Banking Basics of Islamic Banking Islamic Banking is based on Shariah Laws.
Shariah covers every aspect of our life, it provides
principles how to live at individual level, in the society, legal and economic system, etc. or simply it is a complete code of life. Governing principles of Islamic Banking
1. The prohibition of interest or riba based transactions
2. Avoidance of speculations (gharar)
3. Avoidance of oppression (zulm)
4. Introduction of Islamic tax (zakat)
5. Financing of Sharia Approved activities and
discouraging the production of goods and services which are not allowed in Islamic values (haram). 1. The prohibition of interest based transactions Those who charge usury (riba/interest) are in the same position as those controlled by the devils influence. This is because they claim that usury is the same as commerce. However, God permits commerce and prohibits usury. Thus, whoever heeds this commandment from his Lord and refrains from usury, he may keep his past earnings and his judgment rests with God. As for those who persist in usury, they will incur Hell, wherein they abide forever. (2:274) 1. The prohibition of interest based transactions Riba literally means increase or excess. An increase in a loan transaction or exchange of commodity accrues to the owner without giving an equivalent compensation in return. For example
Exchanging 1kg of grapes with 1.5kg of grapes that are
of the same type, quality and value.
Exchanging Rs.1000 for Rs.1100.
For the same items any difference in their exchange value
is interest whereas pricing of different items while exchanging is allowed. 1. The prohibition of interest based transactions Prohibition of Riba will promote an economic behavior which is
economically just (value addition)
socially fair and ethically correct (equal opportunities).
Inequality is definite in the situation where the lender is
guaranteed a positive return without assuming any share of the borrowers risk whereas the borrower takes upon himself all sorts of risks in addition to his skills and labor. 1. The prohibition of interest based transactions Riba violates the principle of property rights
Money lent on interest is used either productively that it
creates additional wealth or otherwise. When money used (together with labor and entrepreneurial skills) to produce additional wealth, such money lent cannot have any property rights claim to the incremental wealth because there was no prior bargain over it. Instead interest, demanded a guaranteed return regardless of the enterprise. 1. The prohibition of interest based transactions Promotion of profit-and-risk-sharing
The sharing of risks and uncertainties of the enterprise is
fundamental to Shariah contracts. Shariah condemns the act of guaranteeing (even by the entrepreneur) to restore the invested funds intact. 1. The prohibition of interest based transactions Lending is a righteous act
Lending should be a generous act. If money is needed
other than for commercial purposes (thus, risk sharing), such need should not be exploited where the borrower is put under undue burden.
Allah says in Quran
Who is he that will lend unto Allah a goodly loan, that He
may double it for him or his may be a rich reward(57:11) 2. Avoidance of speculations (Gharar)
Definition of Gharar
An Islamic finance term describing a risky or
unsafe sale, where details concerning the sale item are unknown or uncertain. Gharar is generally prohibited under Islam, which explicitly forbids trades that are considered to have excessive risk due to uncertainty. 2. Avoidance of speculations (Gharar) Most of the Islamic scholars view Gharar as both ignorance of the material attributes of the subject matter of a sale and also uncertainty regarding its availability and existence. Majority of derivative contracts are forbidden and considered invalid because of the uncertainty involved in the future delivery of the underlying asset such as forwards, futures and options, short selling, and speculation. 2. Avoidance of speculations (Gharar)
Gharar is prevented when transactions are
transparent with:
all details agreed in advance; and
ownership undisputed.
However, Gharar may be tolerated if there is an
important Maslahah or public benefit. 2. Avoidance of speculations (Gharar) Preventable uncertainty is present in any contract subject to risks in the ordinary course of business Istisna or salam contracts.
Prohibition of Gharar is indirectly a risk management
technique in Islam therefore encouraging the exercise of due diligence and avoidance of contracts with high degree of information inconsistency with high turnover.
Treating Gharar as risk has its penalties i.e. trading of
risks therefore is prohibited where the traded risks may have been transferable in derivative format. 3. Avoidance of oppression (zulm) Zulm refers to all form of inequity, injustice, exploitation, oppression and wrong doing.
A person either deprives others of their rights or does not
fulfill his obligations towards them.
Zulm also refers to trading in matters which are prohibited
(haram) under Shariah such as:-
a. alcoholic drinks/beverages; and
b. non halal poultry/meat, pork.
An extension of the social justice and fair economics.
Comparison of Islamic with Conventional Banks Islamic banks Conventional banks The functions and operating The functions and operating modes of Islamic banks are modes of conventional based on the principles of banks are based on fully Islamic Shariah. manmade principles (capitalism theory). Comparison of Islamic with Conventional Banks Islamic banks Conventional banks
It promotes risk sharing The investor/lender is
between provider of capital guaranteed of a (investor) and the user of predetermined rate of funds (entrepreneur). interest or returns. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks
It also aims at maximizing Unrestricted profit
profit but subject to Shariah maximization illustrated by restrictions. derivatives trading, deposit multiplication, etc. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks In the modern Islamic Conventional banks do offer banking system, it has the service of Zakat become one of the service- deduction but the depositors oriented functions of the are reluctant to pay Zakat Islamic banks to be a Zakat from their accounts in collection centre and they conventional banks. also pay out their Zakat. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks Participation in partnership Lending money and getting business is the fundamental it back with compounding function of the Islamic interest is the fundamental banks. function of the conventional banks. Money is a commodity and the motivation. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks Islamic banks have no It can charge additional provision to charge any money (penalty and extra money from the compounded interest) in defaulters except for case of defaults. compensation and is used for charitable purposes. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks
Importance is given to the Banks interest is the main
public interest. Its ultimate objective. It makes no effort aim is to ensure growth with to ensure growth with equity. fairness. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks
For the Islamic banks, it Interest-based commercial
must be based on a Shariah banks dont care about the approved underlying activities being performed transaction. with their financing. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks Since income from the
Since it shares profit and advances/loans is fixed, it
loss, the Islamic banks pay gives little importance to
greater attention to developing expertise in
developing project appraisal project appraisal and
and evaluations. evaluations. Risks are
transferable at a price (insurance). Comparison of Islamic with Conventional Banks Islamic banks Conventional banks
Greater emphasis on the The conventional banks give
viability of the projects. greater emphasis on creditworthiness of the clients. Comparison of Islamic with Conventional Banks Islamic banks Conventional banks Islamic bank can only A conventional bank has to guarantee deposits for deposit account, which is guarantee all its deposits. based on the principle of al- wadiah, thus the depositors are guaranteed repayment of their funds, however if the account is based on the Mudarabah concept, client have to share in a loss position. 4. Introduction of Islamic tax (zakat) Islamic banks perform as their obligatory duty to take care of the whole system of Zakat as its principal religious liability, and they pay Zakat themselves as well.
Naturally Islamic banks will be trusted more than the
conventional banks to perform this job. 5. Financing of Sharia Approved activities
Islamic banks will make sure that funds are used
only in Sharia approved economic activities, e.g. businesses of alcoholic goods, narcotics, haram meat, pork, casinos, and prostitutions, etc. Islamic Modes of Financing Participatory Modes 1. Mudarabah 2. Musharakah Sale Modes 1. Murabaha 2. Salam and parallel salam 3. Istisna and parallel Istisna Rent based Modes 1. Ijarah 2. Ijarah wa Iqtina