Islamic Banking

Introduction: -
Islamic banking is a banking system that is based on the principles of Islamic law,
also referred to as the Shariah (shariat) law, and guided by Islamic economics. Two
basic principles behind Islamic banking are the sharing of profit & loss and
prohibition of the collection and payment of interest by lenders and investors.
Collecting interest or "riba" is not permitted under Islamic law.

In Islam, money has no intrinsic value – money, therefore, cannot be sold at a profit
and is permitted to be used as per shariat only. The Islamic Law or Shariat prohibits
paying any fee for renting of money (called riba) for specific periods of time. It also
prohibits any sort of investment in businesses that are considered haraam or against
the principles of Islam. It is largely believed that these principles have been derived
from the Quran and have been in practice since then.

An Islamic bank is a financial institution whose status, rules and procedures expressly
state commitment to the principle of Islamic Shariah and to the banning of the receipt
and payment of interest on any of its operations. It is a banking system whose
operation is based on Islamic principle transactions of which profit and loss sharing
(PLS) is a major feature ensuring justice equity in an economy.
Islamic Banks work on the principles of an interest free banking. Riba or interest
under Islamic Law basically means anything in “excess” – the investor should not
make an “undue” profit from the hard work of the other. But it is permitted to follow
a system of reasonable profit and return from investment where the investor takes a
risk that is well calculated. Thus, Islamic banks make available accounts which
provide profit or loss instead of interest rates. The banks use this money collected by
them and invest in something that is shariat compliant that is not haraam and does
not involve high risks. Thus, businesses involving alcohol, drugs, war weapons etc.
as well as all other high risk and speculative activities are prohibited. Islamic
Banking, therefore, acts as an agent by collecting the money on behalf of its
customers, investing them in shariat compliant projects and sharing the profits or
losses with them. There are various products in Islamic Banking that cover the needs
and requirements of the consumers. Some of them are-
 o Mudarbah (profit sharing – one party provides finances, the other provides
expertise),

o Musharaka (joint venture – both parties share everything equally),

o Murabaha (cost plus profit),

o Ijara (letting on lease), Istisna amongst others.

The Dow Jones Islamic Market Index came into being in the year 1999 for investors
willing to invest in shariat compliant projects.

Characteristics of Islamic Banking:-

1. Prohibition of interest or usury: The first and most important concept is that
both the charging and receiving of interest is strictly forbidden. This is
commonly known as Riba or Usury. Money on its own may not generate profits.
When Riba infects an entire economy, it jeopardizes the well-being of everyone
living in that economy. When investors are more concerned with the rates of
interest and guaranteed returns than they are with the uses to which money is
put, the results can only be negative.

1|Page
 2. Ethical standards: When Muslims invest their money in something, it is their
religious duty to ensure that what they invest in is good and wholesome. It is
for this reason that Islamic investing includes serious consideration of the
business to be invested in, its policies, the products it produces, the services it
provides and the impact that these have on society and the environment. In other
words Islamic banks must take a close look at the business they are about to
become involved in.

3. Moral and social values: The Quran calls on all its adherents to care for and
support the poor and destitute. Islamic financial institutions are expected to
provide special services t those in need. This is not confined to mere charitable
donations but has also been institutionalized in the industry in the form of profit-
free loans. An Islamic banks business includes certain social projects as well as
charitable donations.

4. Liability and business risk: The parties concerned should share both risk and
profit of any endeavor. To be entitled to a return a provider of finance must
either accept business risk or provide some service such as supplying an asset,
otherwise the financier is not only an economic parasite but also a sinner from
the point of view of shariah law. “Profit comes with liability” – One becomes
entitled to profit only when one bears the liability or risk of loss.

5. Adherence to Public Interest: Activity of commercial banks being primarily

based on the use of public funds, public interest rather than individual or group
interest will be served by Islamic commercial banks. The Islamic banks should
use all deposits, which come from the public for serving public interest and
realizing the relevant socio-economic goals.

6. More Careful Evaluation of Investment Demand:

Another very important feature of an Islamic bank is its very careful attitude
towards evaluation of applications for equity oriented financing.

Application of Islamic Banking in India:

Introduction of Islamic Banking was mooted by Raghuram Rajan in his report on the
Financial Sector in the year 2008 where he recommended that interest-free banking
2|Page
techniques should be operated on a larger scale so as to give access to those who are
unable to access banking services, including those belong to economically
disadvantaged section of the society.

There are many advantages in introducing an Islamic window in the banks. For
instance, majority of companies in the Stock Exchange are shariat compliant (this
number is more than the shariat complaint companies on the Stock Exchange in
Malaysia), thus this would result in attracting huge funds in the domestic market
alone.

An Islamic Banking window will encourage many from the Muslim community to
come forward and invest in projects thereby mobilizing huge amount of capital which
they may not be willing to put in the banks. This also means that India will be able to
attract huge investments from West Asia and from those who invest only
in shariat compliant projects.

However, the Indian banking laws will have to be amended so as to incorporate the
provisions relating to Islamic banking.

Regulatory Aspect of Islamic Banking:

The principles of Islamic Banking follow Shariah law, which is based on the Quran
and the Hadith, the recorded sayings and actions of the Prophet Muhammad. Islamic
banks are also governed by a Sharia Advisory Board, which is comprised of Islamic
scholars and clerics who are responsible to ensure all of the bank’s activities are in
strict compliance with Sharia (Islamic) law. When more information or guidance is
necessary, Islamic bankers turn to learned scholars or use independent reasoning
based on scholarship and customs, while also ensuring their ideas do not deviate from
the fundamental principles of the Quran.

Since this system of banking is grounded in Islamic principles, all the undertakings
of the banks follow Islamic morals.

Progress and Growth of Islamic Banking:

While Islamic Banking is prevalent and is common in Islamic countries, there are
plenty of non-Islamic countries that are now opening Islamic “windows” in
3|Page
conventional banks. These are departments within the banks and they
offer shariat compliant products to the customers. China, United Kingdom, United
States, Germany are some of the countries that offer Islamic windows.

The US has the American Finance House LARIBA which is a riba free
and shariat complaint financial institution that is involved in auto, business, trade
financing, hedge fund investing etc.

The Dow Jones Islamic Market Index came into being in the year 1999 for investors
willing to invest in shariat compliant projects.

According to Ernst & Young, total Islamic finance assets of commercial banks rose
17% between 2009 and 2013, hitting $778 billion (This is two to three times faster
than the rate at which conventional banks grew over the same period, due in part to
the global financial crisis). Of that, Gulf Cooperation Council (GCC)
countries account for around $517 billion, ASEAN countries for $160 billion and
South Asia for $23 billion; with the rest of the world (especially Turkey) making up
the remaining $78 billion.

4|Page
The United Kingdom was the first non-Islamic country to permit a
complete shariat compliant bank called the Islamic Bank of Britain to operate. In
fact, UK was the first Non-Islamic country to have introduced Islamic Bonds known
as sukuk in the year 2014.

Despite of political opposition to Islamic Banking, India will soon have Islamic
Banking facilities. During Prime Minister Narendra Modi’s visit to UAE in April
last year, the Indian EXIM bank had signed a memorandum of understanding with
Saudi Arabia based Islamic Development Bank (IDB) for a $100 million line of
credit to facilitate exports to IDB’s member countries. IDB will start its operations
from Gujarat this year.

5|Page