Non-Interest Finance/Banking

Islamic Banking and Finance

Key Notes:

• Islamic banking, also referred to as Islamic finance or Shariah-compliant finance, refers to finance or banking activities that adhere to Shariah (Islamic law).
• Two fundamental principles of Islamic banking are the sharing of profit and loss and the prohibition of the collection and payment of interest by lenders and investors.
• Islamic banks make a profit through equity participation, which requires a borrower to give the bank a share in their profits rather than paying interest.
• Some conventional banks have windows or sections that provide designated Islamic banking services to their customers.

One of the primary differences between conventional banking systems and Islamic banking is that Islamic banking prohibits Usury and Speculations.

Shariah strictly prohibits any form of speculation or gambling, which is referred to as maisir. Shariah also prohibits taking interest on loans. In addition, any investments involving items or substances that are prohibited in the Quran—including alcohol, gambling, and pork—are also prohibited. In this way, Islamic banking can be considered a culturally distinct form of ethical investing. 

To earn money without the typical practice of charging interest, Islamic banks use equity participation systems. Equity participation means if a bank loans money to a business, the business will pay back the loan without interest and instead give the bank a share in its profits. If the business defaults or does not earn a profit, then the bank also does not benefit. In general, Islamic banking institutions tend to be more risk-averse in their investment practices. As a result, they typically avoid business that could be associated with economic bubbles.

There are different products under Islamic Banking and Finance:

• Mudaraba:

Mudaraba (profit sharing and loss bearing) is a partnership in business whereby one party provides capital (Rabbul Maal) and the other party provides labour (Mudarib).

• Musharaka

Musharaka (profit and loss sharing) means a relationship established under a contract by mutual consent of the parties for contributing capital, sharing of profits and losses in the joint business.

• Murabaha

Murabaha is a contract of sale between financier and the client for the sale of goods at a price plus an agreed profit margin for the financier. It is often referred to as “cost-plus margin” or “mark-up sale”

• Istisna:

Istisna is a contractual sale agreement for manufacturing well-described equipment or construction of building at a given price allowing cash payment in advance and future delivery.

• Salam:

Salam is the sale of a specific commodity, well defined in its quality and quantity which will be delivered to the purchaser on a fixed date and place in the future against an advanced full payment of price at spot.

• Ijara:

Ijara is the transfer of the usufruct/benefit of a particular property or asset to another party in exchange for a pre-agreed rental for an agreed period.

• Ijara Sukuk:

Ijara sukuk are certificates representing the ownership of well-defined existing and well-known assets, that are tied up to a lease contract.

• The Wakala:

Wakala is an Agency contract in which the principal (Muwakkil) appoints an agent (Wakeel) to carry out a specific task on his/her/its behalf in what can be a subject matter of delegation