Learn

About Islamic Banking

 

What is Islamic Banking?

Islamic Banking is the commercial banking activity that is derived from the rules ascribed from the Islamic Laws; the Islamic Laws are more commonly called the ‘Sharia’h Laws’. The Shariah Laws provide guidance on each and every aspect of human life, and the laws which govern and guide the financial and commercial transactions define Islamic Banking activities. The most important feature of Islamic Banking is it promotes a greater degree of fairness and equity in the conduct of business.

 


 

What is Shariah?

Sharia’h means a way or path. In Islam, Sharia’h refers to the divine guidance & laws derived from Holy Quran and the Sunnah (sayings, deeds and approvals of Prophet Muhammad(peace be upon him). In Islam, anything that is mentioned in the Holy Quran and/or that is proven by way of sayings, deeds, and approvals of the Prophet Muhammad (peace be upon him) is a path of guidance.

 


 

What are the sources of Sharia’h?

Islamic Laws are derived from the following primary sources

  • The Holy Quran (the revelation from Allah to Prophet Muhammad (P.B.U.H) for mankind)
  • The Sunnah of the Holy Prophet – the sayings, deeds, and approvals of the Prophet Muhammad (P.B.U.H)
  • While the following are also used in reaching a ruling:

  • Ijma’a – the complete consensus of the Scholars
  • Qiyas – the reasoning based on analogy referring to Holy Quran and Sunnah
  • Ijtihad – the opinions of Scholars on the contemporary issues based on their reasoning and analysis
  •  


     

    How is Shariah Governance managed in an Islamic Banking context?

    Sharia’h Governance is a management effort within the Islamic Bank to have such systems and qualified resources in place to ensure that all products and transactions carried out by the organization are in compliance with the rules of Sharia’h Law. The Governance is overlooked by a ‘Shariah Supervisory Board’.

     


     

    What is a Shariah Supervisory Board?

    A Shariah Supervisory Board is an independent body of specialized jurists in fiqh al-muamalat (Islamic commercial jurisprudence). Sharia’h Board Members are experts in the field of Islamic financial institutions who bear the responsibility of directing, reviewing, advising and supervising the management with regard to activities of the Islamic financial institution in order to ensure that all the activities are in compliance with Islamic Shariah rules and principles. The fatwa and rulings of the Shariah Supervisory Board are be binding on the Islamic financial institution.

     


     

    What is a fatwa?

    A Fatwa is an authoritative legal opinion based on Sharia’h Law. A Fatwa is issued by a qualified person or body with authoritative knowledge of Sharia’h Law.

     


     

    What are the main differences between Conventional Banking and Islamic Banking?

    The main differentiating factors of Islamic Banking vs. the conventional banking practices are;

    • Prohibition of Riba/Interest
    • The ban on uncertainty and speculation in transactions
    • Prohibition on certain economic sectors such as, liquor, gambling, tobacco etc.
    • The profit and loss sharing principle
    • Asset backed or Asset based financing principle*

     


     

    What is Riba?

    Riba is paying or charging interest on a loan or deposit. Any amount over and above the principal, in a contract of loan is ‘Riba’ which is prohibited by the Holy Quran and Sunnah, regardless of whether the loan is taken for the purpose of consumption or business.
    Moreover, in today’s business practices, Riba may come in other forms such as penalty for late payment of debt, discounting of commercial paper, factoring of receivables, and anything which can be linked as compensation to time value of money.

     


     

    Why has Riba been prohibited by Islam?

    The rationale behind the prohibition of Riba in Islam suggests an economic system where all forms of exploitation are eliminated. In particular, Islam aims to establish justice between the financier and the borrower: the financier should not be assured of a positive return without doing any work or sharing in the risk, while the borrower, in spite of his management and hard work, is not assured of such a positive return.
    Islam does not recognize money as a commodity having an intrinsic value and so someone cannot make a guaranteed return just out of advancing loans. Shariah requires finance to be accompanied by human work, risk sharing, and management to earn a return.

     


     

    Comparison of Conventional Banking vs. Islamic Banking

    Conventional Banking

    Islamic Banking

    Money is a commodity besides medium of exchange and store of value. Therefore, it can be sold at a price higher than its face value and it can also be rented out.

    Money is not a commodity though it is used as a medium of exchange and store of value. Therefore, it cannot be sold at a price higher than its face value or rented out.

    Time value is the basis for charging interest on capital.

    Profit on trade/sale of goods, leasing of assets or fee on providing service is the basis for earning profit.

