Islamic banking gets its name from its compliance to Islamic laws (also known as Shariah laws) governing financial transactions. Islamic law prohibits charging of rent on money that in conventional words means interest and is termed Riba in Islamic laws. The rationale behind not charging interest comes from the Islamic finance concept, which states that interest or riba encourages circulation of wealth in the hands of a few rich entities and limits prosperity to reach to the masses in the society.
However, Islamic banking is not limited to interest-free banking alone but adhering to all Islamic values such as charity, profit sharing, zakat (or Islamic tax collected for the destitute) and not doing business in things classified as haram (or forbidden under injunctions of Islam).
As stated in State Bank of Pakistan’s website that allows Islamic banking practices in that country; “Islamic banking, the more general term is expected not only to avoid interest-based transactions, prohibited in the Islamic Shariah, but also to avoid unethical practices and participate actively in achieving the goals and objectives of an Islamic economy”(faq Islamic banks). The first modern experiment of Islamic banking was carried out in Egypt. This experiment was not labeled as an initiative to establish Islamic banking because the idea holders feared to be labeled as Islamic fundamentalists.
The initiative became a savings back working on profit sharing in the town Mit Ghamr, year 1963( Zaman & Movassaghi 38). Ariff (1988) stated that “These banks neither charged nor paid interest, invested mostly in trade and industry, directly or in partnership with others, and shared profits with depositors” (qtd. in Zaman & Movassaghi 38). It was after the 1970s that Islamic banks saw mushroom growth internationally as stated by Zaman & Movassaghi.
The following banks were opened up; Nasr Social Bank in 1971,Amanah Bank in 1973, the Dubai Islamic Bank in 1975, the Kuwait Finance House in 1977, the Faisal Islamic Bank of Sudan in 1977, Faisal Islamic Bank of Egypt in 1997, the Bahrain Islamic Bank 1979, and the Qatar Islamic Bank 1981. (38). However, it is only in the last few years that Islamic banking and finance has picked up pace and Islamic economists have come up with innovative financial products that are also Shariah compliant. Islamic finance believes that interest on consumer as well as investment or corporate loans is forbidden.
It devises its rulings out of the events of Islamic history and financial transactions there in. Some salient foundations of these rulings are; the concept of profit as well as loss sharing with entities the loans are advanced to. There is no such thing as a confirmed profit in form of interest in Islamic finance. (M. I. Usmani 63). If a custodian is handed money for safekeeping he does not have limited liability but a complete liability towards the clients that handed the money or assets for safe keeping.
The custodian is allowed to invest these amounts in trade and business to earn profits on it. However, is liable to share the profits with the clients according to the ratio of the share of their capital in the entire invested capital (M. I. Usmani 62). Islamic financial practices believe only in asset backed financing and not in money as it does not have any intrinsic value. Therefore, many Islamic banks believe in entering a valid contract with the clients and engage in actual purchase of things such as houses, automobiles or consumer goods and later sell it out to client.
It is imperative to understand the nature of Islamic financial terms of contract and sales too. Under these rulings a contract is void if it violates the Islamic principles governing economics, is not formed through mutual agreement and negotiation, is not part of the normal market transactions and benefits one party over another. Whereas, M. I. Usmani describes sales in Islamic banking are considered void if they do not fulfill these conditions; have a right contract, subject matter, price and possession or delivery promise at the time of transaction (71).
The Islamic modes of financing widely used are namely Musharakah, Mudarabah, Diminshing Mushaharakah, Murabaha, Salam, Istisna, Istijrar, Ijarah and Ijarah Wa Iqtina. Musharakah is a kind of partnership where in profits are shared according to a specified ratio decided upon by the partners in a mutual contract (M. T. Usmani 35). The profit sharing terms of the contract should be mutually agreed to by the partners but should not allocate a fixed return to either of the partners because that is classified as interest. On the other hand, losses are to be shared according to the initial capital invested in the venture.
If compared to the conventional American banks a fixed rate of return is charged termed as interest or markup rate on any capital lent out. Furthermore, American banks do not share liability or losses if the venture that borrowed money accrued losses. However, in Musharakah it is responsibility of bank to share the losses as well. The return of the bank is linked with the profits generated by the venture, if profits are more it will get more profits but the Islamic bank cannot impound these profits but has to share it justly with all the depositors of the bank.
This is not applicable to conventional American banks because they allocate a fixed markup return on loans and cannot therefore also take advantage of sharing profitability of the venture they finance. Mudarabah is closely related to Musharakah but is another form of partnership wherein one partner provides the capital to invest and the other utilizes the capital in business. This is somewhat like the sleeping partner and the working partner concept in conventional banking and financial partnerships. The profit and loss sharing under this mode of finance is left upon the mutual consent of the two partners i.
e. bank and client. However, a fixed lump sum amount irrespective of profits or losses is not allowed. Diminishing musharaka is referred to the mode in which the financer and client have joint ownership of an asset. The financer has a majority stake and the minority stake is with the bank’s client. As the client keeps paying off the parts of payment of the original capital investment his ownership of the asset keeps increasing and the bank’s ownership keeps decreasing. Apart from that the client is supposed to pay a rent on asset to the bank on basis of percentage ownership in the asset. M. I.
Usmani defines murabaha as “a particular kind of sale where the seller expressly mentions the cost of the sold commodity he has incurred and sells it to another person by adding some profit there on” (125). Salam is generally used for Islamic banks to finance agricultural ventures where in a seller agrees to supply particular goods or services to a buyer at a future date of delivery (i. e. mutually consented upon), however, the buyer the price of the transaction is completely paid at spot. (M. I. Usmani 133). In Istisnah, it is a sale transaction where a commodity is transacted before it comes into existence.
It is necessarily for manufactured goods, part or whole of payment is made in advance the bank has right to cancel the contract before manufacturer starts the work. Istijrar involves two parties, a buyer which could be a company seeking financing to purchase the underlying asset and a financial institution. It has two forms; first where the price is determined after all transactions of purchase are complete and second where the price is determined in advance but the purchase is executed from time to time. ( M. I. Usmani 143).
Ijarah (Islamic leasing) is where in the leaser who also is the owner of things transfers the use of thing to another person or the lessee for a mutually agreed time period and on a mutually agreed consideration. Ijarah wa Iqtina (leasing and promise to gift) is a form of leasing agreement in which at the end of the entire payment of lease the object of lease is gifted to the lessee i. e. the ownership is completely transferred. Islamic banks differ from conventional American banks in many ways. Islamic banks design instruments and financing modes in the boundaries prescribed by Islamic law.
Conventional American banks are not subjected to any religious pretexts that define the code of financial ethics but the laws ascertained by financial regulators of the country. American banks are promised a fixed markup rate from the loan that they lend but Islamic bank share both the profit and loss from the forwarded loan. American banks do not encompass any religious taxes to support the community but just the state taxes apply. However, Islamic banks collect the zakat (Islamic tax for benefitting community) and disperse it among the needy segments of the society.
Conventional Islamic banks simply lend the money and are concerned about the principal as well as compound interest payments they receive. However, Islamic banks engage partnerships with clients and partner in the losses or profits of clients. Therefore, they work on understanding the nature of client’s business inside out to monitor their performance. In addition, American banks do not concern the project evaluation or appraisal of their client’s business. This is because they are receiving a designated amount of interest and client’s business proceedings does not affect them.
However, Islamic banks carry out project evaluation of their client because they are a partner in losses as well. In American banking system if an installment is not paid on time or defaulted a compounded interest charge is levied on it. However, in Islamic banking it is prohibited to charge any such late surcharges and care is taken to assess the actual problems faced by the defaulter. If payment was defaulted due to genuine reasons no penalty is imposed but if it was done deliberately then a small compensation is charged. This compensation is not added to the bank’s revenue but is dispersed to charity causes.
American banks may focus only their personal growth targets and revenue growths. However, Islamic banks are required to focus on growth of their partners in business i. e. clients and keeping public interest at heart of future objectives. American banks can borrow money from money markets easily. However, Islamic banks face constraints towards such actions because any borrowings they make have to be Shariah compliant. American banks give greater weightage to the credit ratings of their clients to assess the advancement of loans.
Whereas, Islamic banks emphasize the project viability while deciding upon advancing loans. A typical American bank while financing projects mainly functions as a creditor to its clients (or debtors). On the other hand, Islamic banks become partners, investors, and sellers to their clients which depend upon the modes of finance taken up. Conventional American banks need to guarantee all the deposits they accept. However, Islamic banks only guarantee saving deposit accounts in their portfolio. Their clients have to share the losses as well depending upon the nature of the contract (Rahman).
Securitization is “the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security (i. e. bond issue, share certificate etc) (investopedia. com). Islamic banks have now ventured in securitization of Musharkah, Murabaha, Mudarabah and Ijarah. Many countries now have Mudarbahs listed at stock exchanges to be traded in. Islamic bankers are also bringing investment funds that are compliant with Shariah laws to the financial services market. Some of the funds established include equity fund, commodity fund, ijarah fund, murabaha fund, Bai-Al-Dain, and Mixed fund.
Therefore, it can be seen that Islamic banking sets its foundations in Islamic laws governing financial transparency. These are very different from conventional American banks in their economic concepts, financial products and services offered to clients. Furthermore, Islamic banking is relatively a new concept as compared to the conventional banking and economic concepts that have developed over ages. Islamic bankers and scholars are working upon deriving more products and services based upon Shariah to offer a greater range of financial products in the financial industry.
It holds appeals in its concept of community care and client care. However, the complete implementation of this form of banking on a large scale seems a questionable and daunting task. Works Cited “FAQs”. Sbp. org. pk. Retrieved 28th April from www. sbp. org. pk/ibd/faqs. pdf Rahman, Zaharuddin A. “Differences Between Islamic Bank and Conventional Bank” Zaharuddin. net . Retrieved 28th April 2009 from <http://www. zaharuddin. net/ index. php? option=com_content&task=view&id=297&Itemid=72> Usmani, Muhammad I. Meezanbank’s guide to Islamic Banking. Karachi Pakistan :Darul-Ishaat 2008