Islamic Banking

Islamic banking or Islamic finance is a form of Sharia (Islamic law)-compliant finance. Here, the banking and financial practices strictly adhere to Islamic legal practices. It incorporates cultural and ethical components into finance. Some practices like Islamic banking loans, profit sharing, and investing significantly differ from conventional banking.

In Islamic banking, the banks do not collect interests from creditors. Instead, they earn money using equity participation systems and share profits and losses. Islamic finance is practiced in many Muslim countries and is extremely popular among Islamic communities, as some conventional banking practices might be against Sharia.

• Islamic banking and finance are the kinds of banking practices that strictly adhere to the Sharia and the teachings of the Quran.
• It was developed in opposition to the conventional banking theories of profit maximization and collection of interest on loans, which were ethically unacceptable to the Muslim community members.
• An important principle of Islamic finance is that banks do not collect interests. Instead, they share profits and even losses. Also, while trading, banks go for non-speculative and risk-averse investments.

Islamic banking development can be attributed to some conventional banking theories and practices which go against and hurt the sentiments of the Muslim communities. Hence, Islamic finance was developed by inventing methods that are Sharia-compliant.

Sharia is the Islamic law present in the Quran's teachings. Creating practices that align with the Muslim culture and beliefs encourages many to take up banking. Islamic finance is so strictly followed that banks look to religious leaders and scholars for guidance.

The main objective of Islamic banking and finance is that all society participants should create wealth and benefit. Usually, in conventional banking, some parties benefit at the expense of others. The Islamic banks are a clear exception to this.

Now, let's discuss the principles of Islamic banking.

1. Based on Sharia – The Sharia, or the Islamic law, is based on the holy scripture of Islam, the Quran. Hence, conventional banking practices, like collecting interest payments from creditors, or Riba, are prohibited under the law.
2. Profit and loss sharing – Since banks do not collect interests, their source of revenue is the profit offered by their clients. And when the clients do not make a profit or suffer a loss, the bank suffers too.
3. Trading – Sharia restrictions on trading are comparatively lesser. However, gambling and high-risk transactions or investments are prohibited. Speculation is also restricted in Islamic finance.
4. Investing – Banks, when investing in businesses, verify their compliance with the Sharia. Hence, they do not invest in companies participating in illegal or forbidden activities.

There are six types of Islamic banking.

#1 – Murabaha

Murabaha is a type of financing or contracts the bank purchases on behalf of a client. The client utilizes the purchased property and agrees to make deferred payments. The client also promises to deliver a sure profit to the bank. The bank transfers the full ownership to the client on completing the costs.

#2 – Ijarah

Ijarah is a leasing contract where the bank purchases property or capital goods like machinery, equipment, etc., and leases the property to the client. The client pays rent to the bank. Or, primarily, the bank invests in the business and receives a share of the profit.

#3 – Istisnaa

Istisnaa is similar to Murabaha, except that the client will only be able to utilize the property purchased by the bank on the complete payment of dues. Here too, the bank receives a share of the client's profit.

#4 – Mudarabah

This type of contract involves investors sharing their plans with the bank. The bank then reviews the plan and verifies if it complies with the Sharia. If the project is approved, the bank offers the funds. Profits from the investment are paid to the bank as a Mudarabah fee.

#5 – Musharaka

A Musharaka is a contract where the bank agrees to a venture with its client. First, they work as partners and raise the capital together. Then, they operate together and share profits in a pre-determined ratio. The bank usually verifies the venture's compliance with Islamic law before partnering with the client.

#6 – Tawarruq (Tawarooq)

Tawarruq, often considered the reverse Murabaha, is a type of contract where the client approaches the bank to make a purchase and buys the property from the bank. The client then buys from the bank, uses the property, and sells it to the bank itself. The bank then sells it back to the initial seller.

Let's study some examples of Islamic banking to understand the concept better.

Example #1

Consider the hypothetical example of Islamic banking in Dubai. Bank X follows Sharia-compliant practices. It has around 20 branches in Dubai and plans to expand to other parts of the United Arab Emirates (UAE). Some of the bank's financial offerings include Sukuk, Murabaha, Istisnaa, etc. The banks adhere to Islamic practices and offer interest-free banking, leading them to become a popular finance choice among religious communities.

Example #2

Here's recent news from Bloomberg. When the global bond markets are fueled by inflation and fears of recession, the Sukuk (Sharia-compliant bonds) market, especially in Saudi Arabia, is booming. The sales of Sukuk shot up 185% from $14.4 billion last year. 

Such an Islamic banking development is part of the Saudi crown prince Mohammed bin Salman's Vision 2030 project, which he rolled out six years ago. The project aims to strengthen the economy and make it less reliant on its oil reserves.

Though the Islamic and conventional banking systems share the same scope, their objectives and way of operations are different. So, let's distinguish between the two:

This article has been a guide to What is Islamic Banking. Here, we explain its principles, types, examples, and differences from conventional Banking. You can learn more about it from the following articles –

• Zakat
• Takaful
• Banks in UAE