Islamic Banking System – What and How Does It Work?

What Is Islamic Banking System?

Islamic banking, additionally known as Islamic finance or shariah-compliant finance, refers to finance or banking actions that adhere to shariah (Islamic regulation). Two basic ideas of the Islamic banking system are the sharing of revenue and loss, and the prohibition of the gathering and fee of curiosity by lenders and traders.

The Qur’an prohibits riba, which accurately means “increase”. Technically riba is the rise when liquid or fungible belongings (money, debit, grains, and many others.) are exchanged aside from at par worth. The most prevalent instance in as we speak economic system is lending cash at curiosity, for instance, a change of $100 money now for $110 payable in a 12 months’ time, a rise of $10. (Some Muslims dispute whether or not there’s a consensus that curiosity is equal to riba).

There are greater than 300 banks and 250 mutual funds around the globe that adjust to Islamic ideas. Between 2000 and 2016, Islamic banks’ capital grew from $200 billion to shut to $3 trillion in 2016. This development is essential because of the rising economies of Muslim international locations (particularly people who have benefited from the rising value of oil).

The Islamic monetary system will not be a lot totally different from the services within the conventional monetary system. But it surely operations are primarily based on a sure set of ethical and moral ideas. That decided what’s considered as morally ‘right’ implying actions and transactions that promote the public good, and ‘wrong’ implying actions and transactions more likely to be towards the general public good.

Describing the Islamic monetary system merely as “interest-free” doesn’t present an accurate image of the system as an entire and tends to create confusion. While prohibiting the receipt and fee of curiosity is the nucleus of the system. It’s supported by different ideas of Islamic teachings advocating people’ rights and duties, property rights, equitable distribution of wealth, risk-sharing, the fulfilment of obligations and the sanctity of contracts.

The Islamic monetary system will not be restricted to banking however covers insurance coverage, capital formation, capital markets, and all sorts of economic intermediation and means that ethical and moral features within the regulatory framework are additionally mandatory along with prudent and sound controls.

Islamic Banking could also be considered as a type of moral investing, or moral lending, besides that no loans are attainable except they’re interest-free. The targets (mqasid) of Islamic finance transactions could also be summarised as beneath:

To be true to the Shari’ah ideas of fairness and justice.

  • Should be free from unjust enrichment.
  • Must be primarily based on true consent of all events.
  • Must be an integral a part of actual commerce or financial exercise similar to a sale, lease, manufacture or partnership.

Knowing About Islamic Banking

Islamic banking is grounded within the tenets of the Islamic religion. As they relate to business transactions. The ideas of Islamic banking are derived from the Qur’an–the central non-secular textual content of Islam. In Islamic banking, all transactions should be compliant with shariah, the authorized code of Islam (primarily based on the teachings of the Qur’an). The guidelines that govern business transactions in Islamic banking are known as Fiqh al-muamalat.

Bankers who’re employed by establishments. That abides by Islamic banking are entrusted with not deviating from the basic ideas of the Qur’an. Whereas they’re conducting enterprise. When extra info or steering is important, Islamic bankers flip to realized students or use unbiased reasoning primarily based on scholarship and customary practices.

The basic ideas of an Islamic Banking system could be summarised as follows-

Prohibition of curiosity 

The prohibition of curiosity is based on the prohibition of riba, a time period actually that means “an excess” and is interpreted as “any unjustifiable increase of capital whether in loans or sales”; that is the central tenet in mutual dealings.  

This prohibition is predicated on arguments of social justice, equality, and property rights. Islam encourages the incomes of earnings however forbids the charging of curiosity as a result of earning. Decided ex-post, symbolize profitable entrepreneurship and the creation of further wealth. Whereas curiosity, decided ex-ante, is a price that’s accrued no matter the result of enterprise operations. And will not create wealth if there are enterprise losses.

Social justice calls for that debtors and lenders share rewards in addition to losses in an equitable style. And that the method of wealth accumulation and distribution within the economic system be truthful and consultant of true productiveness.

Equitable Distribution of Wealth

Islam is towards the philosophy that wealth ought to be concentrated in a number of fingers. The distinction between the wealthy and the poor ought to be lowered. Otherwise, they’d turn into enemies unto one another. For this, Islam has devised a system of “Zakat” that each Muslim, who has extra wealth exceeding the quantity equal to or greater than 85 grams of Gold.

This quantity is spent on the poor, orphans, needy and so forth. If each particular person on this planet practices this method of “Zakat“, not a single individual in the entire world would die of starvation. Islam teaches to search out lawful employment for the unemployed and to pay him a superb remuneration.

