Islamic Banking

Published Apr 29, 2024

Definition of Islamic Banking

Islamic banking, also known as Islamic finance or sharia-compliant finance, refers to banking activities that comply with sharia, the Islamic law. Islamic law prohibits usury, the collection and payment of interest, and investing in businesses that are considered haram (forbidden) such as companies that sell alcohol or pork, or those that produce un-Islamic media. As a result, Islamic banking operates on Islamic principles of profit and risk sharing.

Principles of Islamic Banking

Islamic banking is built on the foundation that money itself has no intrinsic value and the concept of interest (riba) is forbidden. The main principles include:

• Risk Sharing: Financial activities must involve some level of risk sharing. Investments are made under contracts that allow for the distribution of risk according to each party’s contribution.
• Prohibition of Speculation (Gharar): Islamic banking discourages speculative transactions, emphasizing contracts where the terms are clear and known to all parties.
• Asset-Backing: Financial transactions must be backed by tangible assets. Money cannot be made from money.

Example

A typical example of Islamic banking in action is a home finance product. Instead of a conventional mortgage where interest is charged on a loan, Islamic banks use a declining balance partnership model. In this arrangement, the bank and the homeowner jointly purchase the property. The homeowner then gradually buys the bank’s share over time and pays rent on the portion of the property the bank owns, until the homeowner eventually owns 100% of the property.

Why Islamic Banking Matters

Islamic banking offers an ethical alternative to conventional banking by adhering to moral and ethical values in economic activities. It encourages stability in investments since it avoids unsecured credit and speculative transactions. Furthermore, by focusing on asset-backed financing and risk sharing, it contributes to the development of a more resilient and socially responsible financial system.

Frequently Asked Questions (FAQ)

How do Islamic banks make money without charging interest?

Islamic banks earn money through profit-sharing schemes, fees for services, and leasing contracts. For loans, they use methods like Murabaha (mark-up financing), where the bank buys an item and sells it to the customer at a higher price, or Ijara (leasing), where the bank leases an item to a customer for a fixed period and rate.

What makes Islamic banking different from conventional banking?

The key difference lies in the prohibition of interest and speculative elements, as Islamic banking must comply with sharia law. Investments are evaluated not just for their financial return but also their social and ethical implications. This includes an emphasis on risk-sharing and funding projects that have tangible assets or social benefits.

Is Islamic banking only for Muslims?

No, Islamic banking is open to everyone. While it operates according to Islamic principles, non-Muslims who wish to engage in ethical banking practices may also find Islamic banking suitable for their financial needs.

Can Islamic Banking Cooperate with Conventional Banks?

Yes, Islamic banks often cooperate with conventional banks through correspondent banking relationships, syndicated loans, or when entering new markets. Nonetheless, Islamic financial institutions strictly adhere to Islamic principles, even when engaging with traditional banks.

Islamic banking represents a critical segment of the global financial system, providing ethical, socially responsible alternatives for investment and financing. Its principles of risk-sharing, prohibition of interest, and asset-backed financing distinguish it from conventional banking, offering unique solutions that appeal to Muslims and non-Muslims alike.