Principles

About Islamic Banking

With the support of the Islamic Civilization, Arab Muslims not only adopted banking but perfected it beyond anything the Romans achieved. But, it was all subject to compliant with principles and rules of the Islamic Shari'a.

Back then, a deposit was defined as money kept in trust for someone by a trustee. This banking concept was adopted at the dawn of Islam when people would deposit their money with the esteemed companion of the Prophet (Allah's peace be upon him) Al-Zubair Bin Awwam (radiah Allah anhu), who used to tell people "Make it a loan, so that I can guarantee it for you". He would then invest these deposits by trading.

Muslims soon became familiar with these money transfers and the practice of using cheques. Back in history the Prince of Aleppo, Saif Addawlah Alhamadani, once visited Baghdad disguised as a commoner. Here he spent the night among the Bani Khaqan tribe and gave them a signed notice ordering money exchangers in Baghdad to handover the holder of the notice, one thousand dinars.

The spread of foreign conventional (usurious) banks in most Muslim countries created the need for an Islamic alternative. Most Muslim scholars criticized them and their sinful transactions without having to search for any alternative. Later on, in view of the huge benefits of conventional banking, scholars focused their efforts on coming up with a solution that would conform to the principles and rules of Shari'a.

One of the first attempts to start Islamic banking was in 1963 at Ghamr city in Egypt By Dr. Ahmed Al Najar. The bank succeeded to establish 53 braches which include 85000 Muslims. It was providing invesment, social, and education services to the people. It was 1971 the Egypt government issue law for establishing Nasser Social Bank which had 3 sources for income 1) Zakat management, 2) management of public insurance and 3) management of public debt. In 1975, UAE issued a decree to establish the first Islamic Bank in the country and same year Islamic Development Bank established in Jeddah, KSA.

In the beginning, Islamic banking was very basic. The principle of Murabaha was used due to its simplicity and low-risk factor. Mudaraba Islamic contracts, both restricted and unrestricted, were then used to collect deposits with a view to investing them.

Innovation in Islamic banking happened as capitals returned to the Arab and Islamic regions, necessitating the need to again explore the heritage of the Islamic Jurisprudence to enhance Shari'a compliant tools of finance and investment in line with people's needs and aspirations.

With conventional banks entering into Islamic banking, there's a lot more competition in this fast growing market. This has meant there are new finance tools, such as Istisna, Parallel Istisna, Musharaka, Diminishing Musharaka, Salam, Parallel Salam, Operational Ijara, Sub-leasing, Financial Ijara, Mudaraba and Investment Wakala and many others.

Various forms of Investment Funds and Sukuk, also, came into practice as a good source to obtain liquidity for non-monetary goods and services by selling to potential dealers.

The variety of Islamic banking tools are unlike those of conventional banking, as conventional ones are usually based on one contract, while in Islamic banking, each tool has its own contractual nature and features that make it different from other tools.

More about Shari’a

What is Shari’a:

It is Islamic law, derived from the divine guidance as given by the Quran and the Sunnah, embodying all as aspect of Islamic faith including belief and practices.

Concept of Islamic Banking

There's a lot to take in when it comes to Shari'a principles and rules in banking, but this will give you some idea what it all means. It goes as follows:

Avoiding the interest is not the only concept of Islamic banking. It's an essential part of the broad concept and ideology of Islamic economics which Islamic banking is based on.

Here's the big picture:

  • Usury is forbidden. Trading is permitted and encouraged
  • Worldly resources are owned by Allah and given on man's disposal in trust
  • Human being is accountable before Allah for all of his deeds
  • Wealth should not merely make a circuit among wealthy people rather to be distributed fairly through concept of Zakat and inheritance rules
  • Speculation and wasteful use of funds are considered unlawful
  • One's gain on other's loss is prohibited (the concept of gambling)
  • Justice, honesty, transparency and moderation flourish the equal opportunities in the society
  • Money is medium exchange
  • Asset-backed financing
  • Greed and yearning lead to putting down the fellow human being's rights.

