7 Key Islamic Banking Principles You Want to Know

In this article we will elaborate on the 7 key Islamic Banking principles that drive the activities of Islamic banks:

  • Predetermined loan repayments as interest (riba) is unpermissible;
  • Profit and loss sharing is at the heart of the Islamic system;
  • Risk Sharing
  • Making money out of money is unacceptable
  • Speculative behaviour is unpermissible;
  • Only Sharia’a-approved contracts are acceptable;
  • Contracts are sacred.

1- Predetermined Payments are Unpermissible

Any predetermined payment over and above the actual amount of money is unpermissible. Islam allows only one kind of loan. It is “qard al hassan“, meaning “good loan”. It is a loan whereby the lender does not charge any interest or additional amount over the money lent. The principle emphasises that any associated or indirect benefits that could potentially accrue to the lender, from lending money, are also unpermissible.

2- Profit and Loss Sharing

The condition here is that the lender must share the profits or losses that come from the business for which the money is given. Islam encourages Muslims to invest their money and to become partners in order to share profits and risks in a business instead of being creditors. Islamic finance is based on the idea that the provider of capital and the user of capital should share the risk of the business ventures equally. In banking terms, the depositor, the bank, and the borrower share the risks and rewards. The key premise is that the financier is only entitled to the returns if there is a risk involved in any transaction. If there is a return, there must be a risk. If there is no relationship between risk and return, then this financial arrangement is not Shariah Compliant.

3- Risk Sharing

One of the main principles of Islamic banking is that it encourages risk-sharing between the fund providers (investors) and the users of funds (entrepreneurs). By contrast, under conventional banking, the investor makes sure that the user of funds pays a predetermined rate of interest.
In conventional banking, all the risk is for the entrepreneur. Whether the project succeeds and generates a profit or fails and generates a loss, the capital provider gets a return with profit. This type of unequal risk distribution is unacceptable in Islam.

From an Islamic finance perspective, both the investor and the entrepreneur have equal responsibility for the project’s success. For instance, in the event of a loss, the capital supplier bears the entire financial loss. While the entrepreneur receives no compensation (wages or salary) for his efforts in the Mudaraba contract. Islamic banking principles are extremely significant in terms of risk-sharing.

4- Emphasis on Productivity as Compared to Credit-worthiness

Making money out of money is haram in Islam. Money is only a medium of transaction and a technique of determining a thing’s value in Islam. It has no intrinsic worth and, as a result, it should not produce additional funds through interest payments simply by being in a bank or lent to someone else.

5- Uncertainty is Impermissible

Next one of the important Islamic Banking principles is Gharar. Gharar (uncertainty) is also impermissible, and so any transaction should be free from this element. Parties in a contract should have perfect knowledge of the counter-values they intend to exchange as a result of their transactions. The phrase counter-values in this context refers to something that delays, such as the price paid or the goods provided. In addition, parties cannot predetermine a guaranteed profit.

6- Only Shariah-Approved Contracts are Acceptable

Conventional banking is oriented toward the secular system. In the Islamic system, on the other hand, all economic agents work within the Islamic ethical framework. Islamic financial institutions are no exception. As a result, they are unable to fund any project that contradicts Islamic moral values. Islamic banks, for example, are not permitted to fund a winery, a casino, a nightclub, or any other activity that is prohibited by Islam or known to be damaging to society.

7- Sanctity of Contract

Certain verses in the Qur’an encourage trade and commerce, and the attitude of Islam is that there should be no impediment to honest and legitimate trade and business. It is the responsibility of Muslims to earn a living, provide for their families and give charities to those in need. Just as Islam regulates and influences all other spheres of life, so it also governs the conduct of business and commerce. In addition, Muslims have an obligation to conduct their business activities according to Shariah. Moreover, they should treat others with fairness, honesty, and justice. Because there is no caveat emptor theory in Islam, therefore merchants should fulfil their obligation.

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