What is Islamic Banking? and How Does Islamic Banking Work?

How does Islamic Banking Work?

1. Practical Implications of Islamic Banking Principles:

Islamic banking operates based on two primary principles. The first is the sharing of both profit and loss, and the second is the prohibition of interest or ‘riba’. In practical terms, this means that instead of providing loans and charging interest, Islamic banks invest in projects, thereby becoming their partners.

2. Islamic Banking: A Partnership Approach to Business Funding:

In a typical investment scenario, an individual or a business approaches the Islamic bank with a proposal. The bank then evaluates the feasibility and potential profitability of the project. If the bank decides to invest, it does not lend money to the business but instead purchases a share in the business or project. This way, the bank and the business share the risk and reward.

3. Ethical Guidelines of Islamic Banking:

In addition to these principles of profit and loss sharing and prohibition of interest, Islamic banking also follows ethical guidelines laid out by Sharia law. It refrains from investing in businesses related to alcohol, gambling, pork, or anything considered ‘haram’ or prohibited by Islamic law. This makes the Islamic banking system a socially responsible and ethically mindful system.

4. Role of Shariah Board in the Islamic Banking System:

The Shariah Board is a pivotal component of the Islamic banking system, serving as its moral compass and ensuring compliance with Islamic law, or Shariah. Comprised of scholars well-versed in Islamic law and finance, the Shariah Board scrutinizes the bank’s practices, products, and contracts, ensuring that the bank is aligned with Islamic principles. Their role extends beyond mere approval, as they also provide guidance and recommendations on how to remedy any non-compliance. In essence, the Shariah Board plays an instrumental role in upholding the integrity and credibility of Islamic banking, reinforcing its commitment to ethical and responsible financial management.

5. Shariah Banking in Early Ages of Islam:

The history of Islamic banking goes back to the earliest reference point of Islam in the 7th century.

• The first spouse of Prophet Muhammad’s (PBUH), Hazrat Khadija (RA), was a businesswoman, and the Prophet Mohammad (PBUH) went about as a specialist for her business, utilizing a significant number of similar standards utilized as a part of contemporary concepts.
• During the Middle Ages, commercial activities and trades across the Muslim world were guided by the same Islamic principles, influencing the economic systems in regions like Spain, the Baltic States, and the Mediterranean, and forming the groundwork for some Western principles.
• The modern world began to adopt this system in earnest from the 1960s to the 1970s, recognizing its potential and relevance in the current economic landscape.

6. Aligning Modern Islamic Banking Practices with Centuries-Old Values:

While the objectives of Islamic banking parallel those of traditional banking systems, its operations adhere strictly to Sharia’s rules, also known as Fiqh al-Muamalat. The practice of Islamic banking, therefore, must conform to and continuously uphold Shari’ah principles in its practical implementation via the progression of Islamic economics. Many of these underlying principles have achieved worldwide acceptance for centuries, as opposed to mere decades. These principles, while age-old, have evolved over hundreds of years, adapting to changing times without compromising their original values.

7. The Distinctive Approach of Islamic Banks to Loan Repayment:

To comprehend the workings of Islamic Banking, one needs to familiarize themselves with the underlying rules. Shariah scholars universally agree on the principle that the credit price of a commodity can indeed exceed its cash price. This price difference has been given the green light by the Islamic Fiqh Academy of OIC and Sharia Boards of all Islamic banks. However, once the price has been agreed upon mutually, no further additions can be made.

Islamic banks aim to earn money without imposing interest by employing equity participation systems. This means that when a bank lends money to a business, repayment of the loan comes without interest, but the bank securitizes a share in the enterprise’s profits. In cases of loan default or a non-profitable term, the bank refrains from gaining any profit.

Is the Islamic Banking System Really Islamic?

Indeed, the Islamic banking system is genuinely Islamic, as it adheres strictly to the principles outlined in the Quran and Hadith, the primary sources of Islamic law or Shariah. This banking system is grounded in ethics, fairness, and transparency, which are tenets deeply enshrined in Islam. Unlike conventional banking, Islamic banking abides by the prohibition of Riba (usury or interest), engaging instead in profit and loss sharing.

