Definition
Islamic Banking refers to a system of banking or banking activity that is consistent with Islamic law (Sharia) principles and guided by Islamic economics. In particular, Islamic law prohibits usury, the collection and payment of interest, also commonly called ‘riba’. Instead, Islamic banking operates on principles such as profit sharing, joint venture, fair and equitable distribution of risk, and financial transactions based on tangible assets or services.
Phonetic
The phonetic pronunciation for “Islamic Banking” in English is: eye-slah-mik bain-king.
Key Takeaways
Sure, here are the three main takeaways about Islamic Banking:
- Interest-Free Transactions: In an Islamic banking system, interest (Riba) is prohibited as per the principles of Islamic law (Shariah law). Instead of interest, the bank earns profit through equity participation which requires a borrower to give the bank a share in their profits rather than making interest payments.
- Risk-sharing approach: Islamic banking promotes risk-sharing between individuals and institutions. When providing funds, banks also share in the risk. This principle is intended to instill greater discipline in the financial industry as money lenders will be hesitant to take risky projects.
- Asset-backed financing: Each transaction under the Islamic banking system must be associated with a real business activity, which means investments and transactions must be backed by real assets. Derivative transactions and speculative business practices are not allowed in this banking system.
Importance
Islamic Banking is significant because it offers a unique, ethical, and non-usurious financial management option in line with Islamic law, or Sharia. It is a system of banking where no interest is charged on loans and investments are only made in businesses that align with the moral principles of Islam, excluding industries such as alcohol, gambling, and pork. This form of banking promotes risk-sharing, fairness, and transparency, appealing not only to the large global Muslim community but also to non-Muslims seeking a more ethical banking system. Consequently, Islamic banking is a crucial contributor to financial inclusivity and diversity worldwide, playing a pivotal role in regions where conventional banking may not be as accepted or trusted.
Explanation
Islamic Banking, as a financial system, is designed to adhere to the principles of Islamic (Sharia) law. It serves the purpose of fostering a system of finance that emphasizes ethical, social, and religious factors to promote both economic prosperity and social welfare. The system goes much beyond prohibiting interest (usury, or “riba” in Arabic) on loans and involves a range of financial practices that are based on mutual risk and reward sharing. These practices include joint venture, safekeeping, and lease-to-own concepts.NThe use of Islamic Banking extends in various sectors of the business world. It includes business lending, where instead of traditional loans with interest rates, Islamic banks may invest in businesses, sharing in both the profits and losses. This approach promotes ethically responsible business behavior and risk management. Personal finance under Islamic Banking also encourages individuals to manage their income, savings, and investment in ways aligning with religious principles. Essentially, Islamic Banking helps to foster a financial environment that aligns with the moral and ethical values of people practicing Islamic faith, impacting on both personal and business finance.
Examples
1. Al Rajhi Bank in Saudi Arabia: Al Rajhi Bank is one of the world’s largest Islamic banks. Islamic banking principles guide all of its operations. For example, instead of charging interest, the bank uses a cost-plus-profit model (called Murabaha) to finance purchases for customers. The bank also invests its assets in industries compliant with Islamic law, avoiding investment in areas like alcohol and gambling.2. Maybank Islamic Berhad in Malaysia: Maybank Islamic is a leading provider of Islamic banking services in Malaysia. To adhere to the principles of no interest (Riba), they offer a form of lease (Ijarah), which allows customers to enjoy the benefits of assets such as property or vehicles without owning them. The customer instead makes a series of payments, with an option to purchase at the end of the term.3. Dubai Islamic Bank in the UAE: As the first bank worldwide to fully adhere to Islamic banking principles since its establishment in 1975, it offers services like home finance under diminishing Musharaka. This involves the joint ownership of a property between the bank and customer, with the customer buying more and more shares of the property over time until they own it outright, avoiding the need for an interest-based mortgage.
Frequently Asked Questions(FAQ)
What is Islamic Banking?
Islamic Banking, also known as Shariah-compliant finance, is a form of banking that follows the principles of Shariah law. It prohibits the collection or payment of interest, making money from money (usury), and investing in businesses that are considered ‘haram’ or forbidden under Islamic law.
How does Islamic Banking make a profit if interest is not allowed?
Instead of interest, Islamic banking earns money through profit-and-loss sharing, leasing, and other trade-based transactions. For example, in a loan scenario, the bank may buy something the customer needs, and then sell it back to them at a higher price, with payment usually made in installments.
What are the basic principles of Islamic Banking?
The fundamental principles are the prohibition of interest (usury), uncertainty (gharar), and engagement in haram (sinful) activities. It also emphasizes risk-sharing, individual rights and duties, property rights, and the sanctity of contracts.
What is Islamic Banking’s approach to risk-sharing?
Islamic Banking operates on the principles of sharing the risk which acts as a safeguard against reckless behavior and helps ensure that the burden of loss doesn’t fall on just one party.
How is Islamic Banking different from conventional banking?
The key difference lies in the fundamental principles on which each operates. Conventional banking relies on earning interest on loans, whereas Islamic Banking uses equity participation systems where profits and losses are shared.
Is Islamic Banking only for Muslims?
No, Islamic Banking is not exclusive to Muslims. Anyone, regardless of faith, who agrees with the principles of Islamic finance – such as risk-sharing, avoiding interest and unethical, uncertain transactions – can use Islamic banking services.
Are Islamic banks safe and regulated?
Yes, Islamic banks are regulated just like conventional banks. They have to follow the rules and regulations set by the financial authorities of the countries they operate in, in addition to following the principles of Islamic law.
What products and services are offered in Islamic Banking?
Islamic banks offer many of the same services that conventional banks do but in a Shariah-compliant way. These can include deposit accounts, home and business financing, auto leasing, credit cards, and more. They also offer Shariah-compliant investment products.
What is the role of a Shariah Board in Islamic Banking?
A Shariah Board is an independent body of specialized scholars in fiqh al-muamalat (Islamic commercial jurisprudence) that reviews and approves all products, systems, and procedures to ensure they comply with Islamic law.
Related Finance Terms
- Mudarabah: A kind of partnership where one party provides the funds and the other provides the expertise and management. Profits are split according to an agreed ratio.
- Murabaha: A type of sale where the bank purchases the item and then sells it to the customer on a deferred basis, with the price including a profit margin agreed by both parties.
- Sukuk: Islamic bonds, structured in such a way as to generate returns to investors without infringing Islamic law against the charging of interest.
- Takaful: Islamic insurance, where members contribute into a pooling system in order to guarantee each other against loss or damage.
- Ijara: A leasing agreement where the bank buys an item for a customer and then leases it back over a specific period.
