Islamic Banking

Islamic Banking INTRODUCTION The basic concept of Islamic banking which is also known as ‘interest-free banking’ is based on basic ethical standards with just one main difference- Muslims are not allowed to pay or receive interest. This does not mean that business activities or making a profit are not encouraged, they are but as long as they don’t involve interest in any form. To fulfil this purpose, financial instruments have been introduced by the Islamic financial institutions to satisfy these requirements. An example that can be seen is that equity financing is used instead of debt financing. Furthermore, instead of giving a fixed interest rate on the savings account, Islamic banks offer a share of the bank’s profit, as a return on deposits and this is around 5% annually.

HISTORY The modern banking system was introduced into the Muslim countries in the late 19th century when most of these countries were performing that well economically as well as politically. These banks founded branches in the capital cities of major Muslim countries to cater their business needs. However, the branches were limited to the capital cities and the other surrounding cities were totally ignored by the banking system. Nevertheless, most local businesses still refrained from engaging with these “commercial” banks, mainly for religious reasons. The reason behind this is that banks operate on the basis of charging interest, a concept totally forbidden by Islam.

As time went by however, it became challenging to avoid commercial banks. They were more efficient in certain banking aspects such as money transfers and current accounts, but borrowing loans and opening saving deposits were still avoided due to the prohibited interest issue. As the second half of the 20th century has witnessed, any business-related transaction almost always involves a bank and hence, avoiding the modern banking system has become virtually impossible. Banks extended into local communities and thus, forced themselves into almost every kind of business and their related transactions. This is when many Muslim intellectuals recognized the need for an Islamic banking system that will serve the needs of Muslims from the business point of view and at the same time respecting the codes of Islam. Islamic banking as an institution has been around for 25 years but interest-free banks have also been tried before.

There was one such bank in Malaysia in the mid-forties and one in Pakistan in the late fifties. Neither of them survived. The early seventies saw the institutional involvement. The Islamic Development Bank, an inter-governmental bank was established in 1975. The first private interest-free bank, the Dubai Islamic Bank was also setup in 1975 by a group of businessmen from several countries. Two more private banks were founded in 1977 under the name of Faisal Islamic Bank in Egypt and Sudan. Twenty-five years since the establishment of the first Islamic bank, more than 150 Islamic institutions have come into existence. Though most of these are in Muslim countries, there are some in Western Europe as well as in North America and Asia.

PRINCIPLES OF ISLAMIC BANKING The Islamic banking system follows certain, yet simple, rules set by the Qur’an and the Shari’ah (Islamic law), which if deviated from the system becomes un-Islamic. These are summarized as follows: 1. Any predetermined payment or benefit over and above the actual amount of principal is prohibited: Islam allows only the type of loan in which interest of any form is not charged. Interest in this case is in either monetary form or other beneficiary forms such as using the borrower’s property, etc. in return for the lent money. In other words, any type of benefit received by the lender from the borrower in return for lending the money is prohibited. This is different however from the concept of ‘profit-sharing’ which will be explained next. This is different from the typical loan types of commercial banks which impose interest on loans in some form or the other.

2. The lender must share in the profits or losses arising out of the enterprise for which the money was lent: One of the basic concepts of Islamic banking is to share profits as well as losses. In this way, the lender and borrower become partners rather than creditor and debtor. The incentive behind this is to make both parties involved to equally share risk of the outcome, regardless of the transaction at hand. In modern days, since an Islamic institution is the intermediary, it shares the risks as well as profits with the borrowers and lenders.

This differs obviously from the traditional banking system which imposes and collects an interest rate on the loan regardless of the success or failure of the borrowers’ businesses. This system puts all the risk on the borrower which at many times can be hectic and merciless. 3. Making money from money in Islam is not acceptable: Money can only be used as a medium of exchange, i.e. to determine the value of an item.

It in itself does not have value and therefore should not be used to generate more money, via fixed interest payments, simply by being put in a bank or lent to someone else. Only human effort and taking risk in starting and managing a venture are the means of generating money. In other words, money should be used as a form of debt rather than being capital, and this debt should not be allowed to generate interest. For this reason, Muslims are encouraged to purchase goods and services rather than accumulating it and/or earning interest on it, whether by depositing it in interest-based banks or lending it to people for benefits in return. 4. Uncertainty, risk or speculation (gharar) is also prohibited: The Islamic banking system allows only transactions in which the results are known and determinable. The parties involved in the transaction have perfect knowledge of what they will receive from the other party.

Therefore, no uncertainty, risk, or speculation are allowed into the transaction. A guaranteed future profit on the basis of uncertain gains is also prohibited. Also, no additional amount on and over the principal amount can be charged on the basis of inflation. The rationale behind the prohibitions is the wish to protect the weak from exploitation. This directly states that investment derivatives such as options and futures are considered as un-Islamic and so are forward foreign exchange transactions because of the predetermined future benefits and gains. 5.

Investments should be utilized only in practices or products that are not forbidden, or even discouraged, by Islam: Money supplied under the Islamic system cannot be used to trade in alcohol, for example. Also, a loan cannot be used to finance the construction of a nightclub, casino, etc. The modern practice of inter-banking lending at a predetermined rate is also prohibited. CURRENT PRACTICES OF ISLAMIC BANKS Generally speaking, all interest-free banks agree on the basic principles of Islamic banking. However, individual banks differ in their internal characteristics, functions, and services. These differences arise as a result of the country’s laws, the citizens needs, and the individual bank’s objectives and experiences.

Despite this, Islamic banks have the following aspects in common: – ? Deposit Accounts: All Islamic banks have 3 types of deposit accounts: current, savings and investment. While the number of current accounts has steadily declined, savings and investment accounts have proliferated. The reason for this is due to the increasing confidence of savers and investors in Islamic banking. Although the current accounts are the same as in conventional banks, the savings account operates in a different manner. In some banks, the depositors allow the banks to use their money but the obtain a guarantee of getting the full amount back from the bank.

Banks adopt several methods of inducing their clients to deposit with them but no profit is promised. In other banks, savings accounts are treated as investment accounts but with less stringent conditions as to withdrawals and minimum balance. Capital is not guaranteed but the banks take care to invest money from such accounts in relatively risk free short-term projects. As such lower profit rates are expected and that too only on a portion of the average minimum balance on the ground that a high level of reserves needs to be kept at all times to meet withdrawal demands. Investment deposits are accepted for a fixed or unlimited period of time and the investors agree in advance to share the profit or loss in a given proportion with the bank.

In addition to the above deposit accounts, some Islamic banks have additional accounts as follows: – Trust Deposits: These deposits are not subject to any conditions for drawing or depositing. The bank may use such deposits at its own risk and responsibility in respect of profit or loss. – Joint Investment Accounts: These are deposits received by the bank from persons who desire to participate with the bank in multilateral and continuous investment operations. Such deposits receive a certain percentage of the annual net profits realized. The way of investing these funds is left to the bank’s discretion. ? Means of Financing: Banks adopt several means of acquiring assets or financing projects and these can be categoriz …

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