Furthermore, Islamic banking shuns investments in industries that are haram (forbidden). Instead, it encourages halal investments (permissible) and contributes to societal well-being. Moreover, Gharar (uncertainty) and Maysir (gambling) are strictly avoided in all transactions, ensuring transparency and eliminating exploitation.

FAQs

How can my profit from a Conventional Bank account become Haram, BUT the Profit from an Islamic Bank is Halal?

Under conventional banking, Profit and Loss Sharing (PLS) accounts may seem similar to Islamic banking at first glance due to the shared risk and profit model. However, the fundamental difference lies in the very basis of both systems. Conventional banking systems operate on a fixed interest rate model, known as ‘riba,’ which is strictly prohibited in Islamic law. Even if the account shares profits and losses, the interest earned is not permissible under Shariah law, rendering it un-Islamic. Conversely, Islamic banking is structured around trading, leasing, and shared risk and profit agreements, such as Mudarabah and Musharakah. This distinct differentiation between the Islamic and conventional banking systems is what makes a PLS account with a conventional bank un-Islamic.

Did the modes of Islamic finance fail to lead to monetary expansion?

Islamic banks operate on a unique principle that excludes the provision of overdrafts, hence they do not contribute to money creation in the traditional sense. The structure of investment accounts within the Islamic banking system distinctly varies from conventional savings accounts. There lies an inherent requirement to maintain a reserve against each deposit, ensuring a safe return of the initial deposit to its owner. When it comes to investment accounts, Islamic banks are committed to repaying the depositor based on the outcome of their investment, a testament to the unique principles of Islamic banking.

Prohibited Elements in Islamic Banking and Finance:

In the books of Shariah, nine basic do-nots are directly or indirectly related to Islamic finance.

1. RIBA:

An excess compensation over and above the principal

2. MAYSIR:

It is known as gambling, and in this transaction, one party is a complete loser and the other is the complete gainer.

3. GHABAN:

It means fraud, and it is completely prohibited by Shariah.

4. IQ’RAH:

It means “imposing a contract or a condition on an unwilling party”.

5. BAI-AL-MUTTAR:

It is the exploitation of the needy, such as charging high prices.

6. EHITKAAR:

It is the hoarding of goods from the market or price manipulation.

7. NAJASH:

It is the raising of prices by manipulating false bids.

8. GHARAR:

That means an uncertain, risky, or hazardous deal.

9. JHAHAL:

Lack of information about a commodity, its quantity, price, etc.

Key Features of Islamic Banking System:

1. INTEREST OR RIBA FREE FINANCING:

Under Islamic law, any level of interest is considered to be usurious and is prohibited.

2. CONTRACTUAL CERTAINTY:

Uncertainty is not allowed unless all of the terms and conditions of the risk are clearly understood by all parties.

3. ASSET BACKING:

Each Islamic financial transaction must be tied to a tangible, identifiable asset, and money is not considered an asset class.

4. RISK SHARING AND PROFIT SHARING:

Parties involved in a financial transaction must share both, the associated risks and profits.

5. ETHICAL INVESTMENTS:

Investments in prohibited industries, such as alcohol, pornography, gambling, and pork-based products are discouraged.

Stepping into the Halal Banking Career:

For those seeking a deeper understanding of the Islamic banking system, numerous educational opportunities await online. You can acquire an Islamic Finance online certification or enroll in Islamic banking online courses to gain insights into the principles and operations of halal banking. There’s also a diploma in Islamic banking and finance that offers an in-depth exploration of Sharia banking procedures, equipping students with the necessary skills to excel in this ethical financial field. If you’re aiming for a more advanced study, MBA Islamic Finance degrees and PhDs in Islamic Economics and Finance are available, which delve into complex financial systems and economic theories from an Islamic perspective.

Islamic Banking Operations:

1. Role of Central Banks in the Islamic Banking System:

Central banks occupy a significant position in overseeing commercial banks and their myriad operations. It’s worth noting that even in numerous Muslim nations, interest-based banks dominate a substantial portion of the money market. The advent of Islamic banking, however, has sparked a series of questions:

QUESTIONS:

1. How the central banking operations can be conducted in an interest-free environment?
2. Can the same interest-based instruments of monetary management, can also be used for interest-free banking systems, or will new instruments have to be devised?
3. What would be the nature of these new instruments, and how would they work?
4. Would there be a need to control Islamic banks?

