How Does Islamic Banking and Finance Actually Work?

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.

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.

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