Islamic banking refers to
a system of banking or banking activity that is consistent with the
principles of Islamic law (Sharia) and its practical application through
the development of Islamic economics. Sharia prohibits the payment or
acceptance of interest fees for the lending and accepting of money
respectively, (Riba, usury) for specific terms, as well as investing in
businesses that provide goods or services considered contrary to its
principles (Haraam, forbidden). While these principles were used as the
basis for a flourishing economy in earlier times, it is only in the late
20th century that a number of Islamic banks were formed to apply these
principles to private or semi-private commercial institutions within the
Islamic Financial Institutions
The word "Riba" means excess, increase or addition, which correctly
interpreted according to Shariah terminology, implies any excess
compensation without due consideration (consideration does not include
time value of money). The definition of riba in classical Islamic
jurisprudence was "surplus value without counterpart." or "to ensure
equivalency in real value" and that "numerical value was immaterial."
During this period, gold and silver currencies were the benchmark metals
that defined the value of all other materials being traded. Applying
interest to the benchmark itself (ex natura sua) made no logical sense
as its value remained constant relative to all other materials: these
metals could be added to but not created (from nothing).
Applying interest was acceptable under some circumstances. Currencies
that were based on guarantees by a government to honor the stated value
(i.e. fiat currency) or based on other materials such as paper or base
metals were allowed to have interest applied to them. When base metal
currencies were first introduced in the Islamic world, no jurist ever
thought that "paying a debt in a higher number of units of this fiat
money was riba" as they were concerned with the real value of money (determined
by weight only) rather than the numerical value. For example, it was
acceptable for a loan of 1000 gold dinars to be paid back as 1050 dinars
of equal aggregate weight (i.e., the value in terms of weight had to be
same because all makes of coins did not carry exactly similar weight).
Modern Islamic banking
The first modern experiment with
Islamic banking was undertaken in Egypt under cover without projecting
an Islamic image—for fear of being seen as a manifestation of Islamic
fundamentalism that was anathema to the political regime. The pioneering
effort, led by Ahmad Elnaggar, took the form of a savings bank based on
profit-sharing in the Egyptian town of Mit Ghamr in 1963. This
experiment lasted until 1967 (Ready 1981), by which time there were nine
such banks in the country.
In 1972, the Mit Ghamr Savings project
became part of Nasr Social Bank which, till date, is still in business
in Egypt. In 1975, the Islamic Development Bank was set-up with the
mission to provide funding to projects in the member countries. The
first modern commercial Islamic bank, Dubai Islamic Bank, opened its
doors in 1975. In the early years, the products offered were basic and
strongly founded on conventional banking products, but in the last few
years the industry is starting to see strong development in new products
Islamic Banking is growing at a rate of 10-15% per year and with signs
of consistent future growth. Islamic banks have more than 300
institutions spread over 51 countries, including the United States
through companies such as the Michigan-based University Bank, as well as
an additional 250 mutual funds that comply with Islamic principles. It
is estimated that over US$822 billion worldwide sharia-compliant assets
are managed according to The Economist.. This represents
approximately 0.5% of total world estimated assets as of 2005.
The World Islamic Banking Conference, held annually in Bahrain since
1994, is internationally recognized as the largest and most significant
gathering of Islamic banking and finance leaders in the world.
The Vatican has put forward the idea that "the principles of Islamic
finance may represent a possible cure for ailing markets."
Largest Islamic Banks
Shariah-compliant assets reached about
$400 billion throughout the world in 2009, according to Standard &
Poor’s Ratings Services, and the potential market is $4 trillion.
Iran, Saudi Arabia and Malaysia have the biggest sharia-compliant assets.
In 2009 Iranian banks accounted for about 40 percent of total assets of
the world's top 100 Islamic banks. Bank Melli Iran, with assets of $45.5
billion came first, followed by Saudi Arabia's Al Rajhi Bank, Bank
Mellat with $39.7 billion and Bank Saderat Iran with $39.3 billion.
Islamic banking has the same purpose as conventional banking except that
it operates in accordance with the rules of Shariah, known as Fiqh al-Muamalat
(Islamic rules on transactions). The basic principle of Islamic banking
is the sharing of profit and loss and the prohibition of riba (usury).
Common terms used in Islamic banking include profit sharing (Mudharabah),
safekeeping (Wadiah), joint venture (Musharakah), cost plus (Murabahah),
and leasing (Ijarah).
