Islamic banking, also known as Islamic finance or Shariah-compliant finance, is a financial system deeply rooted in Islamic principles. This comprehensive guide explores the core principles of Islamic banking, its historical evolution, key differences from conventional banking, and how it sustains profitability while adhering to its ethical foundations. Additionally, we delve into the remarkable growth of Islamic banking and provide insights through FAQs, pros and cons, and key takeaways to empower your understanding of this dynamic financial system.
Understanding Islamic banking
Islamic banking, also referred to as Islamic finance or Shariah-compliant finance, represents a financial system governed by Shariah (Islamic law). It operates on two fundamental principles: profit and loss sharing and the prohibition of interest collection and payment by lenders and investors.
How Islamic banking practices work
With over 560 banks and more than 1,900 mutual funds globally adhering to Islamic principles, the Islamic finance sector has grown remarkably. Between 2015 and 2021, Islamic financial assets expanded from $2.17 trillion to approximately $4 trillion, with projections estimating growth to reach nearly $5.9 trillion by 2026, according to a 2022 report by the Islamic Corporation for the Development of Private Sector (ICD) and Refinitiv.
This growth is substantially attributed to the prospering economies of Muslim-majority countries, particularly those benefiting from increased oil prices.
The foundation of Islamic banking is rooted in the Islamic faith’s tenets concerning commercial transactions. Derived from the Quran, the central religious text of Islam, the principles of Islamic banking mandate strict compliance with Shariah, the Islamic legal code based on Quranic teachings. These principles govern commercial transactions in Islamic banking and are collectively referred to as fiqh al-muamalat.
Practitioners in Islamic banking institutions are entrusted with upholding the Quran’s fundamental principles while conducting business. In cases requiring guidance, Islamic bankers consult knowledgeable scholars or employ independent reasoning based on scholarly insights and customary practices.
Here is a list of the benefits and drawbacks to consider.
- Adherence to ethical and Shariah-compliant principles.
- Promotion of financial inclusivity and fairness.
- Steady growth and resilience, even during economic downturns.
- Complexity in structuring financial products according to Shariah principles.
- Limited exposure to high-risk, high-reward investments.
- Relatively smaller global market share compared to conventional banking.
How Islamic banking differs from conventional banking
Islamic banking significantly differs from conventional banking systems, primarily due to its strict prohibitions on usury and speculation. Shariah strictly forbids any form of speculation or gambling, referred to as maisir.
Shariah also prohibits the collection of interest on loans. Furthermore, any investments involving items or substances forbidden in the Quran, such as alcohol, gambling, and pork, are also strictly prohibited. Islamic banking, therefore, can be considered a unique form of ethical investing deeply rooted in cultural and religious values.
An Islamic bank operates entirely based on Islamic principles, while an Islamic window refers to services provided by conventional banks that adhere to Islamic principles. Some commercial banks offer Islamic banking services through dedicated windows or sections.
To generate profits without charging interest, Islamic banks employ equity participation systems. In this model, when a bank lends money to a business, the business repays the loan without interest and instead offers the bank a share in its profits. If the business defaults or fails to generate profit, the bank also does not receive payment. Generally, Islamic banking institutions tend to be more risk-averse in their investment practices, avoiding ventures associated with economic bubbles.
History of Islamic banking
The origins of Islamic banking can be traced back to Middle Eastern businesspeople who engaged in financial transactions with their European counterparts during the Medieval era.
Initially, they adopted similar financial principles to those of the Europeans. However, as trading systems evolved and European countries established local branches of their banks in the Middle East, some of these banks adopted the local customs, primarily implementing no-interest financial systems based on profit-and-loss sharing methods.
By embracing these practices, European banks could cater to the needs of local Muslim businesspeople.
Islamic banking resurfaced in the modern world starting in the 1960s. Since 1975, numerous interest-free banks have emerged. While the majority of these Islamic banking institutions were founded in Muslim-majority countries, Islamic banks also opened in Western Europe during the early 1980s. Additionally, some governments, such as Iran, Sudan, and to a lesser extent, Pakistan, have developed national interest-free banking systems.
Example of Islamic banking
The Mit-Ghamr Savings Bank, established in 1963 in Egypt, is often considered the pioneer of Islamic banking in the modern world. This bank employed a profit-sharing model when lending money to businesses.
Despite the bank’s closure in 1967 due to political factors, during its operational year, it exercised great caution, approving only about 40% of its business loan applications. Notably, in prosperous economic times, the bank’s default ratio was reported to be zero.
The basis of Islamic banking
Islamic banking is rooted in the tenets of the Islamic faith, specifically concerning commercial transactions. These principles, derived from the Quran, the central religious text of Islam, mandate compliance with Shariah, the legal code of Islam based on Quranic teachings. The rules governing commercial transactions in Islamic banking are referred to as fiqh al-muamalat.
The bottom line
Islamic banking, also referred to as Islamic finance or Shariah-compliant finance, represents a financial system deeply rooted in Islamic principles. There are substantial differences between Islamic and mainstream finance, primarily in the methods of sharing profit and loss and the prohibition of interest collection and payment by lenders and investors. Islamic banks sustain profitability through ethical and Shariah-compliant financial practices, making it an increasingly influential segment of the global financial landscape.
Frequently asked questions
Is Islamic banking only available in Muslim-majority countries?
No, Islamic banking has expanded beyond Muslim-majority countries. It has a presence in many countries, including Western Europe and Asia, where both Muslim and non-Muslim individuals and businesses can access Islamic banking services.
Can non-Muslims utilize Islamic banking services?
Yes, Islamic banking services are not exclusive to Muslims. They are open to individuals and businesses of all faiths who wish to engage in ethical and Shariah-compliant financial practices.
How do Islamic banks ensure their investments comply with Shariah principles?
Islamic banks employ Shariah boards or councils composed of Islamic scholars and financial experts who review and approve financial products and investments to ensure they adhere to Shariah principles.
Are Islamic banks more risk-averse than conventional banks?
Yes, Islamic banks tend to be more risk-averse due to their avoidance of speculative and high-risk ventures. They prioritize ethical investments and profit-sharing models, which inherently mitigate risk.
How has Islamic banking performed during economic downturns?
Islamic banking has demonstrated resilience during economic downturns. Its focus on ethical and sustainable practices has helped it weather financial crises more effectively than some conventional banking systems.
- Islamic banking operates on principles rooted in Shariah law, emphasizing ethical and Shariah-compliant financial practices.
- It strictly prohibits interest, gambling, and investments in prohibited substances.
- Islamic banks generate profits through equity participation systems.
- The Islamic banking sector has witnessed significant growth driven by Muslim-majority countries’ thriving economies.
View Article Sources
- The Role of Islamic Banking in Economic Growth – Claremont Colleges Library
- Islamic Banking and Finance Research Guide: Organizations – DePaul Library
- Effects of Islamic Banking on Financial Market Outcomes in GCC Countries and Iran – Cornell University
- What is an Interest-Bearing Loan? – SuperMoney