Introduction to Islamic Banking and Finance

Aug 12


Rana Ardhita

Rana Ardhita

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A quick reading of Islamic history tells us that practices of certain forms of banking activities go back as early as 1200 years ago in Baghdad, Damascus etc. However the first modern experiment with Islamic Banking was undertaken in Egypt under cover, without projecting an Islamic image, for fear of being seen as a manifestation of Islamic fundamentalism which was anathema of the political regime.

The pioneering effort of Islamic Banking,Introduction to Islamic Banking and Finance Articles led by Ahmad El Najjar took the form of a savings banks based on profit sharing in the Egyptian town of Mit Ghamir in 1963. This experiment lasted until 1967 by which time there were 9 such banks in the country. These banks which neither charged nor paid interest invested mostly by engaging in trade and industry directly or in partnership with others and shared their profits with the depositors. Thus they functioned essentially as savings investment institutions rather then as commercial banks.

According to the common economic laws there are two people involved in a business transaction regarding loans, and the first individual who is being paid the loan is the borrower whereas the second person paying it is the lender. Normally interest is charged by the lender on the amount that he is lending. This concept is rejected by Islam which terms capital as a means of value rather than as an asset, and asserts the negation of receiving interest over money. Further under the Islamic rules this practice called "riba" and regulations it is termed as illegal and "haram". The existence of Islamic banking works towards the supplementation and fulfillment of both the economic and the social objectives of Islam. Some of the investment arrangements that are permitted under Islamic banking have been briefly explained in the following paragraphs.

To recap, one of the basic principles of Islamic banking is the prohibition of riba as mentioned above (usury or interest). Up until the 1980s riba was generally interpreted to only apply to usury but it is now accepted practice to refer to all interest. Other principles are based on simple morality and common sense, which are by no means unique to Islam. For example, usury was also prohibited by the Old as well as the New Testament. Even literary heavyweights such as Shakespeare weighed in against the practice.

The basic principles of Islamic Banking originate in the axioms of justice and harmony with reality and the human nature. The concept of Islamic Banking is evolved on the basis of Shariah principles. One might wonder whether Islamic Banking & Finance is an alternative approach to modern banking.

The most important development in modern banking is the art of mobilizing funds for investment. It happened to be that the method of both collecting and using of funds was based in the West on the interest paid and charged. In contrast Islamic Banking is a system that provides financing and attracts savings on the basis of profit and Loss sharing. The Central feature of Islamic Banking is that no interest would be charged or paid and the returns would be in the form of profits from trade in which the money lent or borrowed is invested. For Muslims this system of Profit or Loss sharing coincides with their prohibition of interest, and helps in mobilizing unused funds for investment and creating new job opportunities. As for non-Muslims, the Islamic Banking system doesn't contradict their faith, while it provides the society with alternative ideas for venture capital and other tools of investment. There were some basic principles of Islamic banking;

  • Interest free Debt
  • Encouraging economic mobility and not hoarding
  • Prohibiting manufacture of wine and restrictions placed on gambling
  • Creating a Tax framework
  • Multipurpose and not purely commercial
  • Equity oriented
  • PLS- Profit Loss Sharing
  • Purchase stock on behalf of a client and sell it to him at a profit over the purchase price

The Islamic economic system is concerned with social justice to ensure that none of the parties involved in a transaction is being exploited without at the same time inhibiting individual enterprise. Extended to the Islamic financial system, this means that the funds individuals and/or companies put at risk share the profits or losses resulting from the enterprise. This concept of sharing the delights or pain of the outcome of business is a progressive one. Islamic banking encourages better resources management, in particular as outright speculation is not permitted by Shariah, ie Islamic law. The participants are keeping pace with sophisticated techniques and have developed products that are not only ethically motivated but also profitable.

For example, in Islamic housing finance the risks involved are shared between the bank and the borrower, rather than transferring all the risk to the latter. The most commonly used contract is the diminishing musharaka (partnership) contract. In this case the bank and the borrower form a partnership, with the bank providing up to 95 percent of the purchase price, and the borrower 5 percent.

The borrower buys out the ownership share of the bank which makes its profit from the rent paid by the client for the share the bank owns. This happens over a period of, usually, 15 to 30 years.

Should the borrower default on a rental or principal repayment, the bank may advance the borrower an interest-free loan to enable him to continue their payments in anticipation that he will pay in full when he is able to. The good news is that during this period of distress, the borrower retains his home rather than face eviction.

Having said this, Islamic banks still appraise credit risk, and indeed are more cautious about who they finance than conventional banks.


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