Categories: BankingNews

Islamic Banking Explained 2021

Everyone was accustomed to Conventional banking until the fall of the 1960s when Islamic Banking was formally introduced as another form of banking. Since then, Islamic Banking has been growing rapidly. From 2009 – 2013 Shari’ah compliant banking grew by 17.6% which was faster than conventional banking at the time. 

Today the Islamic banking assets are worth over $2 Trillion. Saudi Arabia is the most prominent Islamic Banking market with 33% share of the industry. Over 80% of the assets are held in Islamic countries. 

What is Islamic Banking?

Islamic Banking is financing or banking activities that adhere to the Shari’ah law. Shari’ah law is derived from the religious precepts of Islam and that of Qur’an. Islamic banking has two fundamental principles, that is, the sharing of profit and loss, and the prohibition of collection and payment of interest by lenders. 

The prohibition of collection and payment of interest is influenced by the Shari’ah law. The prohibition of collection and payment of interest is the primary difference between conventional banking and Islamic banking. Shari’ah law prohibits usury and any form of speculation. 

For businesses, Islamic banks cannot make investments that involve substances that are prohibited by the Qur’an that includes but are not limited to gambling, pork, and alcohol. Bankers who offer Islamic banking services have to abide by the fundamentals of the Qur’an while they conduct business. 

Since Islamic banks do not charge or collect interest to borrowed capital, these banks use an equity participation system to earn money without having to charge interest. Equity participation refers to share ownership in a company or allowance of partial ownership in exchange for financing.

An Islamic bank needs to operate using Islamic principles in their entirety, however, conventional banks can also provide Islamic banking services through a dedicated section or window. The Islamic banking services by commercial banks are based on Islamic principles, therefore, there is no diversion from the Islamic principles as long as Islamic banking services are provided. 

It is important to understand that Islamic banking can be considered as a culturally distinct form of ethical investing due to the abidance of the Qur’an and the Shari’ah law. 

Principles of Islamic Banking

The principles of Islamic Banking lays the foundation of how Islamic banks should operate. Most scholars view the guiding principles of Islamic Banking as fairness, justice, transparency, and the pursuit of social harmony. 

Here are some of the restrictions or prohibitions that form part of the Islamic banking 

Charging or paying interest

Islam considers lending with interest payments as an exploitative practice that favors the lender at the expense of the borrower who has  to pay interest for the money borrowed regardless of the outcome of the cash employed. 

According to Shari’ah law, interest is usury/(riba) which is prohibited by the Shar’iah law.Riba is mentioned in several different verses of the Qur’an and forbids interest credited from loans or deposits.

Investments in businesses involved in prohibited activities

A number of activities are prohibited by the Shari’ah law and banks that offer Islamic Banking should not be involved in business activities that are prohibited by the Shari’ah law. Activities that are prohibited by the Shariah law include usury, ambiguity in contracts, gambling and games of chance, fraud, bribery, the use of false weights and measures, and taking others’ property unlawfully.

These activities are regarded as haram ( forbidden by Islamic Law), therefore, any investment in such activities is strictly forbidden.

Speculation

Speculation or maisir is prohibited by the Shari’ah law, therefore, Islamic Banks do not engage in any type of speculation. Gambling is also seen as a form of speculation. Islamic financial institutions cannot be involved in contracts where the ownership of goods depends on an uncertain event in the future.

Uncertainty and Risk

Risk and uncertainty form a substantial part of Shariah law and is forbidden. Islamic financial institutions are banned from participating in contracts with excessive risk and/or uncertainty. 

The term Gharar which is a chance, uncertainty, or risk measures the legitimacy of risk or uncertainty in investments. An Islamic financial institution cannot take part in short selling as the Gharar principle does not allow such.

Financing Arrangements under Islamic Banking

Profit and loss sharing partnership

Islamic Institutions form partnerships instead of investing for earning interest. Mudarabah which is a profit and loss sharing partnership agreement whereby one partner provides capital to another partner who is responsible for the management and investment of the capital. 

Mudarabah is a name that is used in Islamic Banking and entails that profits should be shared by participating partners which is the lender and the borrower. Parties involved share profits according to a pre agreed ratio. 

Profit and loss sharing joint venture

Musharakah is a form of joint venture where all partners contribute capital and share profit and loss on a pro rata basis. Most common Musharakahs are:

  • Diminishing partnership

This partnership is more popular with partnerships that want to acquire properties. Normally a bank and an investor join forces to purchase a property and subsequently the bank transfers its equity portion in property to the investor in exchange of payments. 

  • Permanent Musharakah

This partnership is popular with long term projects since the partnership does not have any specific end date and continues to operate as long as the parties involved agree to continue to operate. 

Leasing

Leasing or Ijarah is a financing agreement whereby the lessor leases a property or properties to the lessee in exchange for a stream of rental and purchase payments. This agreement ends with the transfer of property ownership to the lessee. 

Wind up

Shiri’ah has a number of prohibitions that Islamic institutions need to adhere to. Since these institutions cannot invest in investment vehicles such as bonds and derivatives, they invest in equities and fixed income instruments. 

Islamic Institutions invest in company shares since Shari’ah law allows such investments. However, investments in shares must not be in companies that engage in prohibited activities. Fixed income instruments that Islamic institutions can invest in are ‘Shari’ah compliant bonds’ which represents partial ownership. 

Lethabo Ntsoane

Lethabo Ntsoane is a Financial Product commentator at Rateweb. He is an expect financial product analyst with years of experience in reviewing products and offering commentary. Lethabo majors in reviews and financial tips.

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