ANSWERS:

Almost all economists of Islamic Finance agree that:

• The central bank in an Islamic economy can continue to perform, as it performs elsewhere.
• The central bank in an Islamic economy should function under the State’s control, and its aim should not be profit-making, but to safeguard the public interest.

2. Regulatory Requirements in Islamic Banking and Finance:

There are 10 Islamic Finance Instruments on the assets side and 12 instruments on the liability side. Before launching any new product, Islamic institutions have to the intimate following to the central bank:

• Compliance and mechanism of new products.
• How Islamic banks will audit according to Shariah?
• Who will carry out the investment in shares?
• Principles and policies for profit distribution between Islamic banks and their partners; and;
• Financial reporting and general disclosures.

3. Impact of Islamic Banking Operations on the Monetary Expansion:

• Generally, central banks like to treat Islamic banks, at par with the deposits.
• The Islamic banks’ products are different from conventional debt-creating products, so they may not result in monetary expansion.
• Money creation by Islamic banks is closely associated with the creation of wealth in the real sector.
• Islamic banks cannot liquidate their assets, as easily as conventional banks. So, they keep more cash in their vaults than conventional banks, to meet withdrawal obligations.

4. Managing Funds in Islamic Banks:

1. NATURE OF INVESTMENT ACCOUNTS:

• To resolve this controversy, it is necessary to understand what money is. how it is created? and what should be the appropriate reserve requirements for Islamic banks to operate?
• Money is a means of payment. Whenever a new checking account comes into being, money is created. That results in monetary expansion because of this fact.

2. PREMIUM PAYMENT AND PROFIT DISTRIBUTION MECHANISM:

Investment accounts in Islamic banks have close similarities to savings and time deposits in conventional banks. COIs of Islamic banks and TDR of Conventional Banks are similar. Nevertheless, the Premium Policies and Profit Distribution mechanism are different.

3. PRE-MATURE ENCASHMENT:

Islamic banks allow investment account holders, to withdraw full money from their accounts. This is in contrast to conventional banks which do not pay the full principal, at premature encashment.

4. EXPANSION THROUGH ISLAMIC BANKS:

Let us see how the Islamic modes of finance may contribute to monetary expansion:

• Funds accumulated in Islamic banks’ investment accounts are invested in industry, Islamic trade finance, or agriculture in Shariah-compliant partnerships with businessmen.
• These funds are received by people as salaries, wages, prices for raw materials, rents, etc. Some of it finds its way back to banks, and are distributed between current and investment accounts. Anyway, the investment based on Musharkah or Mudarbah results in the appearance of some new bank deposits.

5. DIFFERENCES BETWEEN DEBT FINANCE AND PARTICIPATORY FINANCE:

All profit-sharing investments are based on a potential for additional production. This does not necessarily apply to debt finance, in which the borrower’s ability to repay takes precedence over the project’s expected profitability. In case the business runs into losses, lesser profits are earned by Islamic banks. So, Islamic banks debit the amount of the loss, pro rata to the investment accounts.

7. DIFFERENCES BETWEEN MURABAHAH FINANCE AND PARTICIPATORY FINANCE:

• Islamic banks practicing in Murabahah receive a continuous stream of repayments. And, out-flow and inflow of cash can be closely synchronized, if compared with Mudharbah.
• Unlike participatory financing, Murabahah creates a loan obligation on the customer, so the customer pays back the agreed price, even when incurs a loss in trade.

Wrapping Up:

Islamic banking, with its principle of interest-free financing and risk-sharing, offers a unique and ethical alternative to conventional banking systems. It embodies a system that merges finance with values, ensuring monetary transactions respect the socio-economic justice principles of Sharia law. Despite the dominance of interest-based banks, even in many Muslim countries, the emergence of Islamic Banking has paved the way for a shift towards more ethical and inclusive financial systems. As more individuals and businesses become aware of the advantages of Islamic banking and its emphasis on equitable risk-sharing, it is poised to take on a more significant role in global finance.