So Islamic banking truly is a system that lives up to the high ethos and moral values of Islam, which is monitored by a very modern system. The more efficient this system is, the more easily the objectives and goals of Islamic economic system are achieved.

This concept makes all financial activities asset backed in an Islamic set up. Based this concept, Islamic banking involves acquiring physical assets and services, leasing the usufruct and entering into construction contracts through various modes of finance, like Murabaha, Mudaraba, Musharaka, Diminishing Musharaka, Ijarah, Istisna'a, , Salam, Sukuk, Wakala and so on.

What is the Shari'a Board?

Quite simply, it's a group of people with comprehensive knowledge of Islamic laws, appointed by the Shareholders, to effect the day-to-day practice of Shari'a. They review and approve all financial and non-financial contracts, transactions, investments, accounts and annually review financial statements and accounts to make sure they comply with Shari'a law.

How do Islamic Banks operate?

  • Don't believe in borrowing money from depositors, and they never lend money to customers in sense of earning interest.
  • Banks as Mudareb accept deposits from customer who acts as a Rab Al Mal while depositing his money with banks where the realized actual profit is distributed between banks and depositors on pre-agreed ratio.
  • They can't fix the rate of return to a depositor. All they can do is give an idea of what will be based on their historic performance.
  • Islamic banks share the business and ownership risks with the customers whom they finance to as in Mudaraba and Musharaka transactions.
  • Instead of creditworthiness of the customer they mainly concentrate on the soundness of the project as they receive their profit only if the financed project generates income.
  • They abide by the ethical principles and rules of Islam and pay the utmost attention to the moral values. Therefore, they cannot finance for any non-Shari'a activity.

Glossary

Mudaraba

Mudaraba in essence is based on bringing together those who have capital with those who have expertise, where the first party provides capital and the other party provides the expertise and management. The reason for this is earning 'Halal' (lawful) profit, that's divided between them in a way that's pre-agreed upon, while the losses is borne by the provider of the capital. The fund provider is called “Rab Al Mal” and the Bank is “Mudarib”.

Ijarah

A lease is the sale of the benefits or usufruct not the sale of the assets or it is a Sale of a definite usufruct in exchange definite reward. So the same can be defined as a contract where the leaser puts the benefits of an asset or services at the disposal of someone for an agreed period of time in return of agreed rentals. In banking practices, it's generally divided into two broad categories:

1. Operational Lease.

Here the leaser lets the asset to someone for an agreed term and rental price with the leaser remaining the sole owner of subject of the lease throughout the lease term. At expiry of the lease, the leased asset returns back to the leaser.

2. Ijarah Muntahiya Bi Tamleek/Lease Ending with Ownership Transfer.

This is more or less like the Operational Lease, except that at the end of the lease term, the ownership of the asset is transferred by the lessor to the lessee.

Istisna

It is a Sale and Purchase Agreement in which the purchaser (Mustasne) purchases from the seller (Sane) a specified asset to be manufactured or constructed and delivered by the seller (Sane) on an agreed future date for a certain price (Istisna price). The Istisna price can be paid either upfront or in phases during manufacturing or at the delivery of the asset or later.

Murabaha

Is selling the commodity for the purchase price plus an agreed upon profit margin. This margin can be a percentage of the purchase price or a lump sum.

Musharaka

It is a contract between two or more parties where they agree to participate in contributing capital for investment. The accruing profits, if there are any, are distributed among them on an agreed percentage. Any losses, if any, are shared between them according to their share in the capital.

Wakala

Banks often use Wakala for large deposit accounts. A customer with capital, appoints an Islamic bank to carry out an investment as its agent (on his/her behalf) either pays a fee to the bank for taking care of its fund or not.

Bai Al Salam

It is a sale where the price is paid for in advance for a specified commodity to be delivered on a specified date and place.