Is Non-Interest Banking or Interest-Banking More Profitable?

In recent times, a concept known as “Islamic Banking” has gained much prominence across the Islamic world. This system of banking is based on the principle of PLS (profit and loss sharing), wherein a bank’s profit from a contract is directly tied to the profits made by the borrower. The bank and borrower share the risk. Although there exists a plethora of research regarding Islamic banking and PLS, most of these studies are restricted to discussing the mechanisms by which Islamic banks operate as opposed to analyzing whether PLS or interest-based banking is more profitable. In this paper, I create a toy model that simulates the profitability of interest and non-interest-based banks. I find that non-interest-PLS-based banking to be much riskier than interest-based banking, as its profitability tends to fluctuate much more than interest-based banking. Under bountiful conditions, PLS-based banking is much more profitable, whereas in strenuous conditions, PLS-based banking often leads to a collapse. This paper concludes that the risk-sharing nature of PLS contributes heavily to its volatility, while interest-based banking can still profit if its borrowers struggle to immediately repay their loans.