What Is Islamic Banking?
Islamic banking, also known as Islamic finance or Shariah-compliant finance, encompasses financial activities governed by Shariah (Islamic law). At its core, Islamic banking adheres to the principles of profit and loss sharing, while forbidding the payment and receipt of interest by lenders and investors.
Key Insights
- Islamic banking, synonymous with Shariah-compliant finance, operates in accordance with Islamic law.
- The foundational principles of Islamic banking center around profit-sharing and the prohibition of interest transactions.
- Islamic banks generate revenue through equity participation, whereby borrowers share profits instead of paying interest.
- Some traditional banks offer Islamic banking services through specialized sections to cater to specific customer requirements.
How Islamic Banking Practices Work
The global landscape of Islamic finance showcases over 560 banks and 1,900 mutual funds aligning with Islamic principles. The sector’s financial assets burgeoned from $2.17 trillion in 2015 to approximately $4 trillion by 2021, with a projected rise to $5.9 trillion by 2026, as per a 2022 report by the Islamic Corporation for the Development of Private Sector (ICD) and Refinitiv.
This growth is notably fueled by the economic growth in Muslim nations, especially those benefiting from elevated oil prices.
Highlighted by S&P Global Ratings, the global Islamic finance industry thrived in recent years due to increased bond issuance and ongoing market recovery. Despite the pandemic, Islamic assets expanded by over 10% in 2020.
Rooted in Islamic faith tenets related to commerce, Islamic banking derives its principles from the Quran, the central text of Islam. Integral to Islamic banking is the compliance with Shariah, the Islamic legal code based on Quranic teachings, with transactions guided by the rules of fiqh al-muamalat.
Practitioners of Islamic banking are entrusted to adhere strictly to Quranic principles in their dealings. When in need of direction, Islamic bankers seek guidance from learned scholars or apply scholarly knowledge and customary practices.
A prominent divergence between conventional and Islamic banking manifests in the clash over usury and speculation. Islamic banking strictly prohibits speculative practices or gambling, categorically termed as maisir.
Additionally, Shariah prohibits interest-bearing loans and forbids investments entangled with Quran-prohibited items like alcohol, gambling, and pork. Islamic banking, therefore, epitomizes a culturally distinctive form of ethical investment.
Islamic banks wholly operate on Islamic principles, contrasting with Islamic windows available in conventional banks that offer services complying with Islamic tenets. Select commercial banks extend Islamic banking services via dedicated sections.
Islamic banks adopt equity participation models to generate revenue without interest charges. This implies that if a business borrows from the bank, repayment is interest-free, with profits shared instead. In the event of default or profit shortfall, the bank shares the losses, reflecting a risk-averse approach in Islamic banking investments to avert economic bubbles.
History of Islamic Banking
The origins of Islamic banking trace back to Middle Eastern merchants conducting financial transactions with European counterparts during the Medieval era.
Initially adopting European financial practices, as trading evolved and European banks established local branches in the Middle East, some banks integrated local customs, particularly no-interest financial systems founded on profit-and-loss sharing methods.
Embracing these principles enabled European banks to cater to local Muslim entrepreneurs.
In the modern era, the resurgence of Islamic banking dates back to the 1960s, with a surge in interest-free banks from 1975 onwards.
While predominantly established in Muslim nations, Islamic banks emerged in Western Europe in the early 1980s. Furthermore, Iran, Sudan, and Pakistan governments developed national interest-free banking systems to promote this financial approach.
Example of Islamic Banking
The Mit-Ghamr Savings Bank, founded in Egypt in 1963, signifies a historical Islamic banking milestone. Adopting a profit-sharing model, Mit-Ghamr lent to businesses based on profit-sharing agreements.
Despite its closure in 1967 due to political influences, the bank exercised prudence during its operational year, approving only a fraction of loan applications and demonstrating a zero default rate in favorable economic conditions.
What Is the Basis of Islamic Banking?
Islamic banking is rooted in the foundations of Islam concerning commercial transactions. Derived from the Quran, Islamic banking principles operate based on Shariah, the Islamic legal code from the Quran, underpinned by fiqh al-muamalat rules.
How Are Conventional and Islamic Banking Different?
A key contrast between conventional and Islamic banking pertains to the prohibition of usury and speculation in Islamic banking. Shariah categorically rejects any form of gambling or speculation, termed maisir, while also prohibiting interest on loans and investments linked to Quran-prohibited substances.
How Do Islamic Banks Make Money?
Islamic banks utilize equity participation systems to generate revenue without interest charges, akin to profit sharing. With equity participation, businesses repay loans without interest, instead sharing profits with the bank. In cases of business setbacks, the bank shares the losses, reflecting a risk-averse investment strategy in Islamic banking.
The Bottom Line
Islamic banking, synonymous with Islamic finance or Shariah-compliant finance, involves financial operations adhering to Islamic law.
Integral to Islamic vs. conventional finance disparities are profit sharing mechanisms and the elimination of interest in transactions. Furthermore, Shariah prohibits interest collection on loans. Islamic banks leverage equity participation to generate profits, requiring borrowers to share profits rather than paying interest.