Learn Islamic Banking

What is Islamic Banking?

Islamic banking is defined as banking system which is in consonance with the spirit, ethos and value system of Islam and governed by the principles laid down by Islamic Shari’ah. Interest free banking is a narrow concept denoting a number of banking instruments or operations which avoid interest. Islamic banking, the more general term, is based not only to avoid interest-based transactions prohibited in Islamic Shari’ah but also to avoid unethical and un-social practices. In practical sense, Islamic Banking is the transformation of conventional money lending into transactions based on tangible assets and real services. The model of Islamic banking system leads towards the achievement of a system which helps achieve economic prosperity.

What is the philosophy of Islamic banking?

The philosophy of Islamic banking takes the lead from Islamic Shari’ah. According to Islamic Shari’ah, Islamic banking cannot deal in transactions involving interest/riba (an increase stipulated or sought over the principal of a loan or debt). Further, they cannot deal in the transactions having the element of Gharar1 or Maiser2. Moreover, they cannot deal in any transaction, the subject matter of which is invalid (haram in the eyes of Islam). Islamic banks focus on generating returns through investment tools which are Shari’ah compliant as well. Islamic Shari’ah links the gain on capital with its performance. Operating within the ambit of Shari’ah, the operations of Islamic banking are based on sharing the risk which may arise through trading and investment activities using contracts of various Islamic modes of finance. The prohibition of a risk free return and permission of trading, as enshrined in the Verse 2:275 of the Holy Quran, makes the financial activities asset-backed in an Islamic set-up with ability to cause ‘value addition’.

What is Meant By Riba?

The word "Riba" means excess, increase or addition, which correctly interpreted according to Shari’ah terminology, implies any excess compensation without due consideration (consideration does not include time value of money). This definition of Riba is derived from the Quran and is unanimously accepted by all Islamic scholars. The meaning of Riba has been clarified in the following verses of Quran (Surah Al Baqarah 2:278-9) "O those who believe; fear Allah and give up what still remains of the Riba if you are believers. But if you do not do so, then be warned of war from Allah and His Messenger. If you repent even now, you have the right of the return of your principal; neither will you do wrong nor will you be wronged."

Difference between Islamic Banking and Conventional Banking

1 Money is a commodity besides medium of exchange and store of value. Therefore, it can be sold at a price higher than its face value and it can also be rented out Money is not a commodity though it is used as a medium of exchange and store of value. Therefore, it cannot be sold at a price higher than its face value or rented out.
2 Time value is the basis for charging Interest on capital. Profit on trade of goods or charging on providing service is the basis for earning profit.
3 Interest is charged even in case the organization suffers losses by using bank’s funds. Therefore, it is not based on profit and loss sharing. Islamic bank operates on the basis of profit and loss sharing. In case, the businessman has suffered losses, thebank will share these losses based on the mode of finance used (Mudarabah, Musharakah).
4 While disbursing cash finance, running finance or working capital finance, no agreement for exchange of goods & services is made. The execution of agreements for the exchange of goods & services is a must, while disbursing funds under Murabaha, Salam & Istisna contracts.
5 Conventional banks use money as a commodity which leads to inflation. Islamic banking tends to create link with the real sectors of the economic system by using trade related activities. Since, the money is linked with the real assets therefore it contributes directly in the economic development.