Islamic banking, also known as Islamic finance or Shariah-compliant finance, involves financial activities that are compliant with Islamic law (Shariah). At its core, it embraces profit and loss sharing and the prohibition of interest (riba) payments for both lenders and borrowers.
Key Takeaways
- Faith-Based Framework: Islamic banking operates within the confines of Shariah, ensuring all financial dealings adhere to the teachings of the Quran.
- Ethical Foundations: Profit and loss sharing replaces the concept of interest, fostering more equitable financial interaction.
- Growing Global Presence: Islamic banking services are not limited to Islamic banks; conventional banks often provide Shariah-compliant solutions.
The Mechanisms of Islamic Banking
Islamic banking has witnessed remarkable growth, escalating Islamic financial assets from $2.17 trillion in 2015 to a projection of $5.9 trillion by 2026, driven by the rise of Muslim economies and favorable economic conditions.
Grounded in Islam’s religious tenets, Islamic banking mandates that all transactions comply with fiqh al-muamalat (Islamic rules pertaining to economic matters). Financial transactions must align with ethical investment principles detailed in the Quran.
In practice, Islamic banks consult with Islamic scholars and employ learned scholars to ensure adherence to Shariah principles. Conventional banks offering Islamic banking services usually create dedicated sections or windows to cater to their specific clientele.
Forbidden Practices in Islamic Banking
Islamic banking strictly forbids usury and speculation (gharar and maisir). Investments in businesses involving alcohol, gambling, pork, or other Quran-prohibited elements are also off-limits.
Moreover, to earn revenue without charging interest, Islamic banks partner with borrowers via equity participation, receiving a share of their profits instead of interest. When businesses face losses, banks also shoulder part of the financial hardship, promoting shared risk and moral accountability.
Historical Context of Islamic Banking
Islamic finance traces its origins to Middle Eastern business practices in the Medieval period. Local customs gradually influenced European banking branches in the Middle East, birthing hybrid financial systems featuring profit-and-loss sharing instead of interest. Modern Islamic banking truly regained momentum in the 1960s, with a notable increase in institutions operating on interest-free models both in Muslim-majority and Western countries since the 1980s.
Example: Mit-Ghamr Savings Bank
A pioneer in modern Islamic banking, Egypt’s Mit-Ghamr Savings Bank exemplified Shariah-compliant finance from its establishment in 1963. Operating on a profit-sharing model, it adhered to cautious lending practices and boasted zero loan defaults in prosperous times. Despite political closure in 1967, its brief existence validated the viability of such financial frameworks.
Comparing Conventional and Islamic Banking
Conventional banking and Islamic banking diverge primarily on three points:
- Prohibition of Interest: Traditional banking thrives on interest-based transactions, unlike its Islamic counterpart.
- Ethical Investment Constraints: Islamic banks avoid investments tied to gambling, alcohol, pork, or other forbidden sectors according to Shariah.
- Speculation and Gambling: Activities incorporating excessive risk or gambling are strictly outlawed in Islamic finance.
Earning Through Partnerships
Instead of profiting from interest, Islamic banks adopt an equity participation model. Loans are repaid by businesses not through interests but profit shares, fostering joint financial responsibility and risk.
An Ethical Alternative
Islamic banking represents an ethical and principled alternative within the financial sector. Despite significant structural differences from mainstream finance, its fundamental approach toward equitable profit sharing and ethical investing continues to draw investors’ attention worldwide.
Related Terms: Shariah law, equity participation, profit-sharing, Islamic finance, ethical investing.
References
- Islamic Corporation for the Development of the Private Sector-Refinitiv. “Islamic Finance Development Report 2022”, Pages 2, 8.
- S&P Global Ratings. “Islamic Finance 2021-2022: Toward Sustainable Growth”. (Registration required.)
- Northwestern University. “How Muslims in the U.S. Follow the Islamic Financial System”.
- Thomson Reuters Practical Law. “Maisir”.
- HG.org. “Understanding Islamic Banking”.
- Alizz Islamic Bank. “Overview of Islamic Banking”.
- Islamic Finance Foundation. “The Establishment of National Interest Free Banking Systems in Iran, Sudan and Pakistan”.
- Orhan, Zeyneb Hafsa. “Mit Ghamr Savings Bank: A Role Model or an Irreplicable Utopia”? The Journal of Humanity and Society, 2018, 85-102. (Registration required.)
- Parikh, Vraj, Shah, Neel, Shah, Dhyani, Hiremath, Pragati, Gaywala, Dipak. “A Comparative Study of Islamic Banking Services and Conventional Banking Services Using CAMELS Analysis in Indonesia”. International Journal of Creative Research Thoughts, Vol. 9, Issue 3, March 2021.
