An overview of Islamic banking

Published January 2, 2009

ISLAMIC banking signifies banking operations that comply with provisions given in the fundamental Islamic texts. While some of these norms are shared by Islamic and western financial systems, certain norms are exclusive to Islam.

In fact, some Islamic banking restrictions are severe enough to render certain western banking practices and transactions absolutely void. Prohibition of riba and gharar are two of the main restrictions imposed by the Quran and the Sunnah. Most of the present-day Islamic scholars agree that riba, which literally means “an excess”, includes both usury and interest. The prohibition of riba is generally considered to be the most important of all Islamic banking principles. Gharar signifies ambiguity, uncertainty, or lack of specificity in the terms of a financial contract.

As riba is prohibited, suppliers of capital become investors instead of creditors. Also, investment can only be made in permitted commodities and activities. For instance, one cannot deal in the import and export of alcohol. Similarly, it is not allowed to invest in a casino.

Based on the above-mentioned principles, there is a variety of Islamic banking instruments and transactions in vogue. Musharaka is a business structure in which the bank not only makes a financial contribution to the enterprise, but may also participate in managing the venture. Profits are shared between the parties according to a pre-determined ratio, and losses are borne by them in proportion to their capital contributions. In terms of classification, this is an equity-based transaction.

In mudaraba, the bank provides the requisite financial resources, but does not participate in managing the enterprise. It is a form of partnership in which one party provides the funds while the other provides expertise and management. Profits are divided among the parties according to a mutually agreed ratio. Financial losses are borne by the investor alone. This is also an equity-based transaction.

Murabaha is an arrangement in which the bank, instead of advancing a loan to the client wishing to purchase certain goods or equipment, purchases the items and sells them to the client at cost plus a declared profit.

In tawarruq, the bank buys an asset and immediately sells it to the client on a deferred payment basis. The client then sells the same to a third party for immediate delivery and payment. Consequently, the client receives a cash amount and has a deferred payment obligation for the marked-up price to the bank. The asset is typically a metal, like copper or platinum.

Ijarah is the leasing or hiring of a physical asset, and it is one of the fastest growing activities of Islamic banks. It must be mentioned that some of the transactions and instruments are not considered to be in conformity with Islamic law by all Muslim scholars. Those opposing these practices do so by pointing out the hidden or concealed elements of riba and gharar in them. For example, actual administrative fee is one thing and interest in the name of administrative fee is another.

In fact, every bank conducting Islamic operations has a committee of Muslim scholars, called the “Sharia committee”, that determines whether a product or practice complies with Islamic law. As there is no set of binding uniform rules, Sharia committees, at times, give conflicting rulings. There can also be a difference between two countries or regions. For instance, in Malaysia, Islamic banking restrictions are interpreted more liberally than in the Gulf.

Another shortcoming confronting Islamic banking is the shortage of qualified professionals. There are not many people who are equally skilled in conventional banking and Islamic law. A person well acquainted with conventional banking can easily understand any Islamic product; however, one cannot develop or market such a product without knowing the rules and logic unique to Islam.

To summarise, lack of uniformity in laws and procedures, and deficiency of skilled professionals are among the main hurdles faced by Islamic banks and their clients. However, the industry is growing — the Arab oil money being one of the main driving forces. This is evident not only from the number of banks established specifically for practising Sharia-compliant finance, but also from the increasing number of western or conventional banks engaging in such operations.

The writer is a graduate of Harvard Law School and specialises in Islamic finance. syed_asad@post.harvard.edu

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