People, who want to know more about Islamic Finance Industry have definitely this question: How does Islamic banking and finance work?
In the last four decades, the rise of Islamic banking and finance as a new phenomenon within the long-established conventional finance has been of particular importance for Muslims. Islamic finance has also shown to be a more efficient, productive, and equitable method of financial intermediation. It also gains support from both Muslims and non-Muslims.
What Is Islamic Banking?
Islamic banking is a banking operation and activity that adhere to Islamic law. The sharing of profit and loss, and the prohibition of interest collection by lenders and investors, are two key concepts of Islamic banking.
Islamic bank serves as financial intermediary. It channels funds from people who have a surplus to people who need funds. Some of the main functions of the bank as a financial intermediary are to transform assets, make regular payments, and transform risk.
More than 300 institutions and 250 mutual funds around the world follow Islamic principles. According to a 2016 Thompson Reuters analysis, Islamic banks’ capital increased from $200 billion to close to $2 trillion between 2000 and 2017. And it is going to reach $3.5 trillion by 2021. The increasing economy of Muslim countries is largely responsible for this expansion. Especially those that have benefited from the rising price of oil.
Must Read: Brief History of Islamic Banking and Finance
Why aren’t conventional bank accounts Shariah-Compliant?
In fact, that money has no intrinsic value; it is simply a medium of exchange that is central to Islamic finance. Each unit is 100% equal in value to another unit of the same denomination and you cannot make a profit by exchanging cash with another person. A Muslim cannot profit from lending or receiving money from others.
This means that earning interest (riba) – whether as an individual or as a bank – is not permissible. Meanwhile, the conventional banks collect the fund from depositors and lend the money to the borrowers based on loans with interest. The bank pays the depositors with lower interest rates and charges the borrowers with higher interest rates. Therefore, conventional banks are not shariah compliant.
How Does Islamic Finance work?
Islamic banks do not pay or receive interest. However, they can earn through a variety of Shariah-compliant methods:
Ijara is when banks buy an asset, such as a car, and lease it to the customer. Bank owns the ownership until the time customer pays off the lease. During this time, the bank is responsible for the maintenance of the asset.
Murabaha is a concept whereby the bank act as an intermediary to buy the asset, then sells it to the customer, plus profit. The customer buys the asset with deferred payments.
Wakala is a type of contract of agency or delegated authority in which the bank is designated as an individual agent to carry out a certain task on behalf of the customer. The bank lends its knowledge for a specific period of time in exchange for a profit.
Salam could be considered forward-financing, or as a kind of debt – the institution pays for specified assets in advance, which the seller will then supply to quality, quantity, and time the parties have pre-agreed.
Islamic banks have the same function as conventional banks. The objective of the existence of these banks is to maintain economic stability. However, the unique features of Islamic contracts used by the Islamic banks make it different from the conventional one. Islamic banks earn their profit based on Shariah-compliant equity-based and debt-based financing. While conventional banks make a profit from charging the interest on their loan.
Key Principles of Islamic Banking and Finance
Islamic banking and finance operate under the principles of Shariah law, which emphasizes ethical, fair, and interest-free financial transactions. This system has gained significant traction globally, especially in Muslim-majority countries, as it provides an alternative to conventional banking that aligns with Islamic values.
1. Prohibition of Interest (Riba)
One of the fundamental principles of Islamic finance is the prohibition of riba, or interest. In Islamic finance, money is considered a medium of exchange with no intrinsic value, meaning it cannot generate profit on its own. Instead of earning interest on loans, Islamic banks engage in profit-sharing arrangements where both the bank and the customer share the profits and losses of the venture. This principle is designed to promote fairness and discourage exploitation.
2. Profit and Loss Sharing
Islamic banks operate on the basis of profit and loss sharing (PLS) rather than fixed interest rates. Two common contracts used in this system are:
- Mudarabah: A partnership where one party provides capital while the other provides expertise and management. Profits are shared according to a pre-agreed ratio, but losses are borne by the capital provider unless there is negligence or misconduct.
- Musharakah: A joint venture where all partners contribute capital and share profits and losses according to their respective contributions. This model encourages risk-sharing and aligns the interests of all parties involved.
3. Asset-Backed Financing
In Islamic finance, transactions must be backed by tangible assets. This means that money cannot be lent for speculative purposes or to generate profit from money itself. Instead, financing is tied to the purchase or sale of real assets, such as property or commodities. This approach ensures that all transactions have a direct link to the real economy, reducing the likelihood of financial bubbles and speculative behavior.
4. Ethical Investment
Islamic banking strictly prohibits investment in industries considered haram, or forbidden, under Shariah law. These include alcohol, gambling, pork products, and other unethical or socially harmful industries. Instead, Islamic finance encourages investments in halal, or permissible, ventures that contribute to societal well-being, such as healthcare, education, and infrastructure.
Also Learn About: 7 Key Islamic Banking Principles You Want to Know
How Does Islamic Finance Work?
Islamic finance is structured around various contracts that facilitate Shariah-compliant transactions. Here are some common modes of Islamic finance:
1. Murabaha (Cost-Plus Financing)
Murabaha is a common Islamic finance structure where the bank purchases an asset and sells it to the customer at a marked-up price. The customer pays for the asset in installments over time. The key difference from conventional loans is that the profit margin is agreed upon upfront, and no interest is charged on the deferred payment.
2. Ijara (Leasing)
Ijara is similar to leasing in conventional finance. The bank buys and leases an asset to the customer for a fixed rental payment. The bank retains ownership of the asset until the end of the lease term, at which point the customer may have the option to purchase the asset.
3. Sukuk (Islamic Bonds)
Sukuk are Islamic financial certificates that represent ownership in a tangible asset, usufruct, or investment. Unlike conventional bonds, which pay interest, sukuk holders receive returns derived from the revenue generated by the underlying asset, ensuring compliance with the prohibition on riba.
The Role of Shariah Supervisory Boards
To ensure compliance with Islamic principles, Islamic banks and financial institutions are guided by Shariah Supervisory Boards (SSBs). These boards are composed of scholars who are experts in Islamic law and finance. They review and certify financial products and transactions to ensure they adhere to Shariah principles. This oversight is crucial for maintaining the integrity of Islamic finance and gaining the trust of customers.
FAQs
1. How do Islamic banks make money if they don’t charge interest?
Islamic banks make money through profit-sharing, asset-based financing, and trading. For example, they may buy and sell assets at a markup (Murabaha), lease assets for a profit (Ijara), or invest in joint ventures where profits are shared (Musharakah).
2. Is Islamic banking only for Muslims?
No, Islamic banking is available to anyone interested in ethical and interest-free banking. While it is rooted in Islamic principles, its emphasis on ethical investment and risk-sharing appeals to a broader audience.
3. How is Islamic finance different from conventional finance?
Islamic finance differs from conventional finance in several ways, including the prohibition of interest, the requirement for asset-backed transactions, and the emphasis on ethical investment. Unlike conventional banks, Islamic banks avoid speculative activities and focus on real economic activities.
4. What are the risks associated with Islamic banking?
Islamic banking carries risks similar to those in conventional banking, such as credit risk and market risk. However, the profit and loss sharing model in Islamic finance means that these risks are more equitably distributed between the bank and the customer.
5. How do I know if a financial product is Shariah-compliant?
Shariah-compliant products are typically certified by a Shariah Supervisory Board. Many Islamic banks provide information on their website about the Shariah compliance of their products, including certificates issued by the board.