According to Islam if an individual dies his wealth ought to be distributed amongst his heirs in line with the rules laid down in Qur’an. Ahadith, and it mustn’t go to only one or two people within the society as it’s carried out as we speak.

Universal Brotherhood and Justice

Qur’an says in Sura al-Hujurat Chapter 49 Verse 13, “O mankind! We created you from a single (pair) of a male and a female and made you into nations and tribes that ye may know each other (not that ye may despise each other). Verily the most honoured of you in the sight of Allah is (he who is) the most righteous of you.”

From this, we come to know the standards that the standards of judgement within the sight of God are usually not wealth, not intercourse, not colour, not Caste, however, it’s Taqwa” God-consciousness, piety and righteousness.

Qur’an says in Sura an-Nisa Chapter 4 Verse 135, “O ye who believe! stand out firmly for justice as witnesses to Allah even as against yourselves or your parents or your kin and whether it be (against) rich or poor: for Allah can best protect all.”

According to this, we’ve to face for fact and justice be it towards anyone even towards our personal selves and sacrifice your personal pursuits.

Prohibition of speculative behaviour 

Islamic finance prohibits transactions that include hypothesis together with excessive uncertainties, playing, and dangers. Therefore, transactions in Islamic finance ought to be backed by actual belongings.

Sanctity of contracts

Islam teachings uphold contractual obligations and the disclosure of knowledge as a sacred responsibility. This characteristic is meant to scale back the danger of symmetric info and ethical hazard.

Shari’ah-approved actions 

Only these enterprise actions that don’t violate the foundations of Shari’ah qualify for funding. For instance, any funding in companies coping with alcohol, playing, and casinos can be prohibited. Project finance, which places emphasis on fairness participation in transactions involving actual belongings, is a pure match for Islamic finance.


Microfinance is one other candidate for the appliance of Islamic finance. Islamic finance promotes entrepreneurship and threat sharing, and its growth to the poor could possibly be an efficient growth software, significantly for financial growth of marginalised communities in addition to poverty alleviation. The social advantages are apparent because the poor at the moment are sometimes exploited by lenders charging usurious charges.

Main Differences Between Conventional Banking Systems and Islamic Banking

One of the first variations between typical banking techniques and Islamic banking is that Islamic banking prohibits usury and hypothesis. Shariah strictly prohibits any type of hypothesis or playing, which is known as maisir. Shariah additionally prohibits taking curiosity on loans.

The System of Islamic Banking and Modern Banking

Let’s analyze the choices open for particular person depositors to deposit their cash in an Islamic financial institution.

Current Account

The cash you deposit in an Islamic financial institution is utilized together with your permission. But when the financial institution goes in loss, the loss will not be shared by the depositor. If the financial institution goes in revenue, neither is the revenue shared by the depositor. The depositor is considering solely the protection of his cash, not revenue. The Islamic banks provide you with a test ebook and a slip ebook with the features of a contemporary financial institution.

Savings Account

Even right here the depositor is especially within the security of his cash. As the financial institution will get revenue from this cash, the financial institution can present a portion of that revenue to the depositor, if the financial institution needs it, however, the depositor cannot demand a hard and fast portion.

In Islamic banking, if a financial institution goes bankrupt then the depositors get their cash first after which, the collectors. While in Modern Banking collectors get their cash first and the majority of the depositors lose their cash. So even if you would like your cash protected, Islamic banks are preferable and safer than Modern banks.

Investment Accounts

They are much like the Fixed Accounts of Modern banks and are additional divided into a number of varieties –

Mudariba (Profit & Loss Sharing)

The depositor deposits a hard and fast sum of money within the financial institution for a hard. And a fast time period, which is possibly a number of three or a number of 4. Here the excess unit is the depositor and the deficit unit is the financial institution. The financial institution makes use of this cash to do enterprise with the businessmen. And no matter revenue the Islamic financial institution makes.

It’s divided on a pre-determined ratio, which could be negotiated. In the Islamic Banking of Malaysia, the ratio is 7 half to three half, which means 70% goes to the depositor and 30% is stored by the financial institution. So there may be sharing of revenue, the larger the revenue the larger the share of every.

Suppose, if there’s a lack of 100 {dollars}, then hundred can be deducted from the depositor’s cash. So theoretically solely the depositor bears the loss. Practically analyzing even the Islamic financial institution goes in the loss as a result of they’re paying cash for the hire, administration and wage. However, the loss ratio of the financial institution is lower than that of the depositor. As even the revenue of the financial institution is lower than that of the depositor.

