Islamic Banking System

Content

• An overview of Islamic banking

• General principles of Islamic banking

• Fundamental differences between Islamic banking and conventional banking

• Modes of Islamic financing

 An overview of Islamic banking

• 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 economies.

• Sharia prohibits the payment or acceptance of interest fees for 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 (Haram, forbidden)
• The term “riba” means excess, increase or addition which is correctly
interpreted according to sharia terminology implies any excess
compensation without due consideration ( consideration does not
include time value of money).

• Moreover, the definition of “riba” in classical Islamic jurisprudence

was “surplus value without counterpart “ hence its strictly prohibited
in Islamic banking.

• The concept riba is limited to interest. Two forms of riba are identified
in Islamic law.
• They are riba al-garud which relates to usury involving loans and riba al-buyu
which relates to usury involving trade.

• The later riba can take two forms: riba al-fadl which involves an exchange of
unequal qualities or quantities of the same commodity simultaneously.

• Whilst, riba al-nasia involves the non-simultaneous exchange of equal qualities

and quantities of the same commodity.

• The prohibition applies to objects which can be measured or weighted and which
belong to same species.

• Forbidden both in an excess in quantity and delay in performance.

• On the other hand , the first modern experiment of Islamic banking was by
 Ahmed Alnaggar during 1963,

followed by Faisal Islamic bank in Sudan and Islamic development bank in Saudi
Arabia during 1975 as well Dubai Islamic bank was launched also during 1975.

In fact, Islamic banking is growing at a rate 10-15% per year and with signs of
consistent future growth.

Moreover, Islamic banks have more than 300 institutions spread around the world.
• In addition , the world Islamic conference held annually in Bahrain since 1994,
and it is recognized international grouping for Islamic banking and finance.

• Further more , the largest Islamic banks include Islamic development bank, melli
Iran, Alrajhi bank, Bank saderat and so on….

• There are considerable experience in applying Islamic banking system including

Saudi Arabia, Iran, Malaysia, Sudan and so on.
 General principles of Islamic Banking

• Islamic banks must conduct business according to basic principles including:

• Sales (bai)
• Hire (Ijarah)
• Gift (hiba)
• Loan( ariyah)
• Moreover, there are five religious principles must be flowed in investment behavior:
1. All activities must be in line with Islamic principles with special sharia board to
supervise and advise the bank on the propriety of transactions.

2. Riba is prohibited in all transactions

3. Business and investment are undertaken on the basics of halal ( legal, permitted
activities).

4. Maysir (gambling) is prohibited and transactions must be free from gharar

(speculation or unreasonable uncertainty).

5. Zakat must be paid by bank to benefit society .

Fundamental Differences between Islamic and
Conventional Banking
Islamic Banking Conventional Banking

A step toward Islamic economics A part of capitalist interest based system

To ensure social justice and welfare Not concerned with social justice &
welfare
Flow of financial resources in favor of Not concerned with poor people
poor people

Reducing income inequality and wealth Increasing the gap between rich and poor
disparity between rich and poor people

Investments funds in favor of poor people Investment funds in favor of rich people
Modes of Islamic Financing

Islamic financing covers a wide range of modes including:

Mudaraba, Murabaha, Musharaka, Ijarah, Istisna, Salum ,Gard Hassan ,Sukuk
Takaful , Islamic equity .
1. Mudaraba:

• Mudaraba is a special kind of partnership where one partner gives money to

another for investing it in commercial enterprise.

• The investment comes from the first partner who is called “rabb-ul -mal” , while
the management and work is an exclusive responsibility of the other , who is
called “mudarib”
2. Musharaka:

• Musharaka (joint venture with capital) is an arrangement or agreement between

two or more partners, whereby each partner provides funds to be used in a
venture.

• Profit made are shared between the partners according to the invested capital
• In case of loss, each partner looses the capital in the same ratio.
• If the Bank is providing capital, same conditions apply.
3. Murabaha:

• This concept refers to the sale of goods at a price, which includes a profit margin
agreed to by both parties.

• The purchase and selling price, other costs, and the profit margin must be clearly
stated at the time of sale agreement.

• The bank is compensated for the time value of its money in the form of the profit
margin.
4. Ijarah:

Ijarah means lease, rent or wage, Generally, Ijarah concept means selling the benefit
of use or service for a fixed price or wage.

Under this concept , the bank makes available to the customer the use of service of
assets equipment's such as plant, office automation ,motor vehicle for a fixed period
and price.
5. Istisna:

• It is a contract in which a party orders another party to manufacture and provide a

commodity, the description of which ,delivery date, price and payment date are all
set in the contract.

• This type of contract of a binding nature and payment of price could be deferred.
6. Bai Alsalam:
• It is a sales contract in which the price is paid in advance at the time of
contracting against delivery of the purchased goods/services and of the lease
agreement.

• This transfer of ownership is made through a new contract, in which the leased
asset is either given to the lessee as a gift or sold to him at nominal price at the
end of the lease agreement.
7. Qard Hassan:

This a loan extended on a goodwill basis, and the debtor is only required to repay
the amount borrowed.

However, the debtor may, pay an extra amount beyond the principal amount of loan
(without promising it) as an appreciated to the creditors.
8. Sukuk (Islamic Bonds):

• A sukuk is an Islamic financial certificate, similar to a bond in Western

finance, that complies with Islamic religious law commonly known as
Sharia. ... The issuer must also make a contractual promise to buy back
the bond at a future date at par value.

• Difference between Sukuk & Bonds

• Sukuk are Sharia-compliant financial certificates through which investors
gain partial ownership on an issuer's assets until maturity.
While Bonds are financial certificates through which investors lend
money to the issuer, indicating an obligation for repayment at maturity
i.e. assets based security not debt instruments.
9. Takaful (Islamic Insurance):

• Takaful is an alternative form of cover that a Muslim can insure himself against
the risk of loss due to misfortunes.

• Takaful is a type of Islamic insurance wherein members contribute money into a

pool system to guarantee each other.

• Takaful-branded insurance is based on sharia or Islamic religious law and covers

health, life, and general insurance needs.

• Any claims made by participants are paid out of the takaful fund.
9. Takaful (Islamic Insurance) Cont.

• Unlike conventional insurance, which risk is transferred from the insured

to the insurer, the Takaful Insurance mutual risk is shared amongst the
participants. Takaful operations are based upon the principles of mutuality,
whereby each participant makes a donation to a Takaful fund.
10. 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