    While disbursing cash finance, running finance or working capital finance, no agreement for exchange of goods & services is made.

    The execution of agreements for the exchange of goods & services is a must, while disbursing funds under Murabaha(commodity/metal trading)

    All sorts of economic sectors can be financed

    Islamic Finance doesn’t allow financing or engagement of certain sectors which are prohibited such as liquor, tobacco, gambling

    The savings accounts operate on a pure interest model. The rates are announced in advance and are fixed.

    The savings accounts work on a Mudaraba model where bank is the Mudarib and Customer is the Rab-bul-Maal and Bank and Customers share profits in a pre-agreed ratio, banks are liable to disclose the ratios used to declare profits. The rates cannot be confirmed in advance as the outcome is dependent on the returns earned by the bank.

     


     

    Shariah Contracts and their Usage in financial transactions

    All the financial and commercial transactions between the individuals and the financial institutions are governed by the specific Shariah Contracts, which have been derived by Sharia’s Scholars, after research through the sources of Sharia’h. The specifications and the terms of these contracts are derived from the rules elaborated by Sharia’h Law.

     

    The basic Shariah Contracts and their usage in Islamic Banking

    The Sharia’s Scholars allow the usage the following basic Shariah Contracts to assist the customers in fulfilling their needs according to the rules specified by the Shariah.

     


     

    The Ijarah Contract

    Ijarah Contract

    Areas of Application

    Ijarah is an agreement whereby Bank purchases the property (moveable or immovable) in its own name, and leases it to the customer to the Customer for the usage, with an option to purchase the item at the end or during the lease period at a pre-agreed price.

    Ijarah Contracts are most suitable for Home Financing, whereby the Bank (lessor) buys the property and the Customer (lessee) uses the property and provides rentals for an agreed period. At the end of the lease term, the home, moves into customer’s name.
    This is applicable for Auto/Car financing too.

     


     

    The Mudaraba Contract

    Mudaraba Contract

    Areas of Application

    Mudaraba Contract is a profit sharing arrangement wherein capital provider (Rabb-ul-Maal) bears the risk and the Manager of funds (Mudarib) contributes expertise and management skills to employ the funds in Shariah Compliant activities and obtain a rate of return.

    Mudaraba Contracts are mainly used in Savings Accounts and Fixed Deposits (Term Investments) for Islamic Banks.
    The customers (Rabb-ul-Maal) provide the funds and pre-agree with the Bank (Mudarib or Fund Manager) on a profit sharing ratio. The Mudarib invests the funds and shares the return with the customer at the end of the term.

     


     

    Murabaha Contract

    Murabaha Contract

    Areas of Application

    Murabaha simply means a Cost Plus (Fixed) Profit = Sales contract, whereby the profit margin is known by the customer. After the sale has happened, the Seller is not allowed to change the price throughout the contract.  

    Murabaha Contracts are widely used in providing Personal Financing and Car financing contracts by the Islamic Banks.

    For example; the bank, on the instructions of the customer, buys the car and immediately sells it to the customer by applying its profit margin. The ownership of the Car also moves into Customer’s name.

    In Personal Finance, if the customer indicates he/she is interested in buying goods, the Bank buys the goods for the customer from the vendor and sells it to the customer by applying its profit.

     


     

    The Ujrah Contract

    The Ujrah Contract

    Areas of Application

    Compensation or a service charge, or contract of agency in which one person appoints someone else to perform a certain task on his or her behalf, usually conducted against a certain fee.

    Ujrah contracts are widely used in terms of Islamic Credit Cards, whereby Customers are provided the facility to use the Cards issued to them for their personal needs, and the Bank pays the vendors and merchants on Customer’s behalf. For this monthly activity Bank applies a monthly fee to the customers. 

     


     

    Takaful (Islamic Insurance)

    Takaful Principles
    (usage of Mudaraba Contract)

    Areas of Application

    Takaful is a co-operative system whereby a fund is managed by an operator from the small regular contributions provided by individuals, paid to individuals who want coverage against the hazardous events.

    The foundation of this concept is traced as early as 1400 years ago, when the Muslims of Mecca and Medina laid the foundation of mutual cooperation in the system of shared responsibility.

    According to this principle the Mudarib (takaful operator) accepts payment of the takaful installments or takaful contributions premiums, known as ra’s-ul-mal) from investors or providers of capital or funds (takaful participants), acting as Sahib-ul-mal.

    The contract specifies how the profits  (or surplus) from the operations of the takaful is to be shared in accordance with the principle of Mudaraba – between the participants (as providers of capital) and the takaful operator.