and fluctuating residual values. The more sukuk are engineered to deliver the certainty, liquidity, ratings treatment, and creditor protections of conventional bonds, the more difficult it becomes to argue that they represent a fundamentally different allocation of risk.

Why Banks Gravitate Toward Predictability

The dominance of debt-like Islamic contracts is not merely the result of weak religious commitment or a lack of imagination.

Commercial banks are structurally designed to protect deposits, maintain liquidity, control credit losses, and generate relatively stable earnings. Their liabilities are often short-term and withdrawable, while true equity partnerships are long-term, volatile, difficult to value, and expensive to monitor.

A bank financing a small business through mudarabah must verify revenues, expenses, management decisions, and the true source of any reported loss. That creates substantial information asymmetry and moral hazard. A murabaha receivable is easier to document, service, provision against, securitize, and supervise.

Regulation reinforces this preference. Basel-style capital and liquidity rules were developed primarily around conventional banking models. Although Islamic regulators have adapted these frameworks, predictable debt-like assets generally remain easier to integrate into modern prudential systems than direct entrepreneurial partnerships.

Depositors also frequently expect capital stability and competitive returns, even where their accounts are formally structured through mudarabah or wakalah. Islamic banks therefore face pressure to smooth returns and remain competitive with conventional savings products.

The result is an industry whose ideals emphasize risk sharing but whose institutional incentives favor credit intermediation.

The Standard Should Be More Than Technical Validity

The most useful way to assess an Islamic financial product is not to ask whether it resembles conventional finance in any respect. Complete isolation from conventional markets is neither realistic nor necessarily desirable.

Instead, the product should be evaluated across several dimensions.

First, does the financier assume genuine ownership, commercial, or investment risk, even for a defined period?

Second, does the asset or economic activity have a substantive role in the transaction, or is it included solely to transform cash today into a larger obligation tomorrow?

Third, are the customer’s obligations, default remedies, and downside exposure materially fairer than under a conventional loan?

Fourth, is profit generated from a legitimate sale, lease, service, or investment, with the associated responsibilities preserved rather than contractually neutralized?

Fifth, does the structure contribute to the maqasid of Islamic commercial law, including transparency, protection of wealth, circulation of capital, responsible risk allocation, and avoidance of exploitation?

A product can pass the first four questions formally while still falling short of the fifth. This is the central difference between Shariah compliance as a legal threshold and Islamic finance as an economic project.

The Industry’s Next Stage

Islamic finance has already proven that it can build commercially viable institutions without writing conventional interest-bearing loans directly. The next challenge is more difficult: demonstrating that its structures can produce distinct economic behavior, not merely distinct documentation.

That does not require abandoning murabaha, ijara, or diminishing musharakah. Sale- and lease-based finance have legitimate foundations and meet real financing needs. Nor does it require every bank to become a venture-capital fund.

It does require a broader product mix and a more substantive understanding of risk sharing.

Fintech, digital accounting, open-banking data, automated revenue verification, and tokenized ownership may reduce the monitoring costs that have historically constrained musharakah and mudarabah. Islamic banks could expand asset-backed working-capital finance, revenue-sharing arrangements, SME investment pools, leasing platforms, and financing models linked to measurable asset cash flows rather than conventional interest benchmarks.

More transparent disclosure would also help. Customers should be able to understand what an Islamic bank owns, what risk it assumes, how its profit is calculated, what happens in default, and where the structure differs economically from a conventional alternative.

The central issue is not whether an Islamic financing product can produce the same return as a conventional loan. Islam does not prohibit profit merely because its amount resembles prevailing interest rates.

The more important question is where that return comes from, what risk accompanies it, and whether the transaction serves a real commercial purpose beyond manufacturing a debt obligation.

Islamic finance should not be judged solely by whether its contracts look different on paper. It should be judged by whether ownership carries responsibility, whether risk is allocated fairly, whether capital remains connected to productive activity, and whether financial institutions behave differently when their customers face uncertainty or hardship.

Contractual form is indispensable. Without it, Islamic commercial law loses its legal structure.

But form should be the beginning of Shariah-compliant finance, not the limit of its ambition.