Project Financing within the Mudariba system                     

If a businessman approaches the Islamic banking system with a challenging thought. And asks for a mortgage for a hard and fast interval. The Islamic financial institution analyzes the challenge, then the businessman and the Islamic financial institution negotiate the revenue ratio. In Modern banking curiosity is negotiated, in Islamic banking revenue ratio is negotiated.

Suppose, the businessman takes a mortgage of $5000 from an Islamic financial institution for six months. And the pre-determined revenue ratio is 60% to the financial institution and 40% to the businessman. If the businessman is working for his enterprise. Even his wage can be included in that $5000 and suppose the wage of the businessman is $200 monthly.

Suppose, if the businessman earns a revenue of $5000. The enterprise would get (his 40%) $2000 from the revenue. And the businessman would receive a commission $200 wage monthly from the $5000 mortgage, amounting $1200 for six months. So the businessman will get his revenue in addition to the wage for his labour if he’s working for his enterprise.

But in case of loss, the financial institution bears the entire loss. And in flip passes the loss to the depositors. But technically even the enterprise additionally goes in the loss as a result of he’s solely paid for labour, not for his considering and concepts.

In Mudariba System, the financial institution cannot intrude within the administration of the enterprise. The enterprise cannot inform the businessman to construct a 12 story constructing as a substitute for a ten-story constructing. The financial institution cannot inform the enterprise to provide a sure article as a substitute for one other article. The financial institution cannot intrude with the administration of the enterprise.

Islamic Banking System – What and How Does Work It?

Mushariqa System (Partnership)

In Mushariqa system or Partnership the Islamic financial institution can intrude within the administration of the enterprise. The financial institution can inform the enterprise to construct a 12 story constructing somewhat than a ten-story constructing. The financial institution can inform the businessman to make a sure product as a substitute for one other product. In Mushariqa system the businessman has a part of the capital. And the opposite half he takes from the financial institution.

The revenue is shared on a pre-determined ratio. Suppose, if the businessman and financial institution give 50-50% capital, they’d get a 50-50% revenue. In case of loss, a loss is shared on pre-determined ration. And the Islamic financial institution bears the extra loss. The Islamic financial institution might need to bear 60% loss, whereas the businessman would solely bear 40% loss.

Mudhaba System

Suppose, you wish to buy specific equipment from overseas costing $10000, within the Modern Bank you open an LC (Letter of Credit) or a TR (Trust Receipt/Sales Slip) and also you deposit the cash within the Modern financial institution and the Modern financial institution costs you a hard and fast quantity of curiosity on the time it takes for the transaction.

If you deposit the cash in an Islamic financial institution. And ask the financial institution to purchase the equipment on your behalf. The Islamic financial institution would cost you a service cost/fee.

If you wouldn’t have the cash to purchase the equipment. You possibly can mix Mudhaba System with Mudariba System or when you’ve got the cash you possibly can mix the Mudhaba System with the Mushariqa System and share the revenue on promoting that equipment with the financial institution on a pre-determined ratio.

Ijara (Leasing or Higher Purchasing)

Suppose, you do not purchase an automobile, you wish to hire it. The Islamic financial institution costs you a sure revenue and rents you the automobile. The value of the automobile and the revenue are divided by the life span of that automobile to calculate the monthly hire. The Islamic financial institution supplies you Ijara ending with the sale and likewise buyback facility. If you do not the automobile, the Islamic financial institution buys again the automobile. A facility which Modern banks don’t present.

Interest-free Loan

It is the mortgage the Islamic financial institution provides to the poor to do enterprise without charging any curiosity in any respect. There is nothing like an Interest-free mortgage in Modern banking. In the Islamic system of banking in Malaysia, 10% of earnings are stored individually/ reserved for Interest-free mortgages for the poor. In Islamic terminology, it’s referred to as “Karze Hasana” which means “the good loan”.

Example of Islamic Banking System

The Mit-Ghamr Savings Bank, established in 1963 in Egypt, is often known as the primary instance of Islamic banking within the trendy world. When Mit Ghamr loaned cash to companies, it did so on a profit-sharing mannequin. The Mit-Ghamr challenge was closed in 1967 attributable to political components. However, throughout its 12 months of operations, the financial institution exercised a substantial amount of warning. Solely authorised about 40% of its enterprise mortgage functions. However, in economically good occasions, the financial institution’s default ratio was stated to be zero.

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