The Basics Of Islamic Banking
14- Mar2020
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The Basics of Islamic Banking

Banking and issues related with it:

A bank is an institution which creates current demand deposits or in simple terms money. A refined banking solution is the core backbone of the monetary network of any country. However traditional banking tends to rely heavily on the interest generated from clients through lending money to different types of borrowers like consumers, SME, Corporates, etc. This contradicts Islamic laws as The Holy Prophet said “Islam is a comprehensive guide for all ages to come, till the Day of Judgment. Islam has strictly prohibited taking, giving and even writing down of interest” [Tirmizi: 1206]. Taking of interest is not just a burden on the economics of society, but is considered as war against Allah and His Apostle (PBUH), as mentioned in the Holy Quran: “O yee who believe, fear Allah and give up what remains of your demand for Riba, if you are indeed believers. If you do it not, take notice of war from Allah and His Messenger.” [2:278-279]

What is Islamic Baking?

An Islamic bank is an interest free banking institution that relies on Islamic principles in order to perform the banking operations; hence it is halal (permissible) according to Islam and Shariah. 


How Islamic banks work? 

At deposit/liability side, Islamic banks work in one or more of the following ways:

  • Mudarabah: The bank takes an account holder’s deposit on the basis of Mudarabah contract whereby the account holder provides capital/deposit and the other partner (bank) manages it in a Shariah compliant manner. The profit is shared as per pre agreed ratio between customer (rab ul mal) and bank (mudarib) whereas loss is shared by the customer

  • Wadiah (Safe keeping): A non-profit and loss account, where the account holder basically gives an asset for safekeeping on basis of trust to the bank. Bank returns the asset on demand / maturity. Banks usually charge nominal fees as account maintenance fee.

  • Musharakah (joint venture): Where bank and investor(s) mutually provide funds for a project/business and the profit or loss is distributed among all involved shareholders. At asset side, Islamic Banks, in addition to the above modes, uses the following transactions for profit generation:

  • Murabaḥah (Cost-plus): The bank allows a person to buy an asset at an increased price from the bank, and the buyer can then pay back the amount in monthly installments. Since no interest is charged and a set price is taken, it is allowed in Shariah.

  • . Ijarah (leasing): A leasing contract of an asset to a client for a stream of rentals. At the end of ijarah tenure, Islamic Bank gifts the leased asset or sells it against token money through independent contract.

  • Salam: In Salam transactions, Islamic Banks pay the price of the commodity in advance and assets are delivered on a deferred date after the delivery, Islamic Banks sell the commodity in the market against the increased price.

  • Istisna: Istisna contract delivery of assets is deferred like Salam, however price can be paid any time with mutual consent and the underlined asset must require manufacturing in Istisna transaction.

Principles of Islamic banking:

  • Profit and loss sharing: A Muslim is not allowed to earn interest on credit and moneylending, if someone wants to utilize his capital, he must have to bear the risk of his capital in case of loss in business. Similarly rate of return could not be guaranteed for capital provider/deposit holder. Instead, profit of the business will be shared in predetermined profit sharing ratio.

  • Interest-free: Interest or Riba will not be given or taken under any circumstances in the light of Quran and Sunnah "Ibn Mas'ud says that the Prophet (pbuh) cursed the consumer of riba and the 'one who feeds it' and the one who witnesses it and the one who documents it." [Ibn Maja: 2277]

  • Shared risk: In Musharakahh contract’s risk is shared proportionately among all involved parties.

  • No investment or slightest involvement in prohibited businesses or activities: As mentioned in Holy Quran "And, O my people, give full measure and weight justly, and defraud not men of their things, and act not corruptly in the land making mischief. What remains with Allah is better for you, if you are believers" [11: 85-86]

  • Gharar: According to Islamic laws, all parties involved should be completely aware of the transaction they are going to execute and there should not be any ambiguity with regard to any term of the contract or with regard to the capacity of any party in relation to execution of the contract, hence selling of goods without proper possession is forbidden by Allah’s Apostle, as mentioned in Sahih Muslim “He who buys food-grain should not sell it until he has taken possession of it.” [Book 10: 3640]

  • Takaful: Gambling and insurance is prohibited in Islam, Allah (SWT) says, “O who you believe! Intoxicants (e.g. alcohol) and gambling and idols and (lottery by) arrows are an abomination of Satan's work, so avoid them so that you may get salvation” [Quran 2:219] hence Islamic banks instead of conventional insurance, take takaful cover that is free from interest, Gharar, and Gambling, it works on the basis of “Tabarru” (Gift) and Ihsan.

Global Islamic finances:

Global Islamic financial service industry is growing at a steady rate as more Muslims are getting involved in this Halal sector of interest free banking around the world. The industry’s total worth was estimated to be USD 2.05 trillion in 2017, showing a strong 8.3% growth. Whereas buying of Sukuk bonds, globally was raised by an astonishing 25.6% (closing at USD 399.9 billion at the end of 2017) as mentioned in the Global Islamic Finance Market 2019 Industry Research Report.