Basic Principles of Islamic Banking:

An Overview
Prof Abdullah Saeed
University of Melbourne
a.saeed@unimelb.edu.au

The presentation will cover

• Historical overview
• Basic framework and key concepts
• Permissible and prohibited contracts
• Application of key concepts to banking

1
 Historical Overview
• Dealing with money, investment on profit and loss sharing
• Attitude to interest: Sharia on the whole did not accept the
legitimacy of interest
• Western banks in Muslim countries: interest
• Literature on banking without interest: 20th century
• Practical steps: village banks in Egypt
• Islamic Development Bank in Jeddah
• Islamic commercial banks
• Today: network of Islamic banks with a range of products
competing with interest-based banks

Basic Framework-1:
Wealth and Ownership
• Wealth as trust
– Right of the needy; circulation; spending;
hoarding
• Ownership
– Trust; individual/community rights;
– Ways and means:
• labour; gift; inheritance
• all ways and means to acquisition must be halal
• Object of ownership: must be halal

2
 Basic Framework
Concept of Halal and Haram - 1
• Basic principle:
– Generally all ways and means are halal (except
those that are clearly prohibited).
– Prohibition is always an exception

Basic Framework:
Concept of Halal and Haram - 2
• Some of the haram ways and means of acquiring
wealth:
– through riba (interpreted as ‘interest’)
– cheating and fraud: quality, measure, weight
– games of chance (lotteries, betting)
– creating artificial scarcities
– manipulation of prices
– sale and dealing in haram products
– engaging in haram professions (eg prostitution)
– exploitation of the poor, the needy and disadvantaged

3
 Basic Framework:
Concept of Money
• Money as a form of wealth
• Money:
– primary function: medium of exchange
– No price should be charged for money
– Basic rule in lending: return an equal amount

Basic Framework:
Prohibition of Riba
• Riba as interest (differences among Muslims)
• Interest in all forms prohibited
• All interest-based transactions should be avoided
• Interest-based transactions are seen as ‘unjust’:
risk on the borrower

4
 Contracts in Islamic Finance
Permissible and Prohibited Contracts
• Contracts:
– in transactions should be permissible (re
Sharia)
– should be based on mutual agreement
– should not be based on: riba, haram, fraud etc
• Terms that both parties agree to (and are not
based on haram) are acceptable

Banks

• Important institutions but should not be based on

interest
• Banks should be in line with the requirements of
Islamic law
• Alternative ways of operating banks and financial
institutions should be found

5
Interest-based system, risk and profit

• Problems with the system:

– risk on the borrower
• Profit related to risk
• Risk should be shared: both parties
• Profit should be shared on an agreed upon ratio
• Loss should be shared strictly according to capital
contribution

Banks: Profit and Loss Sharing (PLS)

• Banking business should be based on PLS:

– the deposits & investments
– PLS contracts of mudaraba and musharaka will form
the backbone of Islamic banking
• PLS contracts of mudaraba and musharaka will
form the backbone of Islamic banking
• Both contracts are developed in Islamic law
Important to refer to Islamic legal texts to
understand the nature of these contracts

6
 PLS and Deposits

• Bank will mobilise deposits on the basis of PLS

• PLS contract of mudaraba is used
• Features of mudaraba contract (bank:depositors)
• Relationship of the Bank with the Depositors

PLS and Investments

• PLS contracts of mudaraba and musharaka should

be used
• Other forms of non-PLS contracts are also used
(murabaha)
• Fee-based services can be provided
• Relationship of the Bank with its investment
clients (mudaraba, musharaka, murabaha)

7
 Objectives of Islamic Banks: An
Example
• To help Muslims, execute their financial dealings in strict
respect of the ethical, individual and social values of the
Shariah, without contravening the prohibition of dealing
in riba (interest or usury).
• To Serve all Muslim communities in mobilising and
utilising the financial resources needed for their economic
development and prosperity.
• To serve the Islamic communities and other nations by
strengthening the economic and financial cooperation for
economic development