In an Islamic mortgage transaction, instead of loaning the buyer money
to purchase the item, a bank might buy the item itself from the seller,
and re-sell it to the buyer at a profit, while allowing the buyer to pay
the bank in installments. However, the bank's profit cannot be made
explicit and therefore there are no additional penalties for late
payment. In order to protect itself against default, the bank asks for
strict collateral. The goods or land is registered to the name of the
buyer from the start of the transaction. This arrangement is called
Murabaha. Another approach is EIjara wa EIqtina, which is similar to
real estate leasing. Islamic banks handle loans for vehicles in a
similar way (selling the vehicle at a higher-than-market price to the
debtor and then retaining ownership of the vehicle until the loan is
An innovative approach applied by some banks for home loans, called
Musharaka al-Mutanaqisa, allows for a floating rate in the form of
rental. The bank and borrower form a partnership entity, both providing
capital at an agreed percentage to purchase the property. The
partnership entity then rents out the property to the borrower and
charges rent. The bank and the borrower will then share the proceeds
from this rent based on the current equity share of the partnership. At
the same time, the borrower in the partnership entity also buys the
bank's share of the property at agreed installments until the full
equity is transferred to the borrower and the partnership is ended. If
default occurs, both the bank and the borrower receive a proportion of
the proceeds from the sale of the property based on each party's current
equity. This method allows for floating rates according to the current
market rate such as the BLR (base lending rate), especially in a dual-banking
system like in Malaysia.
There are several other approaches used in business transactions.
Islamic banks lend their money to companies by issuing floating rate
interest loans. The floating rate of interest is pegged to the company's
individual rate of return. Thus the bank's profit on the loan is equal
to a certain percentage of the company's profits. Once the principal
amount of the loan is repaid, the profit-sharing arrangement is
concluded. This practice is called Musharaka. Further, Mudaraba is
venture capital funding of an entrepreneur who provides labor while
financing is provided by the bank so that both profit and risk are
shared. Such participatory arrangements between capital and labor
reflect the Islamic view that the borrower must not bear all the risk/cost
of a failure, resulting in a balanced distribution of income and not
allowing lender to monopolize the economy.
Islamic banking is restricted to Islamically acceptable transactions,
which exclude those involving alcohol, pork, gambling, etc. The aim of
this is to engage in only ethical investing, and moral purchasing.
In theory, Islamic banking is an example of full-reserve banking, with
banks achieving a 100% reserve ratio. However, in practice, this is not
the case, and no examples of 100 per cent reserve banking are observed.
Islamic banks have grown recently in the Muslim world but are a very
small share of the global banking system. Micro-lending institutions
founded by Muslims, notably Grameen Bank, use conventional lending
practices and are popular in some Muslim nations, especially Bangladesh,
but some do not consider them true Islamic banking. However, Muhammad
Yunus, the founder of Grameen Bank and microfinance banking, and other
supporters of microfinance, argue that the lack of collateral and lack
of excessive interest in micro-lending is consistent with the Islamic
prohibition of usury (riba).
Islamic equity funds
Islamic investment equity funds market is one of the fastest-growing
sectors within the Islamic financial system. Currently, there are
approximately 100 Islamic equity funds worldwide. The total assets
managed through these funds currently exceed US$5 billion and is growing
by 12–15% per annum. With the continuous interest in the Islamic
financial system, there are positive signs that more funds will be
launched. Some Western majors have just joined the fray or are thinking
of launching similar Islamic equity products.
Despite these successes, this market has seen a record of poor marketing
as emphasis is on products and not on addressing the needs of investors.
Over the last few years, quite a number of funds have closed down. Most
of the funds tend to target high net worth individuals and corporate
institutions, with minimum investments ranging from US$50,000 to as high
as US$1 million. Target markets for Islamic funds vary, some cater for
their local markets, e.g., Malaysia and Gulf-based investment funds.
Others clearly target the Middle East and Gulf regions, neglecting local
markets and have been accused of failing to serve Muslim communities.
Since the launch of Islamic equity funds in the early 1990s, there has
been the establishment of credible equity benchmarks by Dow Jones
Islamic market index (Dow Jones Indexes pioneered Islamic investment
indexing in 1999) and the FTSE Global Islamic Index Series. The Web site
failaka.com monitors the performance of Islamic equity funds and provide
a comprehensive list of the Islamic funds worldwide.
Islamic laws on trading
The Qur'an prohibits gambling (games of chance involving money) and
insuring ones' health or property (also considered a game of chance).
The hadith, in addition to prohibiting gambling (games of chance), also
prohibits bayu al-gharar (trading in risk, where the Arabic word gharar
is taken to mean "risk" or excessive uncertainty).
The Hanafi madhab (legal school) in Islam defines gharar as "that whose
consequences are hidden." The Shafi legal school defined gharar as "that
whose nature and consequences are hidden" or "that which admits two
possibilities, with the less desirable one being more likely." The
Hanbali school defined it as "that whose consequences are unknown" or "that
which is undeliverable, whether it exists or not." Ibn Hazm of the
Zahiri school wrote "Gharar is where the buyer does not know what he
bought, or the seller does not know what he sold." The modern scholar of
Islam, Professor Mustafa Al-Zarqa, wrote that "Gharar is the sale of
probable items whose existence or characteristics are not certain, due
to the risky nature that makes the trade similar to gambling." There are
a number of hadith that forbid trading in gharar, often giving specific
examples of gharhar transactions (e.g., selling the birds in the sky or
the fish in the water, the catch of the diver, an unborn calf in its
mother's womb etc.). Jurists have sought many complete definitions of
the term. They also came up with the concept of yasir (minor risk); a
financial transaction with a minor risk is deemed to be halal (permissible)
while trading in non-minor risk (bayu al-ghasar) is deemed to be haram.
What gharar is, exactly, was never fully decided upon by the Muslim
jurists. This was mainly due to the complication of having to decide
what is and is not a minor risk. Derivatives instruments (such as stock
options) have only become common relatively recently. Some Islamic banks
do provide brokerage services for stock trading.
Microfinance is a key concern for Muslims states and recently Islamic
banks also. Islamic microfinance tools can enhance security of tenure
and contribute to transformation of lives of the poor. Already, several
microfinance institutions (MFIs) such as FINCA Afghanistan have
introduced Islamic-compliant financial instruments that accommodate
In Islamabad, Pakistan, on June 16, 2004: Members of leading Islamist
political party in Pakistan, the Muttahida Majlis-e-Amal (MMA) party,
staged a protest walkout from the National Assembly of Pakistan against
what they termed derogatory remarks by a minority member on interest
Taking part in the budget debate, M.P. Bhindara, a minority MNA [Member
of the National Assembly]...referred to a decree by an Al-Azhar
University's scholar that bank interest was not un-Islamic. He said
without interest the country could not get foreign loans and could not
achieve the desired progress. A pandemonium broke out in the house over
his remarks as a number of MMA members...rose from their seats in
protest and tried to respond to Mr Bhindara's observations. However,
they were not allowed to speak on a point of order that led to their
walkout.... Later, the opposition members were persuaded by a team of
ministers...to return to the house...the government team accepted the
right of the MMA to respond to the minority member's remarks....
Sahibzada Fazal Karim said the Council of Islamic ideology had decreed
that interest in all its forms was haram in an Islamic society. Hence,
he said, no member had the right to negate this settled issue.
Some Islamic banks charge for the time value of money, the common
economic definition of Interest (Riba). These institutions are
criticized in some quarters of the Muslim community for their lack of
strict adherence to Sharia.
The concept of Ijarah is used by some Islamic Banks (the Islami Bank in
Bangladesh, for example) to apply to the use of money instead of the
more accepted application of supplying goods or services using money as
a vehicle. A fixed fee is added to the amount of the loan that must be
paid to the bank regardless if the loan generates a return on investment
or not. The reasoning is that if the amount owed does not change over
time, it is profit and not interest and therefore acceptable under
Islamic banks are also criticized by some for not applying the principle
of Mudarabah in an acceptable manner. Where Mudarabah stresses the
sharing of risk, critics point out that these banks are eager to take
part in profit-sharing but they have little tolerance for risk. To some
in the Muslim community, these banks may be conforming to the strict
legal interpretations of Sharia but avoid recognizing the intent that
made the law necessary in the first place.
The majority of Islamic banking clients are found in the Gulf states and
in developed countries. With 60% of muslims living in poverty, Islamic
banking is of little benefit to the general population. The majority of
financial institutions that offer Islamic banking services are majority
owned by Non-Muslims. With Muslims working within these organizations
being employed in the marketing of these services and having little
input into the actual day to day management, the veracity of these
institutions and their services are viewed with suspicion. One Malaysian
Bank offering Islamic based investment funds was found to have the
majority of these funds invested in the gaming industry; the managers
administering these funds were non muslim. These types of stories
contribute to the general impression within the muslim populance that
islamic banking is simply another means for banks to increase profits
through growth of deposits and that only the rich derive benefits from
inplementation of Islamic Banking principles.
Swiss private Islamic