Let us understand what is Islamic Banking and Finance. Before that we need to have clarity on what is a Bank – How a Bank works.

Let us start with a basic question, what do we do with money, we can either save it or spend it

If you have money and you want to save it, what is a good place – A Bank

If you have no money and you want to spend it then what is a good place to get money– A Bank.

So in either of the cases a Bank plays an important role.

A bank is a financial intermediary that accepts deposits and channels those deposits into lending activities. So you can see people depositing money on one side and then on the other side there are people who are approaching the bank to seek funding. Both the activities of deposit taking and providing funds are based on interest. What it means is that a depositor would receive fixed interest rate on his deposits and the fund seeker will have to pay fixed percentage of interest on the money borrowed and the difference of these two interest rates becomes Bank’s profit. 

Now the question is how different is an Islamic Bank from an interest based bank. Islamic law prohibits any excess or premium charged on money lent. Paying interest and charging interest both are not acceptable. Under the principles of Islamic finance, money is viewed as only a medium of exchange and a measure of value. Money is a tool to measure the value of all commodities and it is not a commodity in itself.

  • So the question is how will an Islamic bank work without giving or charging interest?
  • How will it make a profit?
  • How will it provide return to its depositors?
  • How will it provide financing to its customers?
  • In a way how will an Islamic bank work? 

An Islamic Bank plays two roles, one as a partner where it invests the funds of the depositors in Shariah compliant business ventures and provides them a return on a profit  and loss sharing basis. And the second as a trader where the Islamic bank purchases assets, bear the risk of ownership and then either sell or lease out the assets to the customers who require financing.

Let us now understand what are the principles on which Islamic Banks work.

In Islamic law which is called as Shariah there are two primary sources , the Quran and the Sunnah. Quran is a divine book and word of Allah revealed as a final revelation and guidance to mankind while the Sunnah refers to traditions of Prophet Muhammad (Peace be Upon Him) that include his sayings, actions and tacit approvals.

The basic principles related to business transactions and trade can be interpreted based on the circumstances provided such interpretation does not contradict with the Quran and the Sunnah. This unique feature or flexibility of Islam makes it relevant to every generation.

Now let us see who provides guidance to an Islamic bank on Shariah?

It is a Shariah Board

Shariah board is an independent body that consists of Shariah scholars. Each Islamic bank is required to appoint an independent Shariah Board which will advise them on how the Islamic banking activities be done in a Shariah compliant manner. The Shariah Board checks whether the Shariah guidelines are implemented effectively by the Islamic Bank and a regular Shariah audit is conducted to ensure this.

Now, who are the customers of an Islamic Bank? 

It can be:

  • Individuals
  • Companies
  • Financial Institutions and
  • Governments
  • What are the needs of the customers which are being fulfilled by the Islamic Bank?

The Saving Needs and the Spending Needs

Islam provides guidelines for a comprehensive system of life and it also provides guidelines on economics, business and commerce. Islam gives a complete model of an economic system. According to the principles of Islamic economic system, Allah is the ultimate owner of the wealth and resources available to human beings in this world. He (Allah) has created  humans as His vicegerent or Khalifa or representative on earth to manage and benefit from this wealth and resources in the way prescribed by Him. Islam strongly discourages idleness that results in poverty. In fact, it encourages the economic activities, trade and business within the permitted boundaries. Wealth cannot be accumulated and hoarded in few hands it needs to be exchanged amongst individuals through trade and mutual consent. There is a due share of every individual who lacks the ability in the Surplus wealth earned by an able individual. This due share is transferred to them in the form of Inheritance, Will, Zakat and Sadaqat. One is accountable for one’s earning and expenditure to Allah.

The concept of debt plays an important role in the financial industry. Let us see how Islam views debt.

Islam views debt as an obligation. Involvement in debt is generally discouraged in Islam except in the condition where it becomes a necessity. One cannot take debt to fulfill false pride and greed.  Another important point is that the one who enters into a debt base transaction should make sure that one has the potential ability or capability to repay in accordance with the terms and conditions of the debt arrangement.

Another important point which you need to be aware of is about speculation.

Speculative transaction leads to uncertainty which is known as “Gharar” in Islamic Jurisprudence. So any speculative transaction is not permissible in shariah. For example, Options, Futures and Hedges these are speculative financial instruments which are traded in conventional financial market.

So within this Islamic economic philosophy, people are free to adopt any Shariah permitted source that can satisfy their economic needs. Based on this philosophy, the Shariah scholars and the Islamic Economists of every age have been developing the Islamic Finance model.

Let us have a look at the evolution of Islamic finance.

If we go back in the history we will see that the Islamic finance and financial institutions evolved and developed since the time of the Prophet Mohammed (Peace be upon Him) from the cities of Mecca and Medina. The central treasury (Baitul-maal), Zakat and taxes like, land tax  and poll tax , etc. were successfully operated during that period. In addition, there have been a few developments such as the use of silver minted Dirhams, bills of exchange and cheques. The traces of Islamic finance practices could be found in various Islamic finance civilizations between 750 AD to 1900 AD.  

However, the modern development of Islamic finance began in 19th century when Muslim scholars called for a financial system within the Shariah norms. Various theories and theoretical models were proposed by the Islamic economists, academicians and Shariah scholars of the time which further resulted in the emergence of Islamic banking and financial institutions. At present there are more than 250 Islamic financial institutions that include Islamic banks, investment companies, Takaful (insurance), regulatory and rating agencies, which operate throughout the globe.