What Is Islamic Banking?

Islamic banking, also referred to as Islamic finance or Shariah-compliant

finance, refers to financial activities that adhere to Shariah (Islamic law). Two
fundamental principles of Islamic banking are the sharing of profit and loss
and the prohibition of the collection and payment of interest by lenders and
investors.

KEY TAKEAWAYS

 Islamic banking, also referred to as Islamic finance or Shariah-

compliant finance, refers to finance or banking activities that adhere to
Shariah (Islamic law).
 Two fundamental principles of Islamic banking are the sharing of profit
and loss and the prohibition of the collection and payment of interest by
lenders and investors.
 Islamic banks make a profit through equity participation, which requires
a borrower to give the bank a share in their profits rather than paying
interest.
 Some conventional banks have windows or sections that provide
designated Islamic banking services to their customers.

Islamic Banking Principles

Islamic banking is based on a set of principles linked to Shari’a, ethical, moral, social and
economic standards, most important of which are:

 That financial transactions are, in principle, permissible,

 Prohibition of Riba (usury),
 Prohibition of Gharar (deception and sale of risky assets),
 Prohibition of trading in Haram (prohibited) products and services,
 The need to be linked to real economy,
 The adoption of the risk-sharing principle in contracts for the sale and sharing of profits
and losses in Musharaka contracts and profit-sharing in Mudaraba contracts,
 Prohibition of the sale of items that are not actually acquired,
 As well as other Shari’a principles related to Islamic finance operations.
Principles of Islamic Finance

Islamic finance strictly complies with Sharia law. Contemporary Islamic

finance is based on a number of prohibitions that are not always illegal in the
countries where Islamic financial institutions are operating:

1. Paying or charging an interest

Islam considers lending with interest payments as an exploitative practice that

favors the lender at the expense of the borrower. According to Sharia law,
interest is usury (riba), which is strictly prohibited.

2. Investing in businesses involved in prohibited activities

Some activities, such as producing and selling alcohol or pork, are prohibited
in Islam. The activities are considered haram or forbidden. Therefore,
investing in such activities is likewise forbidden.

3. Speculation (maisir)

Sharia strictly prohibits any form of speculation or gambling, which is

called maisir. Thus, Islamic financial institutions cannot be involved in
contracts where the ownership of goods depends on an uncertain event in the
future.

4. Uncertainty and risk (gharar)

The rules of Islamic finance ban participation in contracts with excessive risk
and/or uncertainty. The term gharar measures the legitimacy of risk or
uncertainty in investments. Gharar is observed with derivative contracts and
short-selling, which are forbidden in Islamic finance.

In addition to the above prohibitions, Islamic finance is based on two other

crucial principles:

 Material finality of the transaction: Each transaction must be related

to a real underlying economic transaction.
 Profit/loss sharing: Parties entering into the contracts in Islamic
finance share profit/loss and risks associated with the transaction. No
one can benefit from the transaction more than the other party.
FORMS OF CONTACTS IN AN ISLAMIC FINANCE

1 MUDARABAH Partnership

2 MUSHARAKA Equity Partnership

3 SUKUK Islamic Bond

4 IJARAH A Form of Lease

5 MURABAHA A Form of credit Sale

MUDARABAH
Mudarabah is a profit-and-loss sharing partnership agreement where one
partner (financier or rab-ul mal) provides the capital to another partner (labor
provider or mudarib) who is responsible for the management and investment of
the capital. The profits are shared between the parties according to a pre-
agreed ratio.

MUSHARAKAH
Musharakah is a form of a joint venture where all partners contribute capital
and share the profit and loss on a pro-rata basis. The major types of these
joint ventures are:

 Diminishing partnership: This type of venture is commonly used to

acquire properties. The bank and investor jointly purchase a property.
Subsequently, the bank gradually transfers its portion of equity in the
property to the investor in exchange for payments.
 Permanent musharkah: This type of joint venture does not have a
specific end date and continues operating as long as the participating
parties agree to continue operations. Generally, it is used to finance
long-term projects.

SUKUK
Is an Islamic bond that are Structured in such a way as to generate returns to investors without infringing
Islamic laws that prohibits interest.

It aims at profit sharing by offering the investor ownership in business or Asset.

So, unlike conventional bonds, Sukuk are linked to an underlying Tangible Asset.

IJARAH (LEASE CONTRACT)

In this type of financing arrangement, the lessor (who must own the property)
leases the property to the lessee in exchange for a stream of rental and
purchase payments, ending with the transfer of property ownership to the
lessee.
 MURABAHA

Five Main Contracts in Islamic Finance

Banking

For Islamic banks to a make profit and to satisfy the borrowers’ needs of cash, they
have to conduct transactions that do not violate Islamic rules by looking for
allowed contracts that can achieve the required goal. Mostly, they are based on
sale and purchase transactions, accompanied by a degree of risk.
There are five main contracts in Islamic finance: Mudarabah, Musharakah,
Murabahah, Ijarah and Salam:
i. Profit and loss sharing (Mudarabah): is a contract between two parties; one
provides the capital and the other provides the labor to form a partnership to
share the profits by certain agreed proportions.
ii. Joint venture (Musharakah): is a financial contract between two or many parties
to establish a commercial enterprise based on capital and labor. The profit and
loss are shared at an agreed proportion according to the amount of contribution.
iii. Cost plus (Murabahah): refers to a sale of a good or property with an agreed
profit against a deferred or a lump sum payment. There are two contracts in
Murabahah: the first contract is between the client and the bank, whereas the
second contract is between the bank and supplier. The client (purchaser) orders
a certain commodity through the bank, the bank then buys the commodity from
the supplier and sells it to the client with specified profit whereby the client can
make a lump sum or a deferred payment to the bank.
iv. Leasing (Ijarah): in which two parties are involved therein: the lessee and
leaser. The leaser (bank) is the real owner of the asset or property and it is
rented out to the lessee until full payment is received. The lessee has the option
to keep the asset at contract maturity or give it back to the bank. If all payments
are received, the lessee can keep the asset but at a higher price than the usual
asset price.
v. Salam: is another contract where full payment for a good is paid in advance but
the delivery of the good is made at